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Corporate Ownership & Control / Volume 13, Issue 1, Autumn 2015, Continued – 2

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CORPORATE

OWNERSHIP & CONTROL

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CORPORATE OWNERSHIP & CONTROL VOLUME 13, ISSUE 1, AUTUMN 2015, СONTINUED – 2

CONTENTS

ROLE OF NON-EXECUTIVE DIRECTORS IN IMPLEMENTING NON-REGULATORY CODES ON CORPORATE GOVERNANCE IN SMES LISTED IN THE ALTERNATIVE INVESTMENT MARKET IN THE UK: A CONTENT ANALYSIS 220 Anil Chandrakumara, Gunetilleke Walter BANKS’ SOCIAL INVESTMENT AND MARKET SHARE 237 Martie P. Mphelo, Collins C. Ngwakwe LEVERAGING VALUE WITH INTANGIBLES: MORE GUARANTEES WITH LESS COLLATERAL? 241 Roberto Moro Visconti REVENUES FROM RELATED PARTIES: A RISK FACTOR IN ITALIAN LISTED COMPANY FINANCIAL STATEMENTS 254 Fabrizio Bava, Melchiorre Gromis di Trana THE EFFECT OF IFRS ENFORCEMENT FACTORS ON ANALYSTS’ EARNINGS FORECASTS ACCURACY 266 Nadia Cheikh Rouhou, Wyème Ben Mrad Douagi, Khaled Hussainey COMMITMENT TO MARKETING STRATEGIES IN COOPERATIVE BUSINESS ARRANGEMENT: ROLE OF APPROPRIATE INTELLIGENCE GENERATION AND INCLUSIVE PARTICIPATION 283 Joseph Musandiwa, Mercy Mpinganjira PRODUCTIVITY AND STOCK PRICE REACTION TO SPIN-OFF DECISION 292 Manojj M., Mridula Sahay THE RELATIONSHIP BETWEEN CAPITAL STRUCTURE AND FINANCIAL PERFORMANCE OF FIRMS LISTED ON THE NAIROBI SECURITIES EXCHANGE 296 Odhiambo Luther Otieno, Sam Ngwenya


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SOCIAL CAPITAL INTERVENTIONS AT FIRM LEVEL AFFECTING PERFORMANCE IN THE ZIMBABWEAN MANUFACTURING SECTOR 315 Patience Siwadi, Collins Miruka, Florence Achieng Ogutu BANK DISCLOSURE PRACTICES: IMPACT OF USERS’ PERSPECTIVE OF FINANCIAL GOVERNANCE 324 George Hooi, Pran Boolaky


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ROLE OF NON-EXECUTIVE DIRECTORS IN IMPLEMENTING NON-REGULATORY CODES ON CORPORATE GOVERNANCE IN SMES LISTED IN THE ALTERNATIVE INVESTMENT MARKET IN

THE UK: A CONTENT ANALYSIS

Anil Chandrakumara*, Gunetilleke Walter**

Abstract

This study explores roles of NEDs of SMEs listed in the Alternative Investment Market (AIM) in the London Stock Exchange. It extends the literature on NEDs’ roles relevant to a context where the adherence to the principles of non-regularity corporate governance is not compulsory. We adopted a content analysis approach as a novel method for exploring roles of NEDs using details of 1220 NEDs recorded in 75 annual reports. It revealed that NEDs meet the expectations of several stakeholders simultaneously by playing multiple roles. A conceptual model depicting testable relationship between cognitive tasks and key roles of NEDs is also developed.

Keywords: Roles of NEDs, SMEs, Content Analysis, Corporate Governance in AIM Companies, Role Theory *School of Management, Operations and Marketing, Faculty of Business, University of Wollongong, Australia, NSW 2522 **University of Roehampton, London SW15 5PU, United Kingdom

1 Introduction The separation of ownership and management in listed companies demands the appointment of the Non-Executive Directors (NEDs) into the board of directors to align the interests of the managers and the shareholders (Fama and Jensen, 1983a). However, corporate governance problems such as expropriation of assets of the shareholders by managers (Shleifer and Vishny, 1997), excessive salary increases for CEOs and other executives (Bebchuk and Fried, 2005), expenditure on decoration of office complexes and luxury facilities (Berle and Means, 1933) etc. are some of the sources of conflicts of interests between the shareholders and the managers. Although these conflicts have been documented as relevant to large scale and public limited liability firms, they might be generally applicable for any small or medium firms (SMEs) listed in the Alternative Investment Market (AIM) (e.g. Chris and Kean, 2010; Gunatilake and Chandrakumara, 2012). The negligence of duties towards a number of other stakeholders such as debtors and suppliers has also been noted by a number of other researchers (e.g. Byrd and Hickman, 1992; Donaldson and Preston, 1995; Helland and Sykuta, 2005; Belden, Fister and Knapp, 2005). Essentially, these issues are associated with roles of NEDs directors (Maseda et al., 2014) and codes on corporate governance.

With regard to empirical research on the roles of NEDs in SMEs, a number of related issues have also been reported. First, research on roles of NEDs in SMEs has not received adequate and continuous

attention (e.g. Seiascia et al., 2013; Voordeckers et al., 2007) and they have largely been taken only when there are corporate collapses (Jones and Pollit, 2003; Šević, 2005). Second, the topic of corporate governance role in SMEs is relatively recent (Gnan et al., 2013; Al-Najjar, 2014) and largely under researched, and remains poorly theorized (Seiascia et al., 2013; Pye and Pettigrew; 2005, Collier, 2004). Third, the role of NEDs in SMEs has not been examined in the context where the implementation of NRCCGA is not compulsory. As such, this paper aims at filling the knowledge gap in understanding the role of NEDs of SMEs listed in the Alternative Investment Market (AIM) in the London Stock Exchange with specific reference to voluntary codes on corporate governance. Specifically, this study examines (a) what are the roles played by NEDs of SMEs in AIM listed companies in the UK? (b) What characteristics of NEDs’ roles of these companies could be identified through content analysis? and, (c) Is there any relationship between different roles played by NEDs of AIM companies?

The AIM has grown in many aspects since its launch in 1995 to date, which includes an increase in number of the UK and international companies to 861 and 226 respectively and in equity capital from a mere £82 million to £80,592 million(AIM, 2014). However, there is a dearth of research on the AIM listed companies. For example, we have found only two papers which discuss some aspects of the corporate life of these companies and with the use the phrase ‘Alternative Investment Market’ within the title of their papers (Mallin and Ow-Yong, 1998;


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Parsa and Kouchy, 2008; Alessandra, 2010). Further, NEDs in SMEs play such critical roles as advising, formulating strategies, supervising day to day operations, paying marketing visits to foreign firms etc. (e.g. Deakins, O’Neill and Milliken, 2000; Corbetta and Salvato, 2004; Long, Dulewicz and Gay, 2005; Minichilli and Hansen, 2007). However, the role of NEDs with regard to voluntary application of the UK’s Code on Corporate Governance by the AIM listed firms has not been paid much attention. This may be due to the fact that those SMEs that are new to listing might consider that some of the provisions are disproportionate or less relevant in their cases or some of the provisions do not apply for companies below the FTSE 350 (Financial Times Stock Exchange -350). Given these realities, such SMEs may consider that it might be appropriate for them to adopt the approach outlined in the Code as they are encouraged to do so (FRC, 2012). As such, this study is aimed at contributing to the knowledge in understanding the role of NEDs of SMEs in implementing the NRCCG by the AIM listed companies in the UK.

The paper proceeds as follows. Introduction to the study is followed by a brief review of literature on the role of NEDs and role theories. Research methodology with the adoption of content analysis is presented in detail in the second section of the paper. The presentation of results and discussion of finding is presented next. Finally, we conclude the paper with our contribution to the knowledge on the role of NEDs of SMEs listed in AIM in London stock exchange with a direction for further research.

2 Literaure review The role of the directors of public limited liability companies in the UK is explained broadly in sections 171 to 177 in the Companies Act of 2006 as (i) to serve the company within the powers, (ii) promotion of the business and (iii) exercise judgment and exercise reasonable care. The Corporate Governance Code (FRC, 2012) in the UK explains the role of the NEDs as follows:

‘Non-executive directors should scrutinise the performance of management in meeting agreed goals and objectives and monitor the reporting of performance. They should satisfy themselves on the integrity of financial information and that financial controls and systems of risk management are robust and defensible. They are responsible for determining appropriate levels of remuneration of executive directors and have a prime role in appointing and, where necessary, removing executive directors, and in succession planning’ (FRC, 2012, p.10).

Within the unitary board system in the UK,

executive directors as well as the NEDs take joint decisions and bind them all for the decisions taken (Davies, 2003; Conyon and Muldoon, 2006). A

unitary board system or any other board system such as the two-tier system of boards exists in countries such as Germany and Japan (Vives, 2000), members in the board could have many differences in terms of the age, qualifications, experience and so on. A number of authors note the importance of a mixed bag of cognitive tasks such as right perception, positive beliefs, assumptions and attributions necessary to create a successful board (Walsh and Seward, 1990; Forbes and Milliken, 1999; Sundaramurthy and Lewis, 2003; Haleblian and Rajagopalan, 2006).

According to Stiles and Taylor (2001), NEDs are required to execute three roles: monitoring the managers, setting the strategic frame, and the service. However, they argue that ‘the strategic role is said to be the defining role of the board and given the term ‘director’ means playing an important part in determining organization’s effectiveness’ (Styles and Taylor, 2001, p.27). Because of the significanct nature of these roles, a board is explained as the apex of the firm’s decision control system by Fama and Jensen (1983a). Many authors also agree on the fact that the NEDs perform a vital function in securing vital resources for the SMEs such as the markets, technology, financial institutions and so on (Neilsen and Rao, 1987; Burt, 1997). In general, Mintzberg (1983) identified seven roles of the NEDs: (1) selecting the CEO; (2) exercising direct control during periods of crisis; (3) reviewing managerial decisions and performance; (4) co-opting external influencers; (5) establishing contacts and raising funds; (6) enhancing the organisation’s reputation and (7) giving advice to the organisation.

In addition, Roberts, McNulty and Stiles (2005) emphasise the need to create accountability within the board by the NEDs in making an effective dialogue at the board meetings. Accordingly, NEDs could be effective if only they pay their attention at the board meetings in challenging and questioning appropriately about the assumptions of the managers while supporting them. They caution that the NEDs must understand about their non-executive function and must have an incremental approach with a mindset of an ‘experienced ignorance’ which they term as ‘… just by asking the idiot-boy questions’ (Roberts, McNulty and Stiles, 2005, p.14). Useem (2003) also note that corporate failure could be avoided with probing and challenging the assumptions of the managers. A synthesis of several arguments cited above has been brought under a concept of “corporate directing” by Pye (2002), which covers governing, strategizing and leading. Corporate directing includes, ‘more than just board behaviour, but all aspects of directors’ communications, both explicit and implicit as well as inside and outside their organisation in the process of shaping their organisation’s future’ (Pye,2002, P.155).

http://uwl.summon.serialssolutions.com/search?s.dym=false&s.q=Author%3A%22Colombelli%2C+Alessandra%22


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3 Theories on roles According to the above analysis, the role of the board is complex and it has to deal with a multitude of tasks other than the monitoring and controlling proposed by the agency theorists (Jensen and Meckling, 1976; Eisenhardt, 1989). As such, the approach of this paper is to use the Role Theory (Sarbin and Allen, 1968) as the guiding framework to analyse the role of NEDs. In role theory, a role is never defined by itself. It is defined in relation to other possible tasks – mother and father in relation to daughter and son, merchant in relation to customer and artisan, etc., ‘which can be designated as counter positions. … a role frame’ (Connell, 1979, p.11). These counter positions or ‘role senders’ (Rogers and Molnar, 1976:598) represent a number of parties. Shareholders (Koehn and Ueng, 2005; Jong, Mertens and Roosenboom, 2006), employees (Clapham and Cooper, 2005), and debtors (Day and Taylor, 1998) are the major role senders or the stakeholders. These stakeholders have the decision making power to offer rewards if their expectations are met, otherwise the use of punishments such as the removal of the directors from the positions may occur (Connell, 1979).

According to these theoretical arguments, if the expectations of the stakeholders could be identified, it could be possible to list out the tasks to be performed by the NEDs, disregarding the fact that job contract of NEDs could be incomplete due to many other factors (Eisenhardt, 1989). Due to the large number and a wide variety of stakeholders (Stenberg, 1997) and the difficulty of understanding the relative importance of each stakeholder (Friedman and Miles, 2002), writing the job contract for the NEDs is challenging and a difficult task. While the Principal-Agent Theory (Jensen and Meckling, (1976) explains that shareholders expect the principals to maximise their interests mainly the return on capital, Huse (2005) argues that there are altruists also among the shareholders who do not necessarily expect maximisation of return for their investments. Huse (2005) argues that investors expect their investments to generate some social benefits too such as environmental protection, social equity and so on. Given these theoretical positions and arguments, what is identifiable is the difficulty of getting a clear idea about the desired roles of NEDs, which provides the theoretical basis for adopting the content analysis of annual reports of companies listed in the AIM.

4 Methodology

We adopted content analysis as a method of data collection form companied listed in the AIM. It is based on the analysis of annual reports of companies to be selected. Corporate annual reports are widely used in content analysis in accounting research such as disclosures and social reporting (e.g., Milne and Adler, 1999; Smith and Taffler, 2000; Beattie, McInnes and Fearnley, 2004; Alsaeed, 2006).

Research evidence also indicates that a number of other disciplines such as communication through internet web sites (Perry and Bodkin, 2000; Jun and Cai, 2001); management research (Jauch, Osborn and Martin, 1980), marketing (Harris and Attour, 2000), Business Ethics (Bell and Bryman, 2007) and Political Science (Hart, Jarvis and Lim, 2002) have also benefitted from the content analysis research method. Alsaeed’s (2006) analysis of the relationship between the disclosure level and the appointment of the NEDs was also based on the content analysis. To the best of our knowledge on roles of NEDs, no studies can be found with the adoption of content analysis method using annual reports of companies.

4,1 Unit of analysis

Milne and Adler (1999) point out that a sentence of a text is reliable than a word and page in a document for content analysis. However, the decision on the selection of the unit of analysis has to be taken in the context of the research and the type of the document (Weber, 1990; Neuendorf, 2002; Krippendorff, 2004). Stiles (2001, p.634) notes that ‘sentences that contain reference to board’s involvement in strategy was analysed and key verbs or qualifiers were highlighted to ascertain the mode of involvement’. For the proposed study, we also selected the sentence as the unit of analysis.

4.2 Stability, reliability and validity

Kassarjian (1977, p.8) notes that content analysis is a research technique for the ‘objective, systematic and quantitative description of the manifest content of communication’ and that three properties should be achieved by a content analyst, namely; stability, reliability and validity.

According to Kassarjian (1977), the stability can be achieved if the coding of a document is done in the same way after a period of two weeks, and if the same codes are given for the document coded. Reliability is the degree of confidence a reader could develop in his or her mind about the results of the content analysis. In order to ensure reliability, there are many steps to follow in the content analysis.

Several steps are taken to ensure reliability: (1) preparation of the coding instrument for the coding of annual reports; (2) theoretical framework to develop the coding instrument, (3) establishment of coding decision rules. These steps could ensure the protection of two properties in content analysis (Weber, 1990; Neuendorf, 2002; Krippendorff, 2004), i.e. mutual exclusiveness and mutual exhaustiveness. Mutual exclusiveness means that a sentence could fall only into a single category and mutual exhaustiveness means that all the sentences in the selected ‘locations’ (Milne and Adler, 1999) in an annual report are paid the attention of the coder (Weber, 1990; Neuendorf, 2002; Krippendorff, 2004). Denscombe (2003) points out that constant comparison by going backward and


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upward in the document could ensure the above two properties.

Validity means the categories established in the content analysis have the property of explaining the particular phenomena that is meant for the analysis. Validity consists of two components namely internal validity and external validity. If the categories established through the coding process are backed by the theory, internal validity is ensured. For example, category of strategy, advice and monitoring and so on are found as tasks of the NEDs (Stiles and Taylor, 2001). Any conceptual term not familiar with the researcher is required to be considered as unique at the open coding stage (Glaser and Strauss, 1967). However, in order to ensure complete understanding of such conceptual terms or what Glaser and Strauss (1967) explain as theoretical saturation or theoretical sensitivity (Ahuvia, 2001). Such conceptual terms found in the open coding stage is further studied to see whether there is any theory behind (Perry and Bodkin, 2000).

4.3 Coding of annual reports For the coding of the annual reports for content analysis, a sample of AIM annual reports is selected. The number of annual reports selected is not a priori decision. As Glasser and Strauss (1967) and Ahuvia (2001) explain, last annual report to be coded would be decided when only the coder gets an understanding of the emerging pattern of the data and the picture. When there are two or more coders, it is essential to see the inter-coder agreement (Milne and Adler, 1999). However, when there is only one coder as found in this research, Ahuvia (2001) and Milne and Adler (1999) explain that the researcher should have the theoretical knowledge to gain theoretical saturation and the development of the coding instrument, which could be considered to show the theoretical knowledge and sensitivity in the subject. Location of sentences in the annual reports and coding rules applicable to current study are presented below.

4.4 Location of the sentences: Berg (2004) emphasises the need to look across the document to identify the themes needed for the analysis. ‘Themes may be located in a variety of places in most written documents, it becomes necessary to specify in advance which places will be searched’ (Berg, 2004, p.273). Thus the page or the section of the document or ‘location in report’ (Milne and Adler, 1999) is identified before the proper coding takes place. We examined a number of sections as highlighted below from 75 annual reports to prepare the coding instrument and to select the location of the themes of the coding instrument in the annual reports. The selected sections include Chair’s statement, CEOs statement/review, Corporate governance report, Directors’ details, and Directors’ report.

4.5 Coding decision rules Milne and Adler (1999) and Beattie, McInnes and Fearnley (2004) point out the need for developing coding rules in order to make the coding instrument and coding process reliable and valid. Following decision rules are developed for the coding process of the annual reports of the AIM companies:

(1) The objective is to identify the role of NEDs. (2) Selection of annual reports Annual reports of AIM companies are chosen

irrespective of the sector. Number of annual reports or the sections selected is not a priori decision. It will depend on the theoretical saturation or sensitivity explained earlier.

(3) Coding process - basic rules, specific rules and exclusion rules Basic rules of coding are as follows:

(a) Unit of analysis is the sentence. A conceptual term should reside in the sentence selected otherwise the sentence is excluded protecting the two properties explained earlier (mutual exclusiveness and mutual exhaustiveness).

(b) Following locations in an annual report are coded: (a) Chairman’s statement (b) Chief Executive Officer’s report (c) Corporate Governance report; (d) Directors’ details or biographies report and (e) Directors’ report.

(c) The paragraph number and the location of the sentence is entered in the database in order to enable constant comparison (Denscombe, 2003), that is going backward and forward in the document to ensure mutual exclusiveness and exhaustiveness explained earlier.

Specific rules: Following questions are asked before the coding process begins.

(a) Does the sentence mention the words Non Executive Directors (NEDs)?

(b) Does it have an identifiable outcome and who claim it? NED or board?

(c) If the word NED does not appear, does the word ‘Board’ or the phrase ‘Board of Directors’ appear?

(d) If the above criteria fulfils, does the board has NEDs?

Exclusion rules on coding are as follows:

(a) Sentences which start with the words ‘We’ and

‘Our’ are excluded. Top management which include NEDs take decisions jointly (Hambrick and Mason, 1984). The context (Johns, 2001) of the sentence is evaluated.

(b) Within the annual reports, corporate governance report and the directors’ report, the statutory responsibilities of the directors as per the Companies Act (2006) have been indicated. If a sentence says anything other


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than these statutory responsibilities such as the maintenance of the web site, it will be considered as a contribution of the NEDs. As such, the sentence is considered for coding.

4.6 Bases of interpretation of coded data: Contingency tables (Rose and Sullivan, 1998) or frequency analysis is the popular method of data tabulation interpretation of content analysts (Farrell and Cobbin, 1996; Perry and Bodkin, 2000, Jun and Cai, 2001, Harris and Attour, 2003; Beattie, McInnes and Fearnley 2004). This paper also follows the methodological insights of the above papers namely, the preparation of cross tabulated data tables and frequency analysis.

This research paper uses x2test (Cooper and

Schindler, 2003) to see how close the observed frequencies are to the expected frequencies. We find that it appropriate to use this test because the coding of the annual reports generates only categorical data. Number of pre-requisites are required in order to

calculate the x2(Cooper and Schindler, 2003): (1)

content analysis data should be from a sample of a population which is assumed to be randomly distributed; (2) categorical data must be mutually exclusive and exhaustive; (3) data must be reported in frequencies not in percentages; (4) there should not be any cells with zero frequency and (5) expected frequencies below five should not compose more than twenty per cent of the cells.

Muhr (1991, p. 358) argues that the insignificant frequencies could either be deleted, amalgamated or redefined. ‘Codes and memos that have already been delineated can be renamed, deleted, uncoupled from codes or redefined by simply re-selecting them’. However, uncoupling or collapsing of the categories should avoid any loss of the significance of the data. The removal of the less frequent categories ensures

the application of the x2 but could damage the

picture to emerge. However, Cooper and Schindler (2003) point out that if there is a significant difference between the observed and expected values, it is required to identify those cells and reasons behind the differences. 4.7 Content analysis schedule In order to understand the nature of implementation of the provisions of the FRC (2006), that is separation of chair and the CEO role, appointment of sub- committees of the board and appointment of NEDs, annual reports that are coded are used to get answers for the following questions: (1) How many directors are in the company? (2) How many of them are NEDs? (3) What is the title of the Chair? (4) How many sub committees of the board operate? These questions could be included in a content analysis schedule (Jauch, Osborn and Martin (1980, pp.524-525). Many authors use annual reports to find out the

extent of implementation of the codes on corporate governance in listed companies but do not strictly follow the content analysis rules (Dahya, McConnell and Travlos, 2002; Pass, 2004). With the insights gained through the above methodological approaches, the next section presents the results of our analysis. 5 Analysis and results Our analysis is based on information presented in 75 annual reports. Since the coding of the number of annual reports were decided when the researchers gained an understanding of the emerging pattern of the role of NEDs, the number of annual reports used to get the understanding of the corporate governance mechanisms of the AIM companies were limited to the same number of annual reports (75). Although this may not be a representative sample of the total number of AIM companies (about 1076 as at December 2012), the following data still reflect an important picture with regard to the degree of voluntary acceptance of the principles and provisions of Code on Corporate Governance. Appointment of the NEDs as chairs, number of NEDs and acceptance of the sub committees of the board are some examples we have found in this study.

5.1 Corporate Governance variables: type of chair, number of NEDs and sub committees Table I shows that the AIM companies use three different titles beneath the statement of the chairman in the annual reports coded: Executive chair (22.7 per cent) non-executive chair (52 per cent) and chairman (25.3 per cent). The annual reports which do not specify beneath the statement of chair whether the chair is an executive or non-executive director belong to the category of chairman. However, a closer look at the bibliography page of the board members and in relation to the chair, it is found that the chair is classified either as executive chair or non-executive chair. However, whether the NED chair meets the criteria of independence (Higgs, 2003) could be judged by seeing whether the particular NED chair has shares and any other interests in the company. Our finding shows that majority of the NED chairs of AIM companies have shares in the companies they work and not truly independent as the NED chairs of FTSE 100 companies.

Table 2 shows that vast majority of companies (92 per cent) appoint NEDs. There are no NEDs at present in six companies (8 per cent). Thirty two percent of companies (24) have two NEDs. There are twenty two firms (29 per cent) with three NEDs. While there is only one company with five NEDs, eleven companies have four NEDs each. This picture shows a remarkable acceptance of the significant role present and role of NEDs.

Table 3 shows that the audit and remuneration committees are more established units for about 74 per cent of companies. It also shows that the


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nomination committees (41 per cent) are still to develop as a whole. However, there is no clear term of reference for the sub committees in the AIM listed firms as applicable for the FTSE 100 companies. Interestingly, it is found that 35 per cent of companies have all three sub-committees. There are at least two committees in about 33 percent of companies. More importantly, almost one fourth of companies have no a single sub-committee in the board. This is also compatible with the non-availability of a single NED in 8 per cent of companies (Table 2). The degree of significance given for the sub-committees varies among the firms. This could be due to the firm specific factors such as the stage of growth of the company, appraisal of cost and benefit of sub-committees, growth of the market and so on.

The significance of existence of sub-committees in corporate governance could be a reflection of vigilant corporate governance at the expense of the vital strategic role of the NEDs (e.g. Taylor, 2004). However, sub-committees could be an avenue for more discussions and sharing ideas among board members and also for polarisation of ideas and diversities if they are not matched properly (Sundaramurthy and Lewis, 2003). Pettigrew and McNulty (1995) find that there are two types of board cultures namely maximalist and minimalist. Maximalist culture accommodates more discussions, listening, collaborative work and the minimalist boards are in the opposite side of these attributes.

The evidence shows that there could be more vigilant corporate governance in AIM companies which are dominated by the NED chairs. For example, in Table 4, of the 1,220 sentences coded, 703 sentences (58.0 per cent of total sentences) are in the coded annual reports where there are NED chairs. There are 245 sentences coded (20.1 per cent) in the annual reports reflecting executive chairs. In the unclassified chairman category, there are 272 sentences coded (23.9 per cent). Thus, the number of sentences in the annual reports coded with the presence of NED chairs could be used as a proxy for more vigilance corporate governance.

This picture is further supported by the information presented in Table 5. Table 5 shows that when the number of NEDs in a board is two 34.8 per cent (with 425 sentences) and

30.1 per cent (with 367 sentences) of the coded sentences are found respectively. A remarkable feature is that when there are more than 4 NEDs in a board, the number of coded sentences remains low. A number of previous researchers point out that when there are more than the required number of NEDs, board deliberations are difficult and virtually collapse the board level of discussions (Walsh and Seward, 1990; Sundaramurthy and Lewis, 2003). However, this possibility has to be verified with empirical research as the required number may vary according to the complexity of other aspects of firms.

5.2 Characteristics of the roles of NEDs Content analysis data shows at least four major characteristics of the roles of the NEDs.

5.2.1 Characteristic 1: Multiplicity of roles Multiplicity of the tasks is the major feature found in relation to the roles of the NEDs, which is reflected by existence of a relatively large number of tasks. Table 4 shows that the result of the content analysis indicates 37 tasks of the NEDs. Cognitive tasks are explained in theory but there is lack of empirical evidence in relation to board research (Forbes and Milliken, 1999, Haleblian and Rajagopalan, 2006). This survey finds number of cognitive tasks of the NEDs such as beliefs (2.7 per cent or just 33 sentences), considerations (2.4 per cent or 25 sentences) and expectations (1.9 per cent or 23 sentences). Beliefs make a vital function among many stakeholders in large organisations (Steiner and Edmunds, 1979). Beliefs created among the minds of the stakeholders by the board or beliefs of boards are important to develop the morale of the management and employees. Gist (1987) explains that the beliefs guide many actions such as recruitment, setting of goals for the corporation and motivation of employees. Such beliefs are one of the decisive factors of job satisfaction (Brief and Aldag, 1981). Design and development of criteria to evaluate the board performance and recruitment of the directors is vital to protect interests of the stakeholders as explained by Useem (2003) who points out the lack of such criteria reflects in the failed giant corporations in the US. Interestingly, the issue of whether there is an evaluation of the performance of both the NEDs and executive directors counts for only just close to 1 per cent of sentences (11 sentences) coded. This finding is consistent with Higgs’s (2003) finding that the evaluation is one of the least considered board tasks. Our analysis also shows the less significance role of criteria development for managerial decision making (1.0 per cent). Useem (2003) also pointed out that criteria development for the managerial decisions and for the board tasks is one of the most needed but forgotten task of boards.

5.2.2 Characteristic 2: Differences in roles

according to the type of chair In order to understand the relative significance of each category of roles according to the type of chair, we decided an arbitrary value to judge the most significant role categories for a chair (as 5 per cent of coded sentences or above). Accordingly, Table 5 shows that some role categories are more significant for some type of chairmen. For example, the NED chair considers organisation (11.5 per cent), responsibilities (9.3 per cent), revisions (9.1 per cent), meetings (8.8 per cent), approvals (7.3 per cent), studying information (6.6 per cent), recommendations


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(6.3 per cent) and considerations (5.6 per cent) as relatively significant roles. When we apply the same rule for the executive chair, we could identify meetings (12.7 per cent), organisation (11.2 per cent), responsibilities (10.7 per cent), revisions (8.3 per cent) and approvals (6.3 per cent) as important roles among other categories. Within the unclassified chair, responsibilities (10.8 per cent), revisions (10.3 per cent), meetings (9.9 per cent), organisation (9.4 per cent), approvals (8.1 per cent) and monitoring (7.6 per cent) take higher values according to the above 5 per cent rule. Across all the chairs, several categories such as organising the tasks of the board, meetings, responsibilities, revisions and approvals are more important than other roles.

5.2.3 Characteristic 3: Variation within roles in Role

Engagement Variations in relation to ways of engagement in above roles NEDs are noted under this characteristic. For example, the task in relation to strategy has many variations of engagement such as planning, approval, revision and so on. Stiles (2001) also found such variety of tasks in relation to strategy. In particular, he identified that revision, approvals, monitoring as sub parts of the process of strategy. The result of our analysis presented in Table 5 also indicates a member of such roles such as monitoring, revisions, and approval.

5.2.4 Characteristic 4: Identification of the Gate

Keeper role This survey supports the Gate Keeper role of the NEDs (e.g. Kirkbride and Letza, 2005). Accordingly, preparation of the terms of reference of the NEDs and appointment of the sub committees of the board such as the audit, remuneration and nomination committee could be considered as strengthening the Gate Keeper role of the NEDs. Some excerpts from the annual reports coded to support these roles are: ‘The directors intend to strengthen the Board through the appointment of at least one new non-executive director’ (LPA Group, Annual Report, 2006, p,4). ‘The directors have established audit Nomination and remuneration committees with formally delegated rules and responsibilities. Each of the committees currently comprises the non-executive directors’ (Celoxica Annual Report: 2006, p.15). 5.3 Validity and reliability of content analysis The aim of the Chi Square statistical test was to see whether the coded data is randomly distributed ensuring mutual exclusiveness and exhaustiveness of the categories. As explained earlier, categories which have 5 or less than 5 frequencies are removed to calculate the expectancy values (Cooper and Schindler, 2003). Accordingly, the total number of sentences remained 883 from the initial number of 1,220 sentences (Table 6). Table 6 shows the

calculated expected values. The difference between the observed and the expected values (residual values) is only a matter for further analysis when there is a significant difference between the two.

Accordingly, the calculated Chi Square value is 16.85 with the degree of freedom of 26. The table value for degree of freedom of 26 with the 0.05 confidence level is 38.85. As the calculated value is less than the table value, null hypothesis cannot be rejected. The independence between the variables is indicated. On the other hand, it means that each category has its’ own independent distribution with the protection of the properties in content analysis, that is mutual exclusiveness and exhaustiveness. This signifies that the content analysis data is randomly distributed. A discussion on the relationship between these variable is presented below under discussion.

6 Discussion We found that NEDs play not only just number of roles, but also engage in various tasks and cognitive roles as well. When considering all these as a whole, they represent such characteristics as multiplicity of roles, role differentiation by the type of chair, variation within roles in role engagement, and the existence of the gate-keeper role. In the theoretical section of this study, we emphasized the value of role theory. As such, we discuss our findings in relation to the assertion of role senders or stakeholders’ expectations in identifying and discussing roles of NEDs. In addition, the result of content analysis has provided us with the opportunity to evaluate the weight of corporate governance roles and strategic roles and making a ‘rough hypotheses’ (Berg, 2004:283) about the relative importance of the roles of NEDs of surveyed companies. 6.1 Identification and meeting of expectations of several stakeholders Within the multiple numbers of tasks, it is possible to identify that NEDs play a variety of roles to meet the expectations of several role senders such as the shareholders, CEO and regulatory authorities. Some of these tasks could meet the expectations of several role senders simultaneously. For example, the tasks of meetings (9.8 per cent), communication (3.1 per cent), beliefs (4.3 per cent) and expectations (3.5 per cent) could meet the needs of shareholders, CEO and ‘regulatory authorities’ (Jones and Pollit, 2003), such as Financial Services Authority (FSA, 2006) and Financial Reporting Council (FRC, 2006).

6.2 More emphasis on corporate governance than the strategic direction The content analysis gives the opportunity to understand vital aspects of corporate governance emerging in the context of the enhanced emphasis of the role of NEDs (Gnan et al., 2013; Al-Najjar, 2014; FRC, 2006). The finding of the existence of NED


227

chair and the sub committees of boards could be considered as more attentive compliance for corporate governance. This is rather consistent with Pettigrew and McNulty’s (1995) finding that boards which give equal chance for the directors to discuss or make their points heard by the others, have more independent directors. They further emphasized that such boards involve in more corporate governance roles than the boards with more executive directors.

However, paying more attention on corporate governance could lead to less attention on the entrepreneurial activities of the companies. Strategic contribution and entrepreneurial role are pointed out as key aspects of NEDs’ roles (FRC, 2006). Chambers (2005) argues that ‘many directors will concur with the sentiment that a greater proportion of their available time is now taken up with accountability, audit, risk management and control matters than was historically the case’ (p:28). The roles we found in our content analysis also indicate that organisation, meetings, and responsibilities take a higher value than the areas covered under the theme ‘strategy’. Therefore, corporate governance roles tend to overrides strategic direction of the firms represented in this study. Therefore, the survey could build a ‘Rough hypothesis’ (Berg, 2004, p. :283) that greater the tendency towards NEDs playing more important roles in boards, higher the possibility of

NEDs’ involvement in more corporate governance role than strategic roles. 6.3 Identification of independent and dependent relationship between roles Using the Chi Square test we performed, we could also develop a ‘rough hypothesis’ (Berg, 2004:283) that there is a relationship between the cognitive aspects of the NEDs and the extent of involvement in such roles as strategic, advisory, monitoring, criteria development, evaluation, and leadership. Logical concepts could be related to each other in the context of discussion (Toulmin, Rieke and Janik, 1979). Thus, the Figure 1 shows the mapping of the relationship between cognitive tasks and the more manifest variables such as strategy, advice and monitoring in the context of the tasks of the NEDs found in this survey. Straight lines show the direct relationship between the cognitive tasks. Dashed lines show that the cognitive tasks themselves are moderated by the manifest tasks or the results brought by the particular action in relation to strategy, monitoring and advice. Therefore, there is action and reaction relationship between cognitive tasks and key roles of NEDs.

Figure 1. Testable relationships between cognitive Tasks and Key NED roles

This drawing is a result of logical reasoning (Reynolds, 1971; Toulmin, Rieke and Janik, 1979) and mental

mapping (Farrand, Hussain and Hennessy, 2002), based on the results of content analysis.

Beliefs

Strategy

Expectations

Advice

Considerations

Monitoring

Key: relationship

Indirect direct


228

7 Conclusion and recommendations

We aimed at exploring the roles of NEDs in

implementing NRCCG in SMEs and examining their

characteristics and relationships by adopting content

analysis of annual reports. The findings revealed that

NEDs perform a multiple number of roles, tasks and

cognitive functions to meet the expectation of several

stakeholders simultaneously, such as the CEO,

regulatory authorities, and shareholders. This reflects

the fact that NEDs are a special kind of bees in the

bee hive of board. Therefore, for proper

understanding of roles of NEDs in SMEs, researchers

may consider all these roles, tasks, and functions as

an integrative system (e.g. Gnan et al., 2013). As

such, the realities of NEDs role of SMEs cannot be

understood by relying only on quantitative analysis

and summarised roles. The content analysis

methodology we adopted provided us with the

opportunity to use quantitative, qualitative and

descriptive information for exploring the realities of

NEDs roles in SMEs. For example, when NEDs play

their roles in a situation where the implementation of

NRCCG is not compulsory, cognitive functions such

as positive attitudes, appropriate beliefs and

considerations are found to be important as they are

associated NEDs key roles such as advice, strategy,

and monitoring. Such explanation cannot be made by

relying only on quantitative and summarised

information presented Table 6. As such, the

possibility of looking at the issue from different

perspective is another advantage of the content

analysis approach adopted in this study. Accordingly,

we found that tasks can be identified as dimensions of

roles. This view of NEDs role is consistent with

previous research findings as well. For example, a

number of previous studies have indicated and have

indicated that tasks can be identified not only as just

roles but also as specific roles (Gnan et al., 2013;

Sciascia et al., 2013; Heuvel, Gils and Voordeckers,

2006). Another key finding of this study is that the

role of NEDs is conditioned by NEDs own cognitive

tasks such as beliefs, assumptions and expectations of

NEDs and by the expectations of the stakeholders.

One of the implications of this finding is that NEDs

and CEOs of SMEs can use these insights in the

formation of expectation on job descriptions and

person specifications relevant to recruitment, training

& development, and performance management

purposes.

This study also provides ample insights into the

adoption of content analysis on exploring roles of

boards and actions in corporate boards by using

information recorded in annual reports. Further

research is required to understand the distinctive

processes involved in each tasks identified. For

examples, roles such as recommendation, decision

making, approval etc. have their own processes

despite the fact that they contain closely related

meaning. Such process studies are yet to come into

the reality of board work (Gnan et al., 2013;

Pettigrew, 1997). Further, based on quantitative,

qualitative and descriptive information presented in

this study, we could also develop a model depicting

conceptual and testable relationships between

cognitive tasks and key roles of NEDs for future

studies. As indicated in a number of previous

researches, this study reflects the difficulty of

developing a general theory on the role of NEDs to

satisfy the expectations of stakeholders such as the

CEO, shareholders, and regulatory authorities due to

a number of limitations. First, researchers have

largely focused on the role of NEDs in AIM

companies. Therefore, the results could be more of

relevance to the AIM companies. Second, selection of

a set of annual reports for the content analysis was

done on a random basis from the annual reports

collected from the Annual Report Service in the UK.

Third, declarations of annual reports are assumed to

be true despite the fact that there are arguments on the

accuracy of information (Atkinson and Coffey, 2004,

Abeysekera, 2006). However, χ2 test analysis of this

study proved the randomisation of the categories in

the content analysis. Therefore, it is an assurance of

the reliability of the content analysis. Fourth, when

there are semantic differences, understanding the

meaning of a particular term could become difficult.

This might be addressed in future studies by selecting

methodologies that support looking at issues from

different perspectives.

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Appendices

Table 1. Type of chair

Type of Chairman Number of firms Per cent

Chairman 19 25.3

Executive Chair 17 22.7

Non-Executive Chair 39 52.0

Total 75 100.0

Source: Content analysis data

Table 2. Number of NEDs

Number of NEDs Number of firms Per cent

0 6 8.0

1 11 14.7

2 24 32.0

3 22 29.3

4 11 14.7

5 1 1.3

Total 75 100.0

Source: Content Analysis data

Table 3: Sub committees of the board

Committee Number of firms Per cent (out of 75)

Audit 56 74.7

Remuneration 55 73.3

Nomination 31 41.3

All three of above committees 26 34.7

Two committees 25 33.3

Only one committee 5 6.6

No sub committees 19 25.3

Source: Content analysis data


233

Table 4. Tasks of board members

Ch

airm

an

ship

Ty

pe o

f Ch

air

Tasks of the Boards(number of sentences as per the tasks)

Ad

vice

Ap

preciatio

n

An

nou

ncem

ents

App

rov

als

Attitu

de fo

rmatio

n

Au

tho

rization

Belief fo

rmatio

n

Co

mm

un

ication

s

Con

sideratio

ns

Criteria fo

rmatio

n

Decisio

n tak

ing

Deleg

ation

Do

cum

ent p

reparatio

n

Ev

aluatio

n

End

orsem

ents

Exp

ectation

of fu

ture ev

ents

Gu

idelin

es

Inpu

t Sou

rces

Lead

ership

Meetin

gs

Ob

jectives

Org

anisatio

n o

f bo

ard

Pro

po

sals

Reco

mm

end

ation

s

Resp

on

sibilities

Rev

ision

s

Co

mm

endatio

ns

Con

fiden

ce

Con

sensu

s

Fid

uciary

Care

Monito

ring

NE

D E

valu

ation b

y C

hairm

an

Strateg

y

Strateg

ic Alig

nm

ent o

f Interests

Sp

ecific matters related

of b

oard

Su

bstan

tial shareh

old

ers

NE

D sh

ares

To

tal

Ch

air

39

50

15

13

4

6

9

0

3

1

1

12

4

3

1

6

1

4

1

10

4

10

7

2

15

12

2

0

1

2

6

0

7

12

5

3

1

272

Exe C

hair

48

46

17

10

1

2

4

4

3

0

5

6

0

0

0

6

0

3

2

17

9

11

6

3

9

7

1

0

0

1

7

4

2

3

1

6

1

245

NE

D C

ha

ir

134

95

45

44

6

14

20

11

19

2

4

15

9

8

2

11

0

22

5

24

8

44

9

22

30

29

0

1

1

7

16

1

8

10

8

12

7

703

To

tal

221

191

77

67

11

22

33

15

25

3

10

33

13

11

3

23

1

29

8

51

21

65

22

27

54

48

3

1

2

10

29

5

17

25

14

21

9

1220


234

Table 5. Relationship between number of NEDs and the number of coded sentences

Number of NEDs and sentences as per the category

To

tal n

um

ber o

f senten

ces

Ta

sks a

nd

Nu

mb

er of N

ED

s

Ad

vice

Ap

preciatio

n b

y ch

airman

An

no

un

cemen

ts

Ap

pro

vals

Attitu

des

Au

tho

rity

Beliefs

Co

mm

un

ication

s

Co

nsid

eration

s

Criteria

Decisio

ns

Deleg

ation

Do

cum

ents

Ev

aluatio

n

En

do

rsemen

ts

Ex

pectatio

ns

Gu

idelin

es

Inp

ut S

ou

rces

Lead

ership

Meetin

gs

Ob

jectives

Org

anisatio

n

Pro

po

sals

Reco

mm

end

ation

s

Resp

on

sibilities

Rev

ision

s

Co

mm

end

ation

Co

nfid

ence

Co

nsen

sus

Fid

uciary

Care

Mo

nito

ring

NE

D E

valu

ation

by

Ch

airman

Strateg

y

Strateg

ic Alig

nm

ent o

f

Interests

SM

RB

Su

bstan

tial shareh

old

ers

NE

D sh

ares

To

tal N

um

ber o

f NE

Ds

0

5

11

1

0

0

0

1

0

1

0

0

1

0

0

0

0

0

0

0

1

1

0

5

1

3

0

0

0

0

0

0

0

1

2

0

1

0

35

on

e

35

50

14

6

1

2

7

0

5

1

2

3

2

1

0

5

0

2

0

9

2

11

2

7

8

7

0

0

1

2

3

0

1

4

2

4

1

20

0

two

64

56

33

26

5

8

13

6

10

1

5

11

6

5

3

7

1

16

3

13

7

21

8

5

19

18

2

0

1

6

12

1

8

9

3

9

4

42

5

three

82

51

23

25

5

6

8

7

7

1

2

9

2

5

0

6

0

5

3

21

5

20

2

6

16

16

1

1

0

1

10

3

4

4

5

3

2

36

7

fou

r

25

23

6

9

0

4

4

2

2

0

1

8

3

0

0

5

0

5

1

7

6

11

4

6

8

7

0

0

0

0

4

1

3

6

4

4

2

17

1

five

10

0

0

1

0

2

0

0

0

0

0

1

0

0

0

0

0

1

1

0

0

2

1

2

0

0

0

0

0

1

0

0

0

0

0

0

0

22

To

tal

22

1

19

1

77

67

11

22

33

15

25

3

10

33

13

11

3

23

1

29

8

51

21

65

22

27

54

48

3

1

2

10

29

5

17

25

14

21

9

12

20


235

Table 6. Calculated expected values for Chi Square test

Ch

airman

ship

Ad

vice

Ap

preciatio

n b

y

chairm

an

Bo

ard

An

nou

ncem

ents

Bo

ard

Ap

pro

vals

Bo

ard

Deleg

ation

Bo

ard

Ex

pectatio

ns

Bo

ard M

eeting

s

Bo

ard

Org

anisatio

n

Bo

ard P

ropo

sals

Bo

ard

Resp

on

sibilities

Bo

ard

Rev

ision

s

Mo

nito

ring

To

tal

Count 39 50 15 13 12 6 10 10 7 15 12 6 272

Expected Count 49.3 42.6 17.2 14.9 7.4 5.1 11.4 14.5 4.9 12 10.7 6.5 272

% within Chairmanship 14% 18% 6% 5% 4% 2% 4% 4% 3% 6% 4% 2% 100.00%

% within Category 18% 26% 20% 19% 36% 26% 20% 15% 32% 28% 25%

21

% 22.3%

% of Total 3% 4% 1% 1% 1% 1% 1% 1% 1% 1% 1% 1% 22%

Count 48 46 17 10 6 6 17 11 6 9 7 7 245

Expected Count 44.4 38.4 15.5 13.5 6.6 4.6 10.2 13.1 4.4 10.8 9.6 5.8 245

% within Chairmanship 20% 19% 7% 4% 2% 2% 7% 5% 2% 4% 3% 3% 100%

% within Category 22% 24% 22% 15% 18% 26% 33% 17% 27% 17% 15%

24

% 20%

% of Total 4% 4% 1% 1% 1% 1% 1% 1% 1% 1% 1% 1% 20%

Count 134 95 45 44 15 11 24 44 9 30 29 16 703

Expected Count 127.3 110.1 44.4 38.6 19 13.3 29.4 37.5 12.7 31.1 27.7

16.

7 703

% within Chairmanship 19% 14% 6% 6% 2% 2% 3% 6% 1% 4% 4% 2% 100%

% within Category 61% 50% 58% 66% 46% 48% 47% 68% 41% 56% 60%

55

% 58%

% of Total 11% 8% 4% 4% 1% 1% 2% 4% 1% 3% 2% 1% 58%

Count 221 191 77 67 33 23 51 65 22 54 48 29 1220

Expected Count 221 191 77 67 33 23 51 65 22 54 48 29 1220

% within Chairmanship 18% 16% 6% 6% 3% 2% 4% 5% 2% 4% 4% 2% 100.00%

% within Category 100.00% 100.00% 100.00% 100.00% 100.00% 100.00% 100.00% 100.00% 100.00% 100.00% 100.00%

100

.00

% 100.00%

% of Total 18% 16% 6% 6% 3% 2% 4% 5% 2% 4% 4% 2% 100.00%


236

Table 7: Chi-Square tests

Chi-Square Tests

Value Df Asymp. Sig. (2-sided)

Pearson Chi-Square 112.299a 72 0.002

Likelihood Ratio 117.293 72 0.001

Linear-by-Linear

Association 0.835 1 0.361

N of Valid Cases 1220

a 51 cells (45.9%) have expected count less than 5. The minimum expected count is .20.


237

BANKS’ SOCIAL INVESTMENT AND MARKET SHARE

Martie P. Mphelo*, Collins C. Ngwakwe**

Abstract

This research examined probable relationship between banks’ social investment and market share of selected banks in the JSE SRI Index. Using data from the sustainability report of three selected banks, the research applied the panel data approach to conduct a simple regression analysis between cooperate social investment and banks’ market share (represented by bank deposits). Findings from the analysis suggest that, whilst keeping other factors constant, within the sample banks, a relationship exists between corporate social investment and banks’ market share. The paper thus recommends that further study should include more banks across many years to probe for further relationships between banks’ social investment and market share; such robust study would provide a more generalizable finding that may enhance a broader understanding and inference about the effect of banks’ social investment on banks’ market share. Keywords: Social Investment; Social Responsibility; Market Share; Corporate Governance; South African Banks *Turfloop Graduate School of Leadership, Faculty of Management and Law, University of Limpopo, South Africa **Turfloop Graduate School of Leadership, Faculty of Management and Law, University of Limpopo, South Africa

1 Introduction

Corporate Social Responsibility (CSR) involves the entire

spectrum of responsibility initiatives whereby firms strive

to operate their businesses in an ethical manner – making

profit in consideration of the lives of employees and

society (Fasset, 2012). Whilst corporate social

responsibility emerged in the 1960s (Maignan and Ferrell,

2004); the bourgeoning of corporate social responsibility

campaign has garnered greater momentum since the early

1970s. This has even lead to a new concept of social

marketing (Maignan and Ferrell, 2004) with a conviction

that the market’s view about a firm’s operations and/or

behaviour is paramount to attracting a larger market

patronage or share. The current corporate penchant for

corporate social responsibility assumed an increasing

trend apparently after a stimulation by a renewed market

dissatisfaction about corporate social and environmental

responsibility during the Brent Spar and Shell Nigeria

decommission saga (Livesey, 2001). Consequently,

corporate social responsibility research by academics and

practitioners has soared to encourage business to

appreciate potential benefits accruable from corporate

social responsibility (CSR). Whilst CSR-benefit research

has focussed attention on financial benefits, less research

has looked into the CSR and market share relationship.

Furthermore, existing research in the area of CSR-market

share relationship has sparsely looked into the banks,

especially within the South African context. However,

current research show that, although banks fall under the

low emission impact industry, banks financial service to

high emission intensity industries bestows some social

and environmental obligation on banks (Rainforest Action

Network and BankTrack, 2012). Hence, banks have

begun engagement in various forms of social

responsibility; South Africa is a typical example of a

country where banks are investing in social responsibility

(The Banking Association South Africa, 2015). Few

research have shown that corporate engagement in social

responsibility may improve firm’s market share (Owen

and Scherer,1993; Cheng et al. 2014); but, to the best of

authors’ knowledge, research on market share relationship

with banks’ corporate social investment in South Africa is

not known in South African literature. Therefore, the aim

of this paper is to examine a possible relationship between

banks’ corporate social investment and banks’ market

share using a sample of banks from the Johannesburg

Stock Exchange Socially Responsible Investing Index

(JSE SRI).

This paper is organised as follows: the following

section after the introduction reviews the related

literature; the next section presents the research

methodology and data analysis; the last section draws

conclusions.

2 Related literature

The concept of corporate social responsibility refers to an

amalgam of various initiatives that firms engage in to

improve the social and environmental aspects of their

business environment and to obviate negative image and

costs that may be associated with business impact on

society and environment (Clapp and Rowlands, 2014).

Firms are motivated toward corporate social

responsibility, not only to legitimize their operations, but

also because it has been proven as good business strategy

(Chin et al, 2013) which improves the competitive

dexterity of business (Juščius and Snieška, 2015), and


238

also attracts low cost of capital for a responsible firm (El

Ghoul et al., 2011). However engagement in corporate

social responsibility has cost implications. substantial

amounts of money form part of the budget line items of

socially responsible firms (Di Giuli and Kostovetsky,

2014) ; therefore by virtue of such gargantuan amounts

that most firms plough into societal and environmental

wellbeing, firms can be seen as investing in society, and

hence the concept of corporate social investment.

Although such huge investments may not necessarily

resonate with current profits, research indicates that

corporate social investment may offer future stream of

positive financial performance and/or growth

opportunities to firms that engage in social investment

(Holland, 2002; Di Giuli and Kostovetsky, 2014).

Whilst some firms fall under the socially responsible

classification, many firms are still apathetic to social

investment or “non-socially responsible” (Blanco et al.,

2013, p.67), apparently because of the cost implications

of being socially responsible. Consequently, in an attempt

to boost the motivation of firms’ engagement in corporate

social responsibility, several extant research has dwelt

variously on the linkage between corporate social

responsibility and firm performance (Zhu et al. 2014;

Cheng et al. 2014). Different researches about this

bourgeoning area of business strategy have found mixed

results. Some find positive relationship between social

investment and corporate performance (using different

proxies of performance), others have found no

relationship, yet some research have found that a

relationship may exist under certain conditions, such as

inter alia, the size and type of industry (Branco and

Rodrigues, 2008). Corporate social responsibility research

has largely focused much attention either on multinational

firms, extractive companies or on national manufacturing

or emission intensive companies (Droppert and Bennett,

2015; Ranängen and Zobel, 2014).). However corporate

social responsibility research in banks, specifically,

banks’ social investment research perspective has not

been as ubiquitous like the researches on corporate social

responsibility. This apparent paucity of social investment

research in banks might be understandable from a

generally expressed sentiment that banks fall under the

low emission intensive sector (Rainforest Action Network

and BankTrack , 2012) . However, by virtue of their

service, banks provide financial backing to the growth of

emission intensive industries through banks’ traditional

role of capital provision (Rainforest Action Network and

BankTrack, 2012). Therefore, from the perspective of

financial support to industries that are notorious for

environmental and social disquiet, banks become

somewhat indirectly involved in social and environmental

responsibility, with increasing societal expectations

and/or demand for banks to contribute to healthy upkeep

of society (Hu and Scholtens, 2014). Researches falling

under corporate social responsibility of banks are more on

the side of disclosure, such as the types of social

responsibility disclosure by banks (Castelo & Lima,

2006); public visibility and social responsibility

disclosure (Branco and Rodrigues, 2008) and social

reasonability strategies of banks (Hu and Scholtens,

2014). Others have dwelt on the impact of banks’ social

responsibility disclosure on financial performance (Mallin

et al. 2014; Nadeem and Malik; 2014) and comparative

study of banks’ corporate social responsibility (Ali and

Rahman, 2015). However, research that links corporate

social responsibility with market share are not as common

in the literature as with other research focus areas about

social responsibility. Little research relating social

responsibility to market share includes inter alia Owen

(1993) who found that corporate initiatives on social

responsibility have strong influence on firm’s market

share; in the same vein, others find that corporate social

responsibility may command brand loyalty from the

market (Lai, 2010; Mirabi et al. 2014). Furthermore, Luo

and Bhattacharya (2006) opine that corporate social

investment attracts customer satisfaction and hence

improves firms’ market value. In the same vein, it has be

found that corporate social responsibility attracts

customer awareness about a firm’s responsible business

operations and thus builds customer loyalty (Servaes and

Tamayo, 2013). Other studies such as (Kotler and Lee

(2005) confirm that corporate social investment leads to

increase in revenue and firm market share.

However, research on banks social investment and

market share is not common in South Africa; hence, this

paper uses three banks in the JSE SRI Index to examine

possible relationship between banks social investment and

market share, with the hope that an expanded study may

emanate from this research.

3 Methodology Data for this research were from the annual integrated

reports of three JSE banks under the Socially Responsible

Investment (SRI) index 2014. For confidentiality reasons,

the banks’ pseudo names are Bank A, Bank B and Bank

C. Adopting the purposive sampling method, the three

banks were selected from the group of banks in the 2014

SRI index; these three banks contained all the research

data for the five years period. Data were analysed using

panel data simple linear regression.

The paper used the following regression model:

=0+11+

Where:

= dependent variable (market share); 0=constant;

1=regression coefficient;

1=independent variable: corporate social investment

(CSI); = error

The proxy for market share is the bank deposits (see

e.g.Filbeck et al. 2010). Other variables affecting the bank

deposits are held constant in this analysis.

Data collection from the three banks’ corporate

social investment and market share covered a period of

four years, which thus gives 12 observations in the panel

data analysis; the output result appears in Table 1.


239

Table 1. The relationship between corporate social investment and banks’ market share

Model 1: Fixed-effects, using 12 observations

Included 3 cross-sectional units

Time-series length = 4

Dependent variable: MktShr

Coefficient Std. Error t-ratio p-value

const 13.6707 1.39218 9.8196 <0.00001 ***

CSI 0.0513675 0.0195142 2.6323 0.03007 **

Mean dependent var 17.29167 S.D. dependent var 10.21954

Sum squared resid 4.408837 S.E. of regression 0.742364

R-squared 0.996162 Adjusted R-squared 0.994723

F(3, 8) 692.1978 P-value(F) 5.33e-10

Log-likelihood -11.01949 Akaike criterion 30.03898

Schwarz criterion 31.97860 Hannan-Quinn 29.32086

rho 0.207998 Durbin-Watson 0.848507

The output in Table 1 analysed the relationship between

corporate social investment and banks’ market share. The

data was analysed at a significance level of 0.05%. From

the panel data regression output in Table 2, the p-value,

P= 0.03, is less than 0.05; this therefore shows that,

(whilst holding other factors constant), within the three

banks studied, there is a significant positive relationship

between corporate social investment and bank’s market

share.

4 Conclusion

This paper examined the relationship between corporate

social investment and market share in the three JSE SRI

selected banks. Social investment, revenue and market

share data (represented by bank deposits) were from the

annual integrated sustainability report of the three banks.

Data were analysed through the application of panel data

approach of simple regression statistics to examine the

relationship between corporate social investment and

market share within the three banks. Findings from the

analysis indicate that (whilst holding other factors

constant) there is a positive significance relationship

between banks’ social investment and market share within

the three banks. These findings confirm previous research

findings by Alniacik et al. (2010), Servaes and Tanayo

(2013) who found a positive relationship between CSI and

market share, this finding is in contrast with previous

research findings by Alniacik (2010); Luo and

Bhattacharya (2006) and Sankar (2001) who found a

negative relationship between CSI and market share. This

paper differs slightly from previous research since none of

the previous research examined the relationship in the

banking industry within the South African setting. The

paper thus makes a moderate contribution to the South

African literature on banks’ social responsibility research.

However findings of this paper is limited within the three

banks, hence the paper recommends further research that

may study all the JSE listed banks with an expanded

number of years; it is likely that a larger sample with

more number of years might produce a different result.

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241

LEVERAGING VALUE WITH INTANGIBLES: MORE GUARANTEES WITH LESS COLLATERAL?

Roberto Moro Visconti*

Abstract

This paper shows how intangibles can create scalable value, levered by debt and serviced by intangible-driven incremental EBITDA and cash flows. Intangibles intrinsically incorporate information asymmetries and may so discourage debt, but are also a vital component of cash generating value, so representing a key factor for debt servicing, with paradoxical effects (more guarantees with less collateral?). Operating leverage is enhanced by scalability, an intrinsic characteristic of many intangibles, with a positive impact on cash generation and consequent debt servicing. Ability to improve cash flows emerges as a key feature of value enhancing intangibles, bypassing their lack of collateral value. Keywords: Intangible Valuation; EBITDA; Cash Flows, Information Asymmetries; Operating Leverage; Scalability; Debt Covenants JEL codes: O30, M41, G31, G17 *Università Cattolica del Sacro Cuore, Milan (Italy). [email protected] This publication has been financed with research funds from the Catholic University of Milan (L.D.3.1./2015)

1 Introduction Definition (Mehta & Madhani, 2008), accounting

treatment and a consequent valuation of intangible capital

(IC) are a prerequisite for financial performance appraisal

and consequent bankability, combining economic

margins, such as EBITDA, with debt-servicing cash

flows.

IAS 38 (Para. 12.) defines an intangible asset as “an

identifiable non-monetary asset without physical

substance”. Whatever is not identifiable is allocated in

(residual) goodwill, an Arabian phoenix for accountants.

“The academic and professional interest in IC is

underpinned by the idea that it can be considered one of

the main levers to create value” (Giuliani, 2013) and,

according to Michael Porter’s fundamental insights, value

creation derives from lasting competitive advantage over

rival entities, embedded in continuously innovating

business models, to be properly designed and managed.

Competitive edge is increasingly driven by the catalyst

presence of intangibles, which represent a pivotal

breakthrough, and it occurs when an organization

(painfully) develops core competencies and skills that

allow it to outperform its competitors, especially for what

concerns customized differentiation.

Intangibles constitute an ongoing challenge for

accountants (Giuliani & Marasca, 2011; Roslender &

Fincham, 2001) and their recording is a constant dispute,

with problematic consequences even on market and

performance valuation, exemplified by the increasing gap

- softened during recessions – between market and book

values, mostly attributable to relevant but not (adequately)

accounted for intangibles. International homogeneous

accounting treatment for intangibles is still a daunting

target (Córcoles, 2010).

Intangible value is hidden in the balance sheet by

inadequate accounting, but not in the profit & loss

account or in the cash flow statement, where IC

incremental contribution to profit is detectable.

This paper starts with a comprehensive intangible

valuation approach, with a consequent accounting

analysis of operating leverage and scalability, linked to

financial leverage and market value assessment by

interacting parameters, consistent with a Modigliani &

Miller optimal capital structure scenario. Intangibles,

often underrepresented in the balance sheet, typically

constitute a significant incremental EBITDA driver,

which expresses the dominant income-driven cash flow

source. Intangibles, which are the invisible “glue” behind

going concern and value creation, not only enhance

strategic differential value, but are also likelier to make

results more sustainable in the future, so easing proper

debt service.

DCF or EBITDA calculus is currently used even for

the market valuation of intangibles; even if this fact is

well known by academics and practitioners, some further

considerations, based on intangible driven cash

generation, may add originality to the discussion of IC

valuation and debt servicing. Asset-less incremental

EBITDA, driven by intangibles, reinforces debt service

capacity, through "economic" liquidity, originated in the

income statement.

The paradoxical relationship between intangibles

and debt (discouraged by lack of intangible collateral


242

value but enhanced by its cash flow contribution to debt

servicing) is critically examined, considering the impact

of information asymmetries, traditionally embedded in

intangibles, on debt rationing.

Innovative findings show that deeply rooted asset

backed lending attitudes, deriving from an ancestral

agricultural background where land and real estate

incarnate value, are increasingly overcome by cash flow

based lending, driven by inventive business models and

their income generating factors, more and more guided by

intangible components and consistent with the knowledge

economy framework.

Empirical evidence from an Italian sample of

different industries shows proportionality between

intensity of investments in intangibles and value.

Some practical tips, in order to soften outstanding

issues are lastly enumerated, together with hints for future

research avenues.

2 A comprehensive valuation approach

Intangibles may be valued with many complementary

methods (cost-based; income-based or market-based),

whose practical implications go well beyond plain

appraisals, concerning also proper accounting or ability to

promptly serve debt.

Issues relating to the valuation of intangibles are

surfacing with unprecedented regularity and posit an

intriguing challenge for the accounting fraternity that is

entrenched in the traditional ascendancy of “reliability”

over “relevance” (Singh, 2013).

Intangible assets, such as patents or trademarks

(Salinas & Ambler, 2009), are particularly difficult to

evaluate (Oestreicher, 2011; Moro Visconti, 2012), due to

their intrinsic “immaterial” nature and many different -

complementary – quantitative and qualitative evaluation

methods (Lagrost et al., 2010; Andriessen, 2004) are

traditionally used within the business community;

valuation issues are even more complicated for non

tradable or not deposited non-routine intangibles, such as

know-how (Moro Visconti, 2013), trade-secrets and

unpatented R&D (Ballester, Garcia-Ayuso & Livnat,

2003), goodwill, etc., characterized by limited if any

marketability, higher and pervasive information

asymmetries and less defined legal boundaries, especially

within increasingly specific businesses.

Intangible assets may anyway hardly be estimated

on a single basis, being mostly transacted within

intangible package deals. These difficulties in market

evaluation are even more evident considering that, from

an accounting perspective, according to IAS 38 there is no

active market for intangibles, typically undetected, and it

is consequently difficult to assess their fair value.

The main financial / market methods used for

intangibles’ fair pricing, with an appropriate rating and

ranking, selectively applicable to intangible assets, are the

following:

1. Cost-based methods, with an estimate of the “what-

if” costs to reproduce or replace intangibles from

scratch; this method ignores both maintenance and

the opportunity cost of time (reproducing an

intangible may take years, whereas its missed use is

due to generate a lack of income) and is not very

useful for income generating assets, such as

performing patents or trademarks; cost to cost

comparisons are difficult to imagine, especially if

they are to be protracted over years; even if

intangibles strongly depend on long cumulated costs,

their perspective value may hardly be inferred from

past expenses and is also highly volatile and instable

and cost differs from the value. To the extent that

costs cannot typically be capitalized, their

accounting track record may (partially) be detected

from past income statement recordings.

2. Income methods, based on the estimate of past and

future economic benefits, assessing the ability of the

intangible to produce licensing income (royalties,

which etymologically derive from “sovereign rents”)

or sale of the intangible; they may include:

capitalization of historic profits deriving from the

exploitation of the intangible;

Discounted Cash Flow (DCF), to estimate Net

Present Value (NPV), duly incorporating risk

adder factors in the discount rate, such as

technology venture capital risk;

gross profit differential methods; they look at the

difference in sales price between an “intangible

backed” product (branded, patented, with

embedded know-how …) versus a generic one;

the profit differential is then forecast and

discounted;

excess or premium profit methods; similar to the

gross profit, it is determined by capitalising the

additional profits generated by the business over

and above those generated by similar businesses,

which do not have access to the intangible asset.

Excess profits can be calculated by reference to a

margin differential;

relief from royalty method: based on the

assumption that the owner of the intangible is

"relieved" from paying a royalty to obtain its use,

the process considers the hypothetic “what if”

royalty that a potential user would be willing to

pay, and discounts its projection; a comparable

market range of “reasonable” royalties may

derive from careful arm’s length benchmarking.

3. Market-based methods, evaluating an intangible

asset by comparing it with sales of comparable /

similar assets (considering their nature; using

functional analysis …). Information asymmetries

often conceal the real (mostly secret) nature of the

allegedly comparable transaction. A market based

variety may refer to the evaluation of the

incremental equity, with indicators of the business

surplus, given for example by the Tobin Q, the ratio

between the market value and replacement value of

the same asset; a market value exceeding the


243

replacement value may be a numerical consequence

of valuable intangibles.

While income and market based methods may

theoretically seem based on accrual or, respectively, cash

flow accounting, in reality they tend to share common

parameters, softening the Manichean difference between

these two apparently antithetical accounting procedures.

A synthesis of economic (based on accrual accounting of

revenues and costs) and financial flows, is represented by

their (only) common parameter – EBITDA - as it is

shown in figure 1.

Figure 1. IC Valuation methodologies

Market valuations may use as preferential methods

either DCF or directly an EBITDA multiplier, inspired by

(intrinsically uneasy) IC comparisons. DCF theoretically

stands out as the optimal method, being inspired by the

golden rule according to which “cash is king”.

DCF is ubiquitous in financial valuation and

constitutes the cornerstone of contemporary valuation

theory (Singh, 2013). The robustness of the model as well

as its compatibility with the conventional two

dimensional risk-return structure of investment appraisal

makes it suited to a multitude of asset/liability valuations.

Accounting standards across the globe recognize the

efficacy of this model and advocate its use, wherever

practicable. FAS 141 and 142 of the United States and

IAS 39 that relate to the accounting of intangible assets,

also recommend the use of DCF methodology for

imputing a value to such assets.

Market evaluations also frequently use a

standardized EBITDA multiplied over time (from 2/3 up

to 15 or more times/years, in exceptional cases such as

patented killer application or “superstar” brands) and this

(apparently) simple multiplication brings to an Enterprise

Value (EV), attributable to debt-holders and, residually, to

equity-holders. This approach is consistent with the

accounting nature of EBITDA, which is calculated before

debt servicing.

EV / EBITDA multipliers may be connected to price

/ book value or Tobin q parameters, which reflect the

differential value of intangibles under a hypothetical cost

reproduction hypothesis, so representing a precious bridge

Intellectual Capital Valuation approaches

Market approach (Replacement) Cost approach

Income approach

Royalty relief

Price (volume) premium

Income-split

(multi-period) excess earnings

Price /

book value

Technology factor

Operating

leverage

Financial

leverage

Income statement

(including EBITDA)

Cash-flow

Statement (including EBITDA)

WACC /

Market weights

Incremental cash flow

EV / EBITDA


244

between otherwise disconnected market and cost appraisal

methods.

As a rough calculation, the EV multiple serves as a

proxy for how long it would take for a complete

acquisition of the entire company (including its debt) to

earn enough to pay off its costs (assuming no change in

EBITDA and a constant added value contribution from

the IC portfolio).Temporal mismatches between the

numerator and the denominator may bias the ratio and

should accordingly be minimized.

Equity and debt value may be jointly inferred from

an EBITDA multiplier, which estimates EV, and, after

deduction of market value of debt, residual market value

of equity. Whenever residual market value of equity

exceeds its book value, BV, (price > book value; P/BV>

1), an implicit safety net for principal debt repayment

emerges. Being EV a surrogate for market capitalization

(price), its relationship with market-to-book and Tobin q,

driven by the presence of intangibles (Valladares Soler &

Cuello de Oro, 2007; Chen, Cheng & Hwang, 2005)

seems even more evident.

The stream of (hopefully) growing and not

ephemeral Operating Cash Flows - CFo - (marginally

attributable to the intangible strategic contribution to the

overall value) incorporates growth factors (Tan et al.,

2007), whereas the weighted average cost of capital

(WACC) discounting denominator embodies market risk

elements, as recognised by debt and equity underwriters.

Moreover, cash flows are a cornerstone of debt service, as

it will be shown later. Qualitative issues, such as

consistency, durability, depth of coverage, etc.,

concerning IC, may strategically impact on future

EBITDA, cash flows and consequent value. WACC may

also be affected by the asset substitution problem and

inherent wealth transfer from debt- to equity- holders (or

vice-versa), as it will be shown in the next paragraphs.

What matters, should the valuation consider only IC

marginal contribution to the overall company’s value, is

just described by differential/incremental CFo or

EBITDA, made possible by IC strategic contribution,

which is, however, often uneasy to isolate. Residual

incremental value, not attributable to specific IC

components is allocated within the goodwill cauldron.

Being CFo derived from EBITDA, as depicted in

figure 2, the link between key market methods (possibly

complementary, rather than alternative) is evident. This is

a significant, albeit trivial, finding, somewhat

misperceived by the current literature, with an important

impact on IC valuation. Figure 2 shows the functional

links existing at the level of the profit and loss, balance

sheet and cash flow statement. EBITDA is also indirectly

reflected in (at least some) income valuation methods, for

example, those concerning royalty relief differentials or

marginal economic surpluses made possible by IC

exploitation, and so it constitutes a significant and

precious connection between market and economic

methods.

The (replacement) cost approach is apparently not so

easily linked to EBITDA, even if the projection of

reconstruction costs of the IC portfolio consider operating

economic costs that are a core, albeit not exclusive, part

of EBITDA. Revenues are missing in the replacement

cost method whereas key costs described for example by

depreciation are not present in the EBITDA.

Being the cost method deeply linked to accrual

accounting, it may suffer from somewhat misleading

historical cost convention procedures, which traditionally

underestimate IC accounting and, in particular, their

potential contribution to value creation. Accrual

accounting represents an obstacle for the appraisal of the

IC contribution to CFo creation, even if the

aforementioned links pivoting around EBITDA may

soften these inconveniences (Boujelben & Fedhila, 2011,

p. 481).

EBITDA is commonly used as a (misleading) proxy

for CFo, representing a kind of price to cash flow

multiple, unaffected by leverage and depreciation

policies. This proxy is often misleading, since CFO is

derived from EBITDA, considering also Capital

Expenditure (Capex) and Net Working Capital variations;

while fixed asset investments and their cashless

depreciation may hardly be affected by IC, typically not

capitalized, accounts payable included in NWC often

reflect operating debt connected to costs (for R&D,

advertising …) associated with IC.

EBITDA is also a key parameter for assessing debt

service capacity, so being linked even to classic capital

structure concerns. To the extent that debt is properly

served with positive cash inflows deriving (also) from

EBITDA (and then CFo, as depicted in Figure 2), a key

relationship can consequently be established between

market / income valuation models and bankability

concerns.

Capacity to serve debt is often measured by

EBITDA multipliers over negative interests (and also by

cover ratios, described in the appendix); being EBITDA a

differential and incremental economic / financial flow

from operations, it should conveniently exceed negative

interests at least 4-5 times, considering also its

contribution to the coverage of other monetary costs, such

as for example taxes.

Being IC appraisal so difficult and slippery,

synergistic combination of different complementary

techniques is, whenever possible, highly recommended.

Traditional financial statements do not provide the

relevant information for managers or investors to

understand how their resources – many of which are

intangible – create value in the future. IC statements are

designed to bridge this gap by providing innovative

information about how intangible resources create future

value. Published IC statements are, however rare

documents (Mouritsen, Bukh & Marr, 2004).

Valuation approaches may be synergistically linked

to operating and financial leverage, since they contain key

accounting and economic/financial parameters, as it will

be shown in the next paragraphs. A synthesis of intangible

appraisal methods, which may be summarized in a

comprehensive valuation dashboard, is depicted in

aforementioned Figure 1.


245

Figure 2. Interaction of balance sheet, profit and loss account and cash flow statement

Balance Sheet

∆ Fixed Assets

(CAPEX), including Intangibles

∆ Equity

∆ Financial Debts

∆ Operating Net

Working Capital (NWC)

∆ Liquidity

Income Statement

Operating Revenues - Operating (monetary) Fixed Costs

- Operating Variable Costs

= EBITDA - Amortization, depreciation and Provisions

= EBIT

- Net Financial Charges +/- Extraordinary Components

= Pre Tax Profit

- Taxes

= Net Profit

Cash Flow Statement

Operating Revenues

- Operating Fixed Costs

- Operating Variable Costs

= EBITDA

+/- ∆ Operating Net Working

Capital

+/- ∆ CAPEX

= Operating Cash Flow (CFO)

+/- ∆ Financial Debts

- Taxes

- Extraordinary Costs

+/- ∆ Equity

= Net Cash Flow (CFN)

SC

AL

AB

ILIT

Y

SCALABIL

ITY

Operating Leverage

Invested Capital

(Uses)

Raised Capital

(Sources)


246

These evaluation methods may well be linked to the

Modigliani & Miller, 1958 (M&M) theorems about

optimal capital structure, which will be examined

afterwards, and to the key parameters embedded in their

formulation:

Market approach is proxied by M&M

proposition I and related cost of capital;

Replacement cost is based on cumulated

reconstruction costs and is also linked to lost

opportunities, whose estimate may somewhat refer to

differential cumulated EBITDAs and other economic /

financial parameters, embedded in M&M formulations;

Income approach relies on EBIT / EBITDA

differential contribution to value.

Coherently with IAS 38 prescriptions, DCF is the

key parameter for both accounting and appraisal

estimates, so representing the unifying common

denominator of cost, income or market based methods,

which regularly need to find out their cash part. Cash is

also directly linked to debt service capacity, so connecting

intangible value creation and its book or market appraisal

with its financial coverage, once more remembering that

“cash is king”.

3 Accounting for scalable intangibles, from operating to financial leverage

Intangibles represent a flexible and resilient key part of

competitive advantage, incorporating value-enhancing

productivity and representing a fundamental constituent

of cash flow production, so making debt servicing

sustainable, as it will be shown even in the next

paragraphs.

Operating leverage is a measure of how revenue

growth translates into growth (∆ Sales) in operating

income (∆EBIT), a key economic margin which

incorporates most of the economic and accounting impact

concerning intangibles. It is a measure of how risky

(volatile) a company's operating income is:

SALES

EBITLeverageOperating

SALES

provisionsonDepreciatiEBITDA

)/( (1)

The factors that influence operating revenues are:

revenue volumes and margins,

influenced by intangible items;

variable costs;

fixed costs, mitigated by intangible-

driven productivity gains, which may strongly

contribute pulling down the economic break-even

point.

Operating risk may be reduced and better monitored

with synergistic use of intangibles (intangibles are likely

to have a positive impact on operating leverage, reducing

fixed costs; protecting revenues; enhancing marginality).

Scalability is, broadly speaking, the ability of a

business model to generate incremental demand

(additional revenues) economically, i.e. without

significantly increasing costs. In the presence of a

scalable business, the operating leverage works as a

multiplier of the EBIT.

Since any change in operating leverage affects a key

parameter such as the EBITDA, it also has a financial

effect, due to the circumstance that EBITDA is both an

economic and financial margin, being represented by the

difference between monetary operating revenues and

costs, as it has been shown in figure 2. This well known

property has important side effects and is a key factor in

order to understand why and to what extent financial and

operating risk can be associated.

Since operating leverage indicates the translation of

revenue changes on EBIT, which may be decomposed

into EBITDA + depreciation/amortization, the differential

impact of intangibles on EBIT may also be accordingly

split: an economic/financial impact on EBITDA and an

economic/asset (balance sheet) impact on cashless

depreciation and amortization, which are in turn linked to

cash flow sensitive Capex and, eventually, to operating

cash flow. Any change in the economic marginality,

affecting EBITDA and EBIT, so has an impact on

operating cash flow, a key parameter in order to assess the

financial soundness of the company and its ability to

properly serve the debt burden. Operating cash flow, as it

is shown in the appendix, is in turn associated with key

financial parameters like cover ratio, NPV, IRR, WACC

Interactions of key parameters may bring to significant

insights; for example if IRRinvestment > WACC, the return

on invested capital exceeds the cost of raised capital,

bringing to a positive NPV, with safety resources for debt

service and residual incremental value for equity-holders.

4 Leverage and the paradox of intangibles: more guarantees with less collateral?

Financial leverage, represented by the debt to equity ratio,

paradoxically interacts with intangibles, since their

presence in the asset’s portfolio typically decreases

residual collateral value, so discouraging debt, whereas

unique intangible assets are, on the other side, a

fundamental pant of cash generating value, so

representing a key factor for debt servicing.

Intangibles and their liabilities (García-Parra et al.,

2009). may so decrease leverage, even because tangible

equity (i.e. book equity, net of intangibles) is often used

in the denominator of the leverage formula, but their

presence increases the ability to repay debt, and credit

ratings are improved by innovation (Al-Najjar &

Elgammal, 2013).

This paradox may be softened with a fair

communication of the company’s perspectives, so

relevant for a proper debt servicing, underlying the key

strategic role of intangibles. It may also be noted that

tangible assets are increasingly worthless in a standalone


247

context, their value strongly depending on a continuous

interaction with intangibles, like software with hardware.

The circumstance according to which, in an extreme

“intangible” context, typical of venture backed start-ups

(whose main asset is represented by ideas with strong but

uncertain potential for growth), debt is difficult to

enforce, and so almost nonexistent, is a symptom of a

strong relationship between physical marketable assets

and borrowing capacity. In the valuation of intangibles,

there is so a remarkable difference between going concern

and break-up value, especially in the presence of tailor

made and not autonomously tradable assets.

The value of the firm, in an ideal world with

complete and perfect capital markets, is unaffected by the

way the firm is financed - and so capital structure, in

terms of debt to equity ratio, is in principle irrelevant

(Modigliani & Miller, 1958). Being raised capital (equity

+ financial debt) the balancing counterpart of invested

capital (net working capital + fixed assets, including

intangibles), the financing mix also depends on the assets’

composition. Whenever this composition is changed and

the firm invests in assets, such as intangibles, that are

potentially riskier than those that the debt-holders

expected, an asset substitution problem arises.

The value of an unlevered firm equals that of a

levered firm, being debt irrelevant, and the market value

of a firm (V) depends on its ability to generate operating

cash flows (CFo), to be discounted using a consistent

parameter such as the weighted average cost of capital

(WACC). The formula shows a strong accounting link

between operating and financial leverage, particularly

evident decomposing the numerator and considering the

presence of the debt-to-equity ratio (Df/[Df+E]) as a

weighting part of the cost of debt kd, net of the fiscal

impact (1-t), in the denominator, where also cost of equity

ke is present:

ED

Dtk

ED

Ek

CapexNWCEBITDA

WACC

CFV

f

f

d

f

e

O

)1(

)(

)1( (2)

CFo may be split in its traditional composing

entities: EBITDA, variation in Operating Net Working

NWC

This formula, which represents Modigliani & Miller

(M&M) proposition I, is to be properly linked with M&M

proposition II, described in formula (3).

Leverage does not affect unlevered CFo, and also

WACC is theoretically unaffected, to the extent that any

change in the cost of debt (rising with leverage, due to

agency costs) is counterbalanced, in an ideal world, by

symmetric changes in the cost of equity.

In synthesis, due to a kind of self balancing effect,

any leverage (Df/E) change affects weighting factors of

WACC but it should not (optimally) modify it, nor should

it affect the parameters in the numerator (EBITDA, NWC,

Capex).

Financial leverage does not affect the numerator

(being CFo accounted for before debt servicing), whereas

also the WACC in the denominator is unaffected by debt

to equity changes, where risk is shifted from shareholders

to debt-holders when leverage grows, resulting in a zero

sum game balancing effect, again (only) in an ideal

frictionless world.

As shown in figure 2, CFo (whose impact on IC is

described in Boujelben & Fedhila, 2011), derives from

EBITDA, which is simultaneously an economic and a

financial margin (flow), representing a key link between

Income and the Cash Flow statements; EBITDA is also

strictly linked to EBIT, which is the target component of

operating leverage, sensitive to operating revenue

changes.

Debt capacity is a direct function of the assets’

composition and its intrinsic riskiness, but assets have to

be considered, rather than stand-alone items, a synergistic

bundle of tangible and intangible components,

consistently with the Coasian theory of the firm and so

incarnated by an integrated nexus of contracts, where

know-how and goodwill represent the invisible glue

behind intangible driven value, which represents a kind of

knowledge-based equity (Maditinos et al., 2011).

In the presence of intangible investments, lending

should conveniently pass from an asset-based to a cash

flow-based approach, where liquidity contribution is

worth more than (tangible) asset-backed leverage. Even if

the breakup value of intangibles may be negligible,

especially if they may not be autonomously traded, the

probability to depart from a going concern scenario may

be less likely in the presence of a good intangible

portfolio. Asset substitution (from safer to riskier asset

composition) may so, in practice, misrepresent the

company’s solidity, exaggerating its risk profile.

Intangibles, in pills, are linked to weaker if any

guarantees, within a less likely scenario of enforcing

them. IC unspecific value, ontologically unfit to be used

as “material” collateral, yet has positive debt service

implications, through its cash generating capacity.

Intangible investments do not necessarily absorb

more debt, whereas they can ignite productivity gains

(roughly measured by EBITDA increases), consequently

easing bankability.

The value chain that links leverage to intangibles is

represented in Figure 3, which contains a dynamic flow

chart, starting from leverage and raised capital, to be

invested in fixed assets (Capex), such as intangibles,

which boost sales and then, consequentially, incremental

EBITDA and operating cash flows, ultimately increasing

differential value, linked to IC valuation methods and,

through operating value, to intangible driven scalability.


248

Figure 3. The Leverage – intangibles value chain

scalability

∆ INT ∆ Sales ∆ EBIT(DA) ∆ CFO ∆ V

operating

leverage

∆ Capex

∆ raised (= invested) capital

[embedding ∆ leverage]

# denominator should be mostly

unchanged, unless differential

CFOs have an impact on it.

3

1

2

4 5 6 7

IC

valuation

methodsreplacement

cost approach

income

approach

market

approach

5 Information asymmetries and debt rationing

Information asymmetries have a paradoxical impact on

intangibles, since, in many cases they are needed and

looked for, deterring imitation, as it happens with know-

how and, to a lesser extent, with patents, whereas in other

cases they cause communication problems that may

damage brands and the external perception of the

corporate image. Information asymmetries are so

intrinsically embedded in intangible items, whose value is

uneasy to account for and disclose (Arvidsson, 2011;

Singh & Kansal, 2011; Kristandl & Bontis, 2007). The

prudential exclusion of home-grown intangibles from the

balance sheet increases information asymmetries,

hampering comparability.

Appraisal and diffusion of the company’s market

value, with particular reference to its somewhat

mysterious intangible component, may so be

misrepresented, causing market failures and misbehavior,

in the form of adverse selection, moral hazard or other

corporate governance criticalities.

Since intangible assets are intrinsically difficult to

estimate, their value may be misperceived and

downgraded, with market failures that typically interest

investors, in the form of (potential) debt-holders or

shareholders, which may be frightened or discouraged.

Debt capacity grows in the presence of tangible

assets with potential collateral value given by applicable

guarantees, as confirmed by the seminal paper of Jensen

& Meckling (1976), whose theory of the firm is based on

agency problems created by the coexistence of debt and

outside equity with inside penniless managers.

Intangibles intrinsically incorporate information

asymmetries (Leland & Pyle, 1977; Aboody & Lev, 2000)

and inside managers command superior information over

the firm’s value and prospects, if compared to outsiders;

information asymmetries bring to sub-optimal decisions

and may prevent capital or debt collection, so causing

debt rationing problems which may block financing of

valuable – and IC sensitive - projects.

Corporate governance failures and conflicting

interests among different stakeholders (from

conspiratorial IC managers to ... sometimes gullible

lenders) are also exacerbated by problematic debt

monitoring and control rights in the presence of

undetectable intangibles. Legal protection of debt-

holders, including the right to grab collateral assets, and

the (theoretical) right to liquidate the business, are

weakened by the presence of intangibles with little if any

alternative use.

Information asymmetries are constantly nurtured by

noise (Black, 1986) as a cause of uncertainty and

inefficiency, contrasted with (proper and fair)

information. Arbitrary noise is costly and it naturally

produces volatility through biased and distorted

estimations, hampering discrimination, which is essential

in order to assess the actual impact of intangibles within

the firm. Due to its slippery boundaries and immaterial

plasticity, hardly observable and hazy intangibles are

intrinsically noisy, and their differential impact on

economic and financial flows is difficult to estimate and

distinguish, as well as their potential replacement cost.


249

Noisy and cloudy investments in intangibles,

typically stir up the aforementioned asset substitution

problems, to the extent that companies may exchange

their low risk assets for riskier investments; since debt-

holders typically have a fixed compensation, the higher

risk put on assets is not typically compensated by higher

rewards, and consequently there is a risk transfer from

shareholders to debt-holders.

All these well known corporate governance

problems have to be properly managed, aligning the

interests of inside agents with those of external principals,

with positive and value enhancing side effects, such as

monitoring and accountability.

IC sharing among different firms is an intermediate

solution between internal protection and sale (or, to a

milder degree, licensing).

To the extent that information asymmetries and

secrecy voluntarily soften with IC and knowledge sharing,

economically stimulated by increasingly synergistic value

chains (as the one represented in Figure 3), inappropriate

behaviours (e.g., of counterfeiter competitors) may

accordingly intensify and strategic differential value may

be threatened. Progressive evolution from the industrial to

the information age subverts traditional value chains, with

an impact even on conventional lending, with a shift from

asset-backed tangible collateral to hardly marketable but

value enhancing intangibles.

The paradox of (elsewhere much appreciated)

comparability is that, in many cases it represents a

symptom of weak value, especially if concerning brands

or patents, whose uniqueness (and consequent

incomparability) is possibly the strongest fundament of

intrinsic value. It may so be affirmed that value-

destroying information asymmetries are, for certain

contradictory features, a positive source of value; whereas

these two different aspects represent a zero sum game,

approaching Pareto optimality, remains however a

complex issue, uneasy to be generalized. More

interdisciplinary research is needed even for this not

trivial aspect.

Imitation of unprotected intangibles, intrinsically

reduces information asymmetries, again with a

controversial impact on value, producing trickle down and

spill-over externalities but also destroying monopolistic

secrecy and, with it, egoistic reward for innovative

efforts, up to the point of discouraging R&D. Legal

infringements are increasingly likely in a technological

environment where information is easier to ... copy and

paste, storing and transferring it in real time, up to the

point of making it publicly available through the

libertarian Web.

Some mitigation strategies may soften information

asymmetries:

since the presence of intangibles increases the

company’s payoff upside potential, residually

attributable only to equity-holders; issue of

convertible debt may soften this risk / return

asymmetry (Smith & Warner, 1979);

voluntary disclosure of intangible value (Garcia-

Meca et al., 2005; Kristandl & Bontis, 2007;

Singh & Kansal, 2011) may bridge information

gaps, softening asymmetries, binding managerial

opportunism and easing value diffusion and

sharing, with a simplifying impact even on

(proper) lending contract design;

introduction of debt covenants (Smith & Warner,

1979); for example, dividends are typically

restricted in the presence of relevant intangibles

(as it happens with start-ups);

reduction of the debt’s extension: operating debt,

which backs intangible investments, is typically

short termed, and frequent repricing, with an

implicit reimbursement option for the creditor,

reduces managerial discretion, easing monitoring

and softening information asymmetries;

pecking order hypothesis, where self financing

(driven by EBITDA, up to undistributed net

profits) fully reflect the intangible contribution,

being hierarchically preferred to (increasingly

risky) debt issuance and, ultimately equity

inflows;

protection of intangibles, remembering that if

intangibles can efficiently and unnoticeably be

transferred by free riding managers (often with

the complicity of equity-holders), then creditors

may be damaged;

proper accounting representation of the

incremental impact of intangibles on the income

statement, which may soften info asymmetries

that traditionally concentrate on the balance

sheet, where intangibles are typically

underrepresented.

6 Some empirical evidence from Italian industries

Some empirical evidence about the relationship between

intangibles and value can be extracted from the database

of Mediobanca's annual statistical survey of principal

Italian companies.

The financial aggregates cover 2,035 companies,

typically representative of the Italian manufacturing and

service industries, over the seven-year period 2006-2012.

According to the most recent statistics from ISTAT, the

Italian Statistics Office, the manufacturing businesses in

the 2,035-company group represent 47% of Italy's total

industrial sales.

The sample, reported in Table 1. (with average data

2006-2012), is comprehensive and representative, but also

somewhat noisy and blurred, since it hardly allows to

properly focus on intangibles, collecting “meso” industry

data, which are hardly suitable for deeper micro analysis.


250

Table 1. Intangible intensity and profitability from a sample of Italian industrial companies

Sample / Industry

Intangible intensity= Intangibles / Total assets

EBITDA/Sales

(Cash ROS)

Intangibles / EBITDA

Intangibles (% on Assets) / Cost of Debt

general sample sub-sections

Services companies 28.06% 22.72% 3.28 3.56

Foreign controlled companies 17.41% 10.67% 1.74 2.99

Private Companies 17.20% 10.55% 2.19 2.52

Cumulative data 12.80% 10.99% 1.84 2.03

Companies in constant loss 11.25% -9.12% -2.76 1.11

Companies in steady profit 8.96% 14.33% 0.96 1.65

Public Enterprises 5.37% 12.39% 1.04 1.00

Industrial companies 5.31% 8.24% 0.86 0.86

Medium sized companies 2.64% 7.71% 0.36 0.55

industries

Public services 44.28% 41.82% 3.55 5.97

Tertiary companies 27.15% 23.77% 3.13 4.24

Different companies 15.03% 15.08% 1.76 2.25

Food-canning 14.50% 7.95% 2.02 2.90

Diary Food 12.95% 6.03% 1.95 2.84

Clothing 12.49% 11.06% 1.32 2.03

Electronics 10.16% 6.79% 2.01 1.50

Leather goods 10.01% 11.98% 0.79 1.63

Food and alcohol 9.42% 11.34% 1.18 2.04

Transportation construction 9.00% 4.03% 5.57 1.03

Chemical 7.93% 4.46% 1.89 1.22

Print and publishing 6.46% 7.19% 2.19 1.51

Retail 6.37% 5.80% 1.13 1.82

Confectionery-foods 6.32% 11.89% 0.47 1.43

Mechanical sector 6.24% 8.99% 0.87 0.91

Glass 5.75% 14.68% 0.61 1.40

Pharmaceutical and cosmetics 5.45% 12.96% 0.48 1.09

Wood and forniture 5.20% 6.28% 1.10 1.00

Appliances radio television 4.84% 4.84% 1.01 0.69

Energy 4.58% 9.08% 0.66 0.83

Different foods 3.80% 6.15% 0.51 0.72

Paper 2.66% 7.42% 0.45 0.48

Textile 2.39% 7.59% 0.46 0.44

Plant 2.23% 6.52% 0.80 0.21

Products for construction 1.40% 9.61% 0.46 0.25

Transport 1.25% 8.38% -0.29 0.38

Rubber and cables 1.05% 6.08% 0.20 0.18

Metallurgical 0.61% 6.75% 0.10 0.10

Source: http://www.mbres.it/en/publications/financial-aggregates-italian-companies

Empirical evidence from the selected sample

unequivocally shows that intangible intensity (intangibles

/ total assets) is positively linked to profitability,

measured by parameters such as EBITDA over sales, a

ratio that represents a kind of “cash” Return on Sales

(ROS), and Intangibles over EBITDA, a complementary

multiplier which times intangibles recorded in the balance

sheet to EBITDA.


251

Intangibles are also compared to the cost of

collected debt, with a further multiplier whose ranking is

again consistent with the aforementioned findings,

showing an inverse proportionality between intangible

intensity and cost of collected debt.

The overall sample sub-sections are to be compared

with benchmarking cumulative data, somewhat in the

middle of the ranking.

Interesting findings may also be inferred from the

industry breakup, where 28 different sectors are ranked,

showing an intangible intensity which is somewhat

consistent with the overall sample and, again, positively

linked to profitability.

7 Conclusion

If companies can hardly survive without increasingly

sophisticated intangibles, even their sponsoring banks are

more and more challenged by path-breaking changes in

the strategies of their clients. This is why intangible

valuation is so significant (also) for lending institutions.

Lack of proper intangible “soft” lending may also cause

credit misallocation and consequent market failures.

Starting from these premises, this paper has

addressed many interrelated issues, all pivoting around

intangible valuation and consequent ability to generate

enough cash in order to properly serve debt.

The main propositions / theoretical issues and

findings can so be summarized:

Proposition 1 – Market and Income intangible

evaluation methods and, to a lesser extent, replacement

cost methods, are linked by common accounting

parameters, such as EBITDA.

Proposition 2 – Intangible-driven EBITDA is linked

to scalable operating leverage and they are both related

to operating cash flows, so mattering for debt service

ability.

Proposition 3 – Asset substitution, is due to increase

the company’s riskiness, but intangible investments, albeit

lacking collateral value, may also actively improve

economic and financial margins, easing debt service.

Proposition 4 – Intangible-driven Enterprise Value

is positively related to bankability and debt coverage.

Proposition 5 – In case of default, IC is almost

valueless, but its very presence in the (original) going

concern situation makes default less likely.

More research is needed, considering in particular

the still obscure relationship between assets’ composition

and value, strictly linked to debt service ability, in the

presence of variegated intangibles.

The hierarchy and composition of cash funding

represent another key issue, waiting for deeper

investigation: according to the Pecking Order Hypothesis,

popularized by Myers & Majluf (1984), the cost of

financing increases with asymmetric information - and so,

with intangibles. Companies prioritize their sources of

financing, first preferring internal financing, and after

debt, lastly raising equity as an expensive “last resort”.

Since intangibles stand out as a key income (EBITDA)

liquidity driver, their strategic presence is consistent with

financial pecking order (Degryse, de Goeij & Kappert,

2012); accordingly, when investments in intangibles are

significant, such as in growth type firms, and debt ability

is limited, firms eventually rely on private or other

external equity (Baeyens & Manigart, 2006; Vanacker &

Manigart, 2010; Wu & Yeung, 2012). Deeper analysis

and research is required even for this increasingly critical

value driver problem, especially in a recessionary capital

rationing situation.

IAS compliant DCF appraisal, albeit being

recognized as a preferred accounting option for

intangibles, still represents an uphill goal, so demanding

additional fine tuning.

The differential impact of intangibles on value,

starting from Porter’s competitive advantage, is a well

known cornerstone of IC identification and autonomous

valuation, but its detection is still noisy and troubled, also

due to accounting problems, related in particular to self

generated intangibles: capturing and measuring hidden

value, to be extracted from intangibles, remains an uphill

task.

Information asymmetries preserve but conceal

intangible value, with a double edged sword impact even

on the bankability, again demanding deeper research,

uneasy to model and generalize.

Value is increasingly and crucially coalescing

around intangibles, the foremost breadwinning strategic

driver behind differentiation, with its marginal economic

and financial spillovers and externalities.

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253

Appendices

Appendix. Connections between operating leverage and key financial ratios

ITEMS FORMULA CONNECTIONS WITH

OPERATING LEVERAGE

OPERATING REVENUES

Operating revenues (including active royalties and boosted by IC assets)

- monetary and operating fixed costs * - monetary and operating variable costs *

= EBITDA

- amortization, depreciation and provisions

= EBIT

+/- ∆ Capital Expenditure (CAPEX) +/- ∆ Operating Net Working Capital

= OPERATING CASH FLOW = CFO

* minimized by appropriate use of know-how, patents and other IC assets.

Growing operating revenues generate an increase in EBIT, depending on the

fixed / variable costs mix.

EBITDA

EBITDA, given by the difference between operating revenues and

(monetary) operating costs, influences

Operating Cash Flow. The same happens with EBIT, which additionally

considers non monetary operating costs

(depreciation, amortization, provisions).

EBIT

OPERATING

CASH FLOW

Increases in operating revenues increase

EBITDA, EBIT and Operating Net

Working Capital, normally pushing up

Operating Cash Flow.

Weighted

Average Cost of Capital

(WACC)

ED

D)t1(k

ED

EkWACC

f

f

d

f

e

If operating revenues grow, EBIT and

consequently net profit should increase,

with an induced Equity growth; if equity grows, ceteris paribus leverage

decreases and there is a transfer of risk

from debt-holders to shareholders; to the extent that this risk transfer is

symmetric, WACC should be

unaffected.

Net Present Value NPVproject 0

1 )1(CF

WACC

CFONPV

n

tt

t

project

If EBITDA grows, Operating Cash Flow

(CFO) increases, with a positive impact

on NPV, especially if WACC decreases.

Internal Rate of

Return

IRRproject

0CF)IRR1(

CFO...

)IRR1(

CFO

IRR1

CFONPV 0n

project

n

2

project

2

project

1

project

If Operating Cash Flow grows, NPV might increase, then also IRR grows,

increasing the financial break-even

point; the project is more easily bankable.

Average Debt

Service Cover Ratio

n

ID

CFO

ADSCR

n

1t ttf

t

Operating Leverage is strictly connected

with average debt service cover ratio - a typical debt metric - which strongly

depends on Operating Cash Flow. If

cumulated CFOs grow, then financial debt may be reduced.

(Financial)

Leverage1

ke = [WACC + ( WACC - kd ) * Df/E ] (1-t)

where:

t = tax rate

If the difference ( WACC - kd )

between the weighted average cost

(return) of capital and the cost of debt is positive, then a leverage above unity

(where Df > E) enhances this positive

difference, with a consequential positive effect on the cost (return) of equity.

Enterprise Value

EBITDA * n = Enterprise Value EBITDA is connected to Operating leverage, as shown in formula (1)

EBITDA / financial

charges

EBITDA / financial charges

EBITDA should be consistent enough to

cover financial charges and other monetary costs; this parameter deeply

changes across time, being negative in

the construction phase and sometimes even at the beginning of the

management phase; higher financial

charges, embodied in the cost of debt and in the WACC, decrease the margin

multiplier (EBITDA should be at least

5-6 times the financial charges, depending on the amount of the other

monetary costs), with a direct impact on

cover ratio and leverage.

1 This is the standard Modigliani & Miller proposition II, adjusted for taxes. The M&M theorem states that, in a perfect market, how a firm

is financed is irrelevant to its value.


254

REVENUES FROM RELATED PARTIES: A RISK FACTOR IN ITALIAN LISTED COMPANY FINANCIAL STATEMENTS

Fabrizio Bava*, Melchiorre Gromis di Trana**

Abstract

In recent decades, related party transactions (RPTs) have played a prime role in major corporate scandals, obliging regulators to strengthen the rules with new bans and expensive requirements on companies. This study aims to contribute to the literature on RPTs, providing evidence to justify increasingly expensive and mandatory regulation. Results show that the intensity of related party revenues increases where a company has lost profitability as well as turnover. Keywords: Related Party Transactions, Conflict of Interests, Profitability, Revenues *Associate Professor, University of Turin, Department of Management, C.so Unione Sovietica 218 bis – 10134 Turin (ITALY) **Ph.D., University of Turin, Department of Management, C.so Unione Sovietica 218 bis – 10134 Turin (ITALY)

1 Introduction

Recent shortcomings in corporate affairs, related to the

Global Financial Crisis, have shown how related party

transactions (RPTs), in many cases, played a prime role in

abuse. This forced regulators to strengthen the rules,

introducing new bans and imposing new requirements

aimed at guaranteeing the substantive and economic

fairness of related party transactions (RPTs). The reforms

have focused on two main areas, approval processes and

increasing transparency. From a theoretical perspective,

RPTs are studied according to two different perspectives:

conflict of interest and the efficient transaction

hypothesis.

The first supports the idea that these transactions

represent a conflict of interest and conflict with forms of

company and investor protection (Emshwiller 2003). The

conflict of interest theory claims that RPTs may in

general be an instrument of abuse in relation to two

opposing groups: ownership and control (executive

directors and management), or majority and minority

shareholders.

In opposition to this, the efficient transaction

hypothesis assumes that RPTs are sound business

exchanges, efficiently fulfilling the underlying economic

needs of the corporation (Pizzo 2011), because the

reduction of information asymmetry reduces transaction

costs and risks. The theories coexist and hence RPTs

cannot be banned.

In line with the conflict of interest theory, our study

aims to analyze relations between revenues made with

RPTs (Related Revenues) and corporate economic

trends.

Excluding banks, in Italy subject to specific rules,

we examined the 100 highest capitalized Italian

companies listed in 2011. The focus is on Italy because of

the strong interrelation between Italian listed companies

(as elsewhere in Europe). The relations involve intra-

group entities as well as extra-group entities. In particular,

the Italian listed corporate sector is characterized by

concentrated control (Bianchi & Bianco 2006) through

opaque structures, such as pyramids, dominated by a

small number of interlinked but competing entrepreneurs

(Assonime 2011). Italian companies generally have a

controlling owner (Bianchi et al. 2001), hence the

relevance of the topic in the Italian context because of the

exposure of minority shareholders to a high risk of

exploitation (Nenova 2003, Dyck and Zingales 2004).

As Holderness (2009) says, minority control is a

widespread and constant issue the world over, in different

forms and modes. Data was collected in part from the

AIDA database (Bureau van Dijk S.p.a) and in part from

Financial Statements. Pursuant to Consob Resolution

15519/2006, companies must declare the revenues and

costs produced with RPTs in their Income Statements, as

well as related receivables and liabilities in the Financial

Statements. The data was checked with information set

out in the Supplementary Notes to the Financial

Statements, as required by IAS 24, which disclose details

regarding related parties.

In the literature, the improper use of RPTs has been

found to affect future performance as well as corporate

values in China (Chen et al. 2011; Zhu and Zhu 2012) and

the U.S. (Ryngaert and Thomas 2012; Kohlbeck and

Mayhew 2010). Some studies indicate a positive relation

between RPTs and corporate performance, through

increasing sales or lower transaction costs (Khanna and

Palepu 1997, Chen et al. 2012), whereas other studies

support the evidence that there is a negative association

between RPTs and performance, Tobin’s q ratio and ROA

(Munir & Gul 2011), or ROE (Cheung et al. 2009). Via

an OLS model, this research aims to contribute to the

literature on RPTs by providing evidence to justify

increasingly expensive and mandatory regulation. Results


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show that the intensity of related party revenues is higher

when a company has suffered a reduction in profitability

as well as in turnover. Whereas, there is no evidence of

inverse relations between related party revenues and the

financial position of the company. This provides input for

future research to implement our analysis taking the

financial dimension into account.

2 Review of rpts in the literature

The sequence of corporate scandals (Enron, Arthur

Andersen, WorldCom, Adelphia, Tyco International and

Parmalat) that shook up financial markets at the

beginning of the new millennium has fueled a debate on

Corporate Governance (CG). To understand its

importance, it is necessary to clearly establish the purpose

of a corporation. As Stout (2013) and many other authors

(Clark 2013, Stevelman 2013, Weinstein 2013) argue, the

corporate form may meet the needs of many different

groups of entities. One of the most widespread theories is

the maximization of shareholder value based on the

difficult issue of resolving conflicts between the

ownership and other stakeholders. In this sense CG rules

aim to put shareholder interests before those of Directors

(Agency theory) and stakeholders. Hence RPTs can play a

positive role in helping companies to reach their

shareholder targets. This rules out banning them

altogether (Goshen 2003). However, they can be used to

generate abuses against various other types of entity in

corporate life. RPTs can reduce the problem of

asymmetric information between outside stakeholders

(including investors) and corporate management (Gordon

et al. 2004), partly because of the conflict of interest that

can arise among shareholders.

For this reason, CG is expected to reduce the

opportunistic behavior of management, to improve the

quality of corporate reporting, and to increase corporate

performance (Chen et al. 2009, Bhagat and Bolton 2008,

Denis and McConnell 2003). At the same time, it restrains

(diminishes) opportunistic uses of discretionary accruals

in a company’s Financial Statements (Chung et al. 2002

and Park and Shin 2004), inter-group borrowings

(Berkman et al. 2009), and corporate fraud (Chen et al.

2006).

In the Shareholder Value Myth, Stout (2013) shows

how the traditional managerial focus on shareholder

interest can be harmful to the corporation. He suggests a

more long-term perspective that does not reward a small

subset of shareholders, which is shortsighted,

opportunistic, undiversified, and indifferent to ethics and

the welfare of others. Furthermore, as Biondi (2005)

suggests, the accounting system can be deemed the heart

of the business corporation and can replace or

complement the market price. A method based on

accounting reporting is better able to represent and

control the relationship between shareholders and the

business corporation (Biondi 2012).

Due to this, CG rules must regulate the assessment

process and approval of RPTs and improve the efficiency

and quality of financial reporting (Razaee 2004). This

would limit the improper use of RPTs and foster the

disclosure of the information required to assess these

transactions (Fooladi et al. 2011).

As with CG, RPTs are strongly influenced by the

type of culture to which they are applied. Hoftede (1980)

points to the large cultural differences between countries

to explain the very varied approaches adopted. and the

many different types of CG models and rules. Globally,

three leading forms of capitalism can be identified: the

Anglo-Saxon, the Teutonic and the Latin. Their most

significant differences are generally the result of

differences in culture although there are other elements

that influence CG variables. Despite the globalization

process which is fostering unification of the models in

many counties, significant differences remain regarding

ownership structure and corporate control. In particular,

many studies focus on the relationship between ownership

structure (Zengquan et al. 2004, Kun 2005, Jian & Tak

2010, Munir 2010), the role played by the stock market

(Gordon et al. 2004, Lo et al. 2010, Yeh et al. 2012) and

the quality and relevance of RPTs in corporate life.

Cernat (2004) argues that CG constitutes not only a

crucial difference between varieties of capitalism but is

also a major factor in determining their economic

performance. Chen (2014) found that the financial crisis

has triggered a need for companies to adopt a new

governance structure in order to better cope with the

challenges of the environment. However, as yet, the

literature on RPTs has not paid sufficient attention to the

relationship between CG and RPT disclosure, although

the knowledge of these transactions can affect the way in

which analysts of Financial Statements assess the

performance, financial position, and risk and

opportunities of an entity (Corlaciu and Tudor 2011).

Current rules on RPTs must be revised and improved

because of a lack of efficiency (Gromis di Trana 2014,

Bava and Gromis di Trana 2015).

Two definitions of RPTs are commonly used (Chen-

Wen & Chinshun 2007) in business literature.

The first is that RPTs are generically defined as

transactions between a company and related entities (e.g.,

subsidiaries, affiliates, principal owners, officers, and

directors) (FASB 1982). Young (2005) suggests a second

definition that sees them as «transactions between a

company and an insider», i.e. a person considered to be

part of the company (Pan & Hsiu-Cheng 2007). The

common element is the relationship between the parties

which can influence and establish the binding conditions

of the contract (implicitly or explicitly), which differ from

other contracts because the parties are not independent.

One of the most influential and widespread

definitions is provided by International Accounting

Standards which define RPTs as a «transfer of resources,

services or obligations between a reporting entity and a

related party, regardless of whether a price is charged»

(IAS 24), and where «a related party is a person or entity

that is related to the entity that is preparing its financial

statements» (IAS 24). Two or more parties are considered

to be related, whether companies or individuals, when one

has the ability to influence the other in making


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operational or financial decisions. Furthermore,

International Accounting Standards state that related

entities are members of the same group (which means that

parent companies, subsidiaries and fellow subsidiaries are

all related to each other), including where the entity, or

any member of a group, provides key management

personnel services to the reporting entity or to the parent

of the reporting entity. The latter provision was added by

Annual Improvements to the IFRSs 2010–2012 Cycle,

taking effect for annual periods from 1 July 2014. This

version does not deem two entities related simply because

they have a director or key manager in common. Hence,

RPTs can be observed through different perspectives, one

that puts the risks before the advantages produced by

these transactions, and the other which highlights their

natural tendency to reduce monitoring costs and

information asymmetry.

From a theoretical perspective, RPTs are studied in

light of:

(a) conflicts of interest;

(b) the efficient transaction hypothesis.

Lemmon and Lins (2003) suggest that the

corporation ownership structure is what principally

determines the extent of agency problems between

controlling insiders and outside investors. The insiders

able to control corporate assets can potentially expropriate

outside investors by diverting resources for their personal

use or by committing funds to unprofitable projects that

provide private benefits. Further, Grossman and Hart

(1980) showed that if a corporation has a broad

shareholder base, no single shareholder has adequate

incentives to monitor management closely. In this context

the transfer price can favor the controlling or related party

at the expense of minority shareholders (Johnson et al.

2000). Therefore it is important to guarantee adequate

legal process to protect minorities and small investors. La

Porta et al. (1998) argue that the absence of strong legal

protection and other external governance mechanisms

further increases the severity of agency problems between

controlling insiders and outside investors.

Based on these assumptions, the first theory supports

the idea that these transactions are a conflict of interest

and also conflict with company and investor protection

(Emshwiller 2003). The theory claims that RPTs may in

general generate abuse due to the opposing interests of

ownership and control (executive directors and

management), or of majority and minority shareholders.

The first conflict is examined by Agency Theory

literature (Jensen and Meckling 1976, Fama 1980,

Eisenhardt 1989), which also deals with the effectiveness

of monitoring management (Fama and Jensen 1983 1-2).

The second conflict is sufficiently analyzed in literature as

an investor protection tool (La Porta et al. 2000). In

particular, the transactions are subject to moral hazard, i.e.

a situation where a party tends to take risks because it is

not liable for any costs incurred. Thus, RPTs can produce

benefits for the strong party (insiders) at the expense of

the weak (outsider). The reasons for this discrepancy are

the lack of tools to protect the minority’s rights and the

presence of asymmetric information (Beak et al. 2006).

Some examples of this abuse could lead to a reduction in

shareholder wealth (tunneling transactions), yielding a

virtual increase in the resources of the corporation or,

ultimately, misleading statements (earnings management).

Some studies (Gordon 2004 et al., Kohlbeck and Mayhew

2005) conclude that weak corporate governance leads to a

larger number of RPTs. Several studies have confirmed

the use of earnings management by large numbers of

listed companies in order to achieve particular levels of

ROE (Chen and Yuan 2004, Liu and Lu 2007). The

manipulation of the process of financial reporting to

obtain private gain may easily take place through RPTs.

In contrast with the previous approach, the efficient

transaction hypothesis assumes that related party

transactions represent sound business exchanges,

efficiently fulfilling the underlying economic needs of the

corporation (Pizzo 2011). The basis of this theory is the

reduction of transaction costs as well as the reduction of

the risk associated with these transactions. The conflicts

of interest theory and the efficient transaction theory are

not necessarily in opposition, because these transactions

can produce benefits as well as disadvantages. For this

reason, as stated by Goshen (2003), a total ban on self-

dealing would be irreconcilable with the goal of

preserving the performance of efficient transactions.

Furthermore, a non-interventionist approach would leave

the investor vulnerable the problem of the conflict of

interests.

Related party sales might be an important part in a

firm’s normal business and contribute as importantly to

the firm’s performance and return as do non-related party

sales. However, if related party sales are misused by the

controlling owner for opportunistic earnings management

purposes, the credibility and durability of these sales

numbers are lower than that of non-related party sales,

which are more difficult to manipulate.

Finally, a contingency perspective has been

suggested encompassing both theories (Pizzo 2011). It is

based on the fact that method is perfect and can cope

with all possible cases.

Some studies suggest that, on average, RPTs are not

harmful to outside shareholders (Ryngaert & Thomas

2011). This observation can be extended to the other

classes of stakeholders (Henry et al. 2007). However a

high inherent risk exists due to the increased likelihood of

RPTs being used in fraudulent behavior. In particular, this

type of transaction tends to increase the discrepancy in

treatment between those who hold the power and those

who are subject to it (minority shareholders or

shareholdings in general). Having said this, it should also

be noted that most of these transactions are a normal

feature of business; entities frequently carry out activities

through subsidiaries, joint control or significant influence,

and the fact that a corporation conducts a high volume of

such transactions should not automatically lead to the

conclusion that something fishy is going on (Gordon et al.

2007).


257

Numerous studies provide evidence of their role in

financial crises (Swartz and Watkins 2003; Tague 2004)

and in achieving specific aims (Erickson et al. 2000);

others do the opposite, demonstrating how RPTs played

no strategic role in corporate scandals (Bell & Carcello

2000). While the presence of RPTs does not mean

fraudulent financial reporting, failure to recognize or

disclose related party transactions was found to be one of

the top 10 audit deficiencies in the United States by

Beasleye at al. (2001).

Regulators reacted by strengthening the existing

rules, introducing new bans and imposing additional

statutory requirements, to guarantee stakeholders’ rights.

This fails to address the fact that fraud of this kind

can be carried out with parties not generally considered

related parties. RPTs attract attention due to their

inherent risk. Hence regulation cannot exclude a risk

approach to evaluating the transactions to be disclosed in

order to identify the proper tradeoff between costs and

positive effects.

Business literature has provided ample evidence of

the consequences of RPTs for a firm’s performance.

Kohlbeck and Mayhew (2005) suggest that the potential

benefit or detriment depends on the parties involved in the

transaction or the type of RPTs carried out. Liu and Liu

(2007) state that RP sales and purchases are used to

encourage cooperation among entities and maximize the

operational efficiency and competitiveness of group

companies. As a result, RP sales and purchases in China

improve corporate performance and increase abnormal

stock returns. Chang and Hong (2000) found that firms

perform better when the transfers of products and

managerial expertise within the group increase. Empirical

evidence shows that Chinese firms with high levels of RP

loans and guarantees demonstrate significantly poor

future performance, including sharp declines in

profitability (Jiang et al. 2010).

The higher the level of related party purchase

transactions engaged in by Chinese listed companies, the

better their financial and market performance (Chen et al.

2009), but there is also a significant negative relationship

between related party sales, loans, guarantees, mortgages

and leases, and market performance. Some studies

indicate a positive relation between RPTs and corporate

performance, through increasing sales or reduced

transaction costs (Khanna and Palepu 1997), whereas

other studies support the evidence that there is a negative

association between RPTs and performance, Tobin’s q

ratio and ROA (Munir & Gul 2011), or ROE (Cheung et

al. 2009). This type of evaluation is made harder by the

difficulties in the various activities caused by routine

versus anomalous transactions (Wong & Ming 2003). For

this reason, Chen et al. (2012) divided RPTs into normal

and abnormal. The results show that normal RPTs are

positively correlated with firm performance (ROA, ROE

or ROS) and abnormal RPTs negatively correlated.

Pozzoli and Venuti (2014) conclude that in Italy RPTs

and ROA are not correlated and there is no evidence of

cause and effect. Wen-Yi Lin et al. (2010) claim that it is

difficult, if not impossible, to determine whether such

transactions are beneficial or detrimental to organizational

performance, and this evaluation should be made on a

case by case basis.

Other studies evaluate the effect produced by RPTs

on corporate value. For instance, Kohlbeck & Mayhew

(2009) found that the market assigns lower values and

subsequent returns to corporations that engage in certain

types of RPTs. This study verified the influence that

corporate performance plays on RP revenues.

3 Research question and sample 3.1 Research question

The aim of our analysis is to verify whether there is an

association between the intensity of revenues with related

parties and a firm’s profitability, as well as with trends in

turnover. Data was collected from Consolidated Financial

Statements in order to limit the effects produced by

group size.

In particular, we were not interested in identifying

an association between ROI (return on investments), ROE

(return on equity) and ROA (return on assets), but we

took into account the effects produced by an increase or a

reduction in these ratios between 2010 and 2011. The

reason was that the selected companies operate in

different sectors characterized by different profitability

averages. The analysis was also applied to trends in

turnover over the same period.

The following questions were asked:

RQ 1) Is there an association between revenues

with related parties and corporate profitability?

To identify this correlation we took into account the

variation of ROI (the ratio between EBIT and Total

Assets) between 2010 and 2011, since it shows core

business profitability, whereas other indicators such as

ROE and ROA are affected by extraordinary components

that may vary without indicating a situation of crisis. A

positive association may mean that RPTs are efficient and

can help companies achieve improved economic results.

On the contrary, a negative association could be a

warning sign indicating the inherent risk behind the

transactions.

RQ 2) Is there an association between revenues

with related parties and trends in turnover?

In the last few years the recession has caused a fall

in sales in many sectors, one of the main reasons

companies have stopped generating wealth and have

started to consume it. We wanted to see if companies that increase or

reduce turnover are more or less involved in carrying out revenues with related parties. A statistical association between the intensity of related party revenues and an increase in turnover may be physiological, whereas an association between the intensity of related party


258

transactions and a fall in turnover might be a means to reduce economic imbalance.

3.2 Sample The empirical analysis considers the 100 highest capitalized Italian listed companies in 2010. Banks were excluded for two reasons: firstly the structure of their Income Statements differs from other corporations and secondly, because in Italy banks are subject to specific

rules on related party transactions. Appendix 1 sets out the list of companies. 3.3 Model design The model we suggest is innovative and aims to establish the relation between the intensity of RPTs and the variable selected as the best indicator of a company’s health.

I.

𝑅𝑃𝑅 𝑖𝑛𝑡𝑒𝑛𝑠𝑖𝑡𝑦 = 𝛼 + 𝛽𝑖 Δ𝑇𝑢𝑟𝑛 + 𝛽𝑖𝑖 Δ𝑅𝑂𝐼 + 𝛽𝑖𝑖𝑖 Δ𝐶𝑎𝑠ℎ + 𝛽𝑖𝑣 𝑀𝑎𝑟𝑔2011 + 𝜀 The intensity of RP Revenues is the ratio between

RP revenues and 2011 operating revenues. Turnover id preferred to total asset value because it gives a better picture of the company’s market position. Different

businesses require different investments, which could influence the association with other variables taken into consideration.

The ratio is: II.

𝑅𝑃𝑅 𝑖𝑛𝑡𝑒𝑛𝑠𝑖𝑡𝑦 =𝑅𝑒𝑙𝑎𝑡𝑒𝑑 𝑝𝑎𝑟𝑡𝑦 𝑟𝑒𝑣𝑒𝑛𝑢𝑒𝑠

𝑂𝑝𝑒𝑟𝑎𝑡𝑖𝑛𝑔 𝑟𝑒𝑣𝑒𝑛𝑢𝑒𝑠

ΔTurn is the relative increase or decrease in turnover

between 2011 and 2010. We opted for a ratio in order to reduce the effect produced by the difference in size.

The ratio is:

III.

Δ𝑇𝑢𝑟𝑛 =𝑂𝑝𝑒𝑟𝑎𝑡𝑖𝑛𝑔 𝑟𝑒𝑣𝑒𝑛𝑢𝑒𝑠 2011 − 𝑂𝑝𝑒𝑟𝑎𝑡𝑖𝑛𝑔 𝑟𝑒𝑣𝑒𝑛𝑢𝑒𝑠 2010

𝑂𝑝𝑒𝑟𝑎𝑡𝑖𝑛𝑔 𝑟𝑒𝑣𝑒𝑛𝑢𝑒𝑠 2010

ΔROI is the difference between 2011 and 2010

operating profitability. ROI (return on investment) is a performance measure used to evaluate operating profitability. ROI is the ratio between EBIT and Total Assets, chosen because it reflects the core business and is

not influenced by other variables such as financial elements or extraordinary results.

The formula is:

IV.

Δ𝑅𝑂𝐼 = 𝑅𝑂𝐼 2011 − 𝑅𝑂𝐼 2010 ΔCash is a financial variable that evaluates a firm’s

financial trends. It shows the difference between Net Cash Flow in 2011 and in 2010. It was adopted in order to extend the study to the financial dimension.

The formula is: V.

Δ𝐶𝑎𝑠ℎ =𝐶𝑎𝑠ℎ 2011 − 𝐶𝑎𝑠ℎ 2010

𝐶𝑎𝑠ℎ 2010

Marg 2011 is the relation between EBITDA and

Operating revenues in 2011. It is a stock variable, used to verify if companies with higher related revenues in 2011 had higher operating margins in the same year and to test

whether there is the same relation between profitability trends and stock value.

The formula is:

VI.

Marg 2011 =𝐸𝐵𝐼𝑇𝐷𝐴 2011

𝑂𝑝𝑒𝑟𝑎𝑡𝑖𝑛𝑔 𝑟𝑒𝑣𝑒𝑛𝑢𝑒𝑠 2011

4 Results An OLS linear model was used (Model I) to develop the study. All analyses were performed with IBM’s SPSS

(22). An R2 of .378 is low, but can be considered adequate

because the independent variable is the ratio of related revenues to total operating revenues (Table 1).


259

Table 1- Model Summaryb

Model R R Square

Adjusted R

Square Std. Error Durbin-Watson

1 .615a .378 .351 .17080 1.775

a. Predictors: (Constant), ΔTurn, ΔROI, ΔCash, Marg2011.

b. Dependent Variable: RP Revenue intensity.

Table 2 -ANOVAa

Model Sum of Squares df Mean Square F Sig.

1 Regression 1.634 4 .408 14.001 ,000b

Residual 2.684 92 .029

Total 4.318 96

a. Dependent Variable: RP Revenue intensity.

b. Predictors: (Constant), ΔTurn, ΔROI, ΔCash, Marg2011.

Table 3. Coefficientsa

Model

Unstand. Coeff. Stand.Coeffi.

t Sig. B Std. Error Beta

1 (Constant) .026 .024 1.086 .280

ΔTurn -.264 .086 -.285 -3.081 .003

ΔROI -1.970 .397 -.479 -4.963 .000

ΔCash .071 .022 .301 3.276 .001

Marg2011 3.878E-18 .007 .306 3.612 .000

Empirical evidence shows the all the variables

observed significantly influence the ratio of related

revenues to the total, since their p-value is between

0.05 and 0.01.

The results in Table 3 show a negative relation

between a fluctuation in turnover and the intensity of

RP revenues. Companies with a fall in turnover

between 2010 and 2011, in 2011, had the highest RP

revenue intensity.

The same association is true of corporate

profitability. A reduction in profitability seems to

induce companies to declare more revenues from

RPTs.

Table 3 shows a positive association between the

difference of Net Cash Flow and the intensity of RP

revenues. There are two outputs: the first suggests that

it would be interesting to extend this type of analysis

to the financial dimension of RPTs, and, the second

may suggest that RP revenues are used to inject

liquidity into firms. This may be useful for the firm,

but at the same time it subordinates these transactions

to solely a financial necessity. There is also a positive

association between Marg2011 and the intensity of

RP revenues.

Tables 4 and 5 evaluate the multicollinearity

problem.

Table 4. VIF

Model

Collinearity Statistics

Tolerance VIF

1 (Constant)

ΔTurn .788 1.269

ΔROI .724 1.380

ΔCash .801 1.248

Marg2011 .944 1.059


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Table 5 – Multicollinearity index

Model Dimension Eigenvalue Condition Index

1 1 1.909 1.000

2 1.613 1.088

3 .660 1.701

4 .479 1.996

5 .339 2.374

VIF values in Table 4 are low and suggest that

there are no correlations between independent

variables. Furthermore, in Table 5, the

multicollinearity index is also slow in confirming the

adequateness of the model.

Table 6. Heteroscedasticity

Table 6 shows that our model is not affected by

heteroscedasticity.

5 Conclusions

As suggested in the literature, RPTs can be used to

carry out abuse with conflicts of interest between

ownership and control or between majority and

minority shareholders. These transactions are subject

to moral hazard, and hence are characterized by a

greater inherent risk than other transactions.

Regulators have recently strengthened existing rules,

introducing new bans and requirements, aimed at

guaranteeing the substantive and economic fairness of

these transactions.

The aim of the regulatory process is to guarantee

the proper use of RPTs. This paper provides evidence

of the potential risk of these operations. Focusing on

the revenues made with RPs, we investigated the

relation between business trends and the intensity of

RP revenues in Income Statements.

The first variable considered is the difference in

profitability. Specifically, we investigated the

relationship between the difference in ROI (return on

investments) and the intensity of RP revenues. Our

analysis responds to the first RQ with positive

evidence. There is a statistically negative association

between ROI trends and the intensity of RP revenues.

This is a sign of potential danger because companies

that are losing profitability are more likely to turn to

RPs for revenues.

The second element that we took into account is

the difference in turnover between 2010 and 2011. A

fall in turnover is clearly a major concern for a

corporation. It may be caused by a problem in the

effectiveness of outputs or by adverse environmental

and economic conditions. Obviously, in light of the

importance of fixed costs in Italian Income

Statements, a reduction in turnover can threaten the

continuation of the business.

Our analysis responds to the second RQ with

positive evidence. There is a statistically negative

association between turnover trend and the intensity


261

of RP revenues. This may also be read as a warning

because companies that lose turnover are more likely

to turn to RPs for revenue. These results partially

justify the recent tightening in rules.

We also tested the intensity of RP revenues

against two other variables: the variation of Net Free

Cash Flow and the EBITDA margin.

There is a positive association between

Marg2011 and the intensity of RP revenues. This

suggests that companies with a higher margin

generate more revenues with RPs. This positive

association suggests that RPTs may be instruments to

increase corporate profitability. Indeed, they may be

carried out at conditions that differ from normal

market conditions to cover a reduction in margins. As

is known, this is one of the main risks associated with

RP transactions. Many could be carried out without a

genuine economic reason.

The cash flow trend needs to verify the relation

between RP revenues and the financial position of the

firm. The study highlights a positive association

between these variables. This suggests that companies

with a better financial position between 2010 and

2011 are more likely to generate revenue from RPs.

This positive association produces two different

outputs: the first suggests that it may be interesting in

future research to expand this analysis to the financial

dimension of RPTs (for instance considering related

cash flow values), and the second underlines that RP

revenues are used to inject liquidity into corporations

(a binomial correlation may be found). This may be

useful for corporations but at the same time it could

relegate these transactions to solely financial

necessity.

These two results are realted because a higher

EBITDA margin may produce an increase in cash

flow.

This study provides a starting point for future

research, which could extend our analysis (dealing

only with economic effects) to include financial

effects and consider other elements that are influenced

by the intensity of RP revenues.

In future research we intend to expand this

sample and, at the same time, in line with the

literature, include in the model control variables better

able to explain the effects produced by independent

variables and to reduce error . This paper considers

the intensity of RP revenues in 2011, and it may be of

interest to analyze the same association with a trend in

RP revenues.

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Appendices

Appendix 1 1 A.S. ROMA SPA

2 A2A S.P.A.

3 ACEA S.P.A.

4 ACOTEL GROUP SOCIETA' PER AZIONI

5 ACSM-AGAM S.P.A.

6 AEDES SPA

7 AEFFE S.P.A.

8 AEROPORTO DI FIRENZE S.P.A.

9 AMPLIFON S.P.A.

10 ANSALDO STS S.P.A.

11 ARNOLDO MONDADORI EDITORE SPA

12 ASCOPIAVE S.P.A.

13 ASTALDI S.P.A.

14 ATLANTIA S.P.A.

15 AUTOGRILL S.P.A.

16 AUTOSTRADE MERIDIONALI S.P.A.


264

Appendix 1- Continued

17 B. & C. SPEAKERS - SOCIETA' PER AZIONI

18 BASIC NET S.P.A.

19 BASTOGI S.P.A.

20 BE S.P.A.

21 BEGHELLI S.P.A.

22 BEST UNION COMPANY S.P.A.

23 BIESSE S.P.A.

24 BREMBO S.P.A.

25 BUZZI UNICEM S.P.A.

26 CAIRO COMMUNICATION S.P.A.

27 CALTAGIRONE EDITORE S.P.A.

28 CEMBRE S.P.A.

29 CEMENTIR HOLDING S.P.A.

30 CIR S.P.A.

31 COFIDE - GRUPPO DE BENEDETTI S.P.A.

32 DANIELI & C. S.P.A.

33 DATALOGIC S.P.A.

34 DAVIDE CAMPARI-MILANO S.P.A.

35 DE' LONGHI S.P.A.

36 DIASORIN S.P.A.

37 EL.EN. - S.P.A.

38 EMAK S.P.A.

39 ENEL - SPA

40 ENEL GREEN POWER S.P.A.

41 ENGINEERING - INGEGNERIA INFORMATICA - S.P.A.

42 ENI S.P.A.

43 ERG S.P.A.

44 ESPRINET S.P.A.

45 FALCK RENEWABLES S.P.A.

46 FIERA MILANO S.P.A.

47 FINCANTIERI S.P.A.

48 FINMECCANICA S.P.A.

49 FNM S.P.A.

50 GEOX S.P.A.

51 GRUPPO EDIT ORIALE L'ESPRESSO S.P.A. SI

52 HERA S.P.A.

53 IGD SIIQ S.P.A.

54 IMA S.P.A.

55 IMMSI S.P.A.

56 INTERPUMP GROUP S.P.A.

57 IREN S.P.A.

58 ITALCEMENTI FABBRICHE RIUNITE CEMENTO S.P.A.

59 ITALMOBILIARE SPA


265

Appendix 1 - Continued

60 JUVENTUS F.C. - S.P.A.

61 LA DORIA - S.P.A.

62 LUXOTTICA GROUP SPA

63 MAIRE TECNIMONT S.P.A.

64 MARR S.P.A.

65 MEDIASET S.P.A.

66 NICE S.P.A.

67 OLIDATA S.P.A.

68 PARMALAT S.P.A.

69 PIAGGIO & C. S.P.A.

70 PIRELLI & C. S.P.A.

71 PRADA S.P.A.

72 PRELIOS S.P.A.

73 PRIMA INDUSTRIE - S.P.A.

74 PRYSMIAN S.P.A.

75 RCS S.P.A.

76 RECORDATI INDUSTRIA CHIMICA E FARMACEUTICA S.P.A.

77 REPLY S.P.A.

78 RISANAMENTO SPA

79 SABAF S.P.A.

80 SAFILO GROUP S.P.A.

81 SAIPEM S.P.A.

82 SALVATORE FERRAGAMO S.P.A.

83 SARAS S.P.A.

84 SAVE S.P.A.

85 SEAT PAGINE GIALLE S.P.A.

86 SERVIZI ITALIA S.P.A.

87 SNAI S.P.A.

88 SNAM S.P.A.

89 SOCIETA' INIZIATIVE AUTOSTRADALI E SERVIZI S.P.A.

90 SOGEFI S.P.A.

91 SOL S.P.A.

92 SORIN SPA

93 TAMBURI INVESTMENT PARTNERS S.P.A.

94 TELECOM ITALIA SPA

95 TERNA S.P.A.

96 TOD'S S.P.A.

97 TREVI - FINANZIARIA INDUSTRIALE S.P.A.

98 VIANINI LAVORI - S.P.A

99 YOOX S.P.A.

100 ZIGNAGO VETRO S.P.A.


266

THE EFFECT OF IFRS ENFORCEMENT FACTORS ON ANALYSTS’ EARNINGS FORECASTS ACCURACY

Nadia Cheikh Rouhou*, Wyème Ben Mrad Douagi**, Khaled Hussainey***

Abstract This paper examines the effect of IFRS mandatory adoption by French companies on analysts’ earnings forecast accuracy. In addition, we consider the impact of corporate governance mechanisms, as IFRS enforcement factors, on earnings forecasts. Using a sample of 98 companies over the period from 2003 to 2007, our results show increased forecast accuracy after the mandatory adoption of IFRS. We also find that the independence, the international competency and the efficiency of the board members, the board size, and the quality of external audit are important factors for the implementation of IFRS and, these factors improve earnings forecast accuracy. Keywords: IFRS Enforcement Factors; Corporate Governance *University/Institution: University of Tunis El Manar, Faculté des Sciences Economique et Gestion de Tunis, Tunisia **Department: Finance and Accounting University/Institution: University of Tunis El Manar, Faculté des Sciences Economique et Gestion de Tunis, Tunisia *** Plymouth Business School, University of Plymouth, UK

1 Introduction

There is an increasing debate about the impact of

international financial reporting standards (IFRS)

mandatory adoption on earning quality. At the time of

this study more than 120 countries permit or require

publicly traded companies to use IFRS. In this

context, the European Union (EU) has taken the first

initiative of harmonization by the implementation of

Seventh Directive for consolidated accounts. The

second essay on harmonization was decided by

Regulation 1606/2002 of 16 July 2002 that impose

European listed companies to adopt international

GAAP produced by the IASB (International

Accounting Standards Board) a private organization

(Chiapello, 2005; Jermakowicz and Gornick -

Tomaszewski, 2006). Furthermore, in the United

States (US) the security exchange commission has

allowed foreign companies to use IFRS instead of

reconciling their financial statements to US generally

accepted accounting principles (SEC, 2010). This

study aims to examine the impact of IFRS mandatory

adoption on the quality of financial statements. In

particular, we examine factors that contribute to the

enforcement of IFRS and consequently to the

improvement of analyst’s earnings forecasts accuracy.

Disclosure quality has attracted the interest of

both academics and professional accountants in

various contexts, especially when they adopt

international accounting standards. Accounting

literature show several approaches that could be used

to investigate the impact of international standard on

disclosure quality. Some authors analyse the effect of

different standards on the value relevance that

measure by information asymmetry. (Leuz, 2003;

Daske, 2006; Armstrong et al, 2010). Other research

has examined the impact of IFRS on reliability of

financial disclosure that approximate by earnings

management (Zimmerman and Goncharov, 2007;

Titas and Dipanjan, 2012). A final approach to

analyse IFRS effectiveness consider its effect on

comparability. (DeFond et al, 2011; Jones and Finley,

2011). Moreover, previous literature has concentrated

mainly on the effect of IFRS voluntary adoption by

German companies (Barth et al, 2008; Van Tendeloo

and Vanstraelen, 2005) on earning quality focusing on

the properties of earnings (e.g. earnings management)

and where IFRS enforcement factors are not

controlled for (Zimmerman and Goncharov, 2007;

Titas and Dipanjan, 2012). This research contributes

to this debate by examining the effect of IFRS

mandatory adoption on forecast earnings accuracy by

analysts a sophisticated users of financial statements.

As an aggregate measure of performance, earnings

number is one of the most important items disclosed

by firms. It allows decision makers, especially

analysts, to evaluate a firm efficiency, its financial

and competitive position. Considering the analysts’

earnings forecasts accuracy as a direct measure of the

usefulness of accounting information which is an

important qualitative characteristic (IASB

Framework, Jiao et al, 2012), we use this variable to

approximate earnings quality.

Since the majority of studies focuses on the US

stock exchange markets and investigates the effect of

cross listings on the properties of analyst’s forecasts

(Lang et al, 2003; Ciccone, 2005; Heflin et al, 2003),

we address this issue in the setting of French capital


267

market where IFRS are mandatorily adopted by all

European Union (EU) listed companies. France is a

code law country characterized by regulatory rigidity

and a legalistic prospect that differs largely from

international accounting standard marked by

conceptual framework that protects shareholder

interests. To the best of our knowledge, there is no

study examining the effect of IFRS on analysts’

forecast accuracy in the French market. In this sense,

this paper is one of the first to study whether the

analysts’ earnings forecasts accuracy increases in

France capital market following mandatory IFRS

adoption, and conditions and enforcement factors that

let increases to occur.

Furthermore, previous research shows that the

implementation of international accounting system

reinforces the quality of financial reporting by

meeting the information needs of investors (Van

Tendeloo and Vanstraelen, 2005; Hung and

Subramanyam, 2007; Iatridis, 2010). Nevertheless,

earnings quality cannot be determined by the quality

of accounting standards alone because their

implementation requires judgment (Ball et al, 2000;

Burgstahler et al., 2006). In fact, companies operating

in the same economic context report financial

earnings of significantly different quality (Watrin and

Ullmann, 2012). So, our research contributes to this

debate by examining factors that have entailed the

enforcement of IFRS and improved the quality of

financial reports.

Overall, we extend prior research in two

principles ways:

I- First, we test the impact of IFRS on

analysts’ earnings forecasts in France, a code-law

country, which has undergone a major switch from

following the stakeholder- oriented to the shareholder-

oriented accounting system.

II- Second, while previous studies examined the

effect of institutional differences across countries on

reporting quality (Ball et al, 2003; Lang et al, 2003;

Bushman et Piotroski, 2006), we point out how IFRS

enforcement factors influence earnings quality. So, we

investigate at the firm level by choosing a sample of

firms that are subject to the same institutional

framework.

Our findings show improvements in the accuracy

of analysts’ earnings forecasts after mandatory IFRS

adoption. In addition, the board independence,

international competency and efficiency, the quality

of external audit and the board size are important

factors of IFRS implementation and consequently

contribute to the improvement of disclosure quality.

These results are relevant to the debate on the

decision of the current mandatory switch to a single

set of accounting standards in Europe.

The remainder of this paper is organised as

follows. Section 2 presents the theoretical framework

and the development of the research hypotheses. The

third section explains the research design. The results

are reported and discussed in section 4. Section 5

concludes our paper and provides suggestions for

further research.

2 Theoretical frameworks and hypotheses development:

Two theoretical frameworks can be used in this paper

to explain the effect of IFRS enforcement factors on

analyst’s earnings forecasts. These are agency theory

and signalling theory.

2.1 Agency theory

The agency theory is formalised by Jensen and

Meckling (1976) to highlight both the agency

relationship between shareholders, creditors and

managers and interest conflict that arise from the

separation of ownership and control of public

companies. This theory considers the firm as

organisational form searching to reduce agency

conflicts and costs involved. Based upon agency

theory, disseminating high quality accounting and

financial information is commonly used by firms to

reduce agency costs.

Furthermore, this theory is implicitly proposed

as a framework by IASB. In fact, the IFRS conceptual

framework acknowledges that investors are privileged

financial users (Colasse, 2006). It encourages firms to

enhance the transparency and the level of financial

information disclosed in order to limit discretionary

power of managers, and earnings forecasted will be

improved as a result. Moreover, corporate governance

mechanisms are established by shareholders in order

to align managers’ actions with shareholders’ interest.

That’s why many previous empirical research (Zéghal

et al, 2011; Hussainey and Al Najjar, 2011;

Tauringana and Mangena, 2009) focus on this

settlement as determinants of high quality disclosure

in accordance with agency theory.

2.2 Signalling theory

It is argued that there are several similarities between

agency theory and signalling theory (Morris, 1987;

Sun et al, 2010). Signalling theory was developed by

Akerlof (1970) to alleviate problems due to the

existence of information asymmetry in the capital

markets. These problems may be reduced when the

party who detains more information signals it to other

parties less informed. The reduction of uncertainty

and information asymmetry would improve the

communication between managers and other

interested parties such as shareholders, regulatory and

supervisory authorities, lenders, financial analysts,

etc. This allows, therefore, reducing the related

agency costs that might otherwise arise (Healy and

Palepu, 2001). That’s why signalling prospects can be


268

considered as explaining the agency theory

assumptions.

Furthermore, IFRS are issued by IASB in order

“to develop, in the public interest, a single set of high

quality, understandable and enforceable global

accounting standards that require high quality,

transparent and comparable information in financial

statements and other financial reporting to help

participants in the world's capital markets and other

users make economic decisions” (Epstein and Mirza,

2002). The EU objective of mandating IFRS was to

improve the capital market functioning. In fact, the

implementation of IFRS, a single set of high quality

accounting standards, would lead to more transparent

financial reports and reduce the information

asymmetry between informed and uninformed

investors (Armstrong et al, 2010; Jiao et al, 2012).

Hence, the IFRS adoption and enforcement could be

considered as positive signal to the stakeholders as

information disclosed under international standards is

of high quality and improves analysts’ earnings

forecasts.

2.3 Impact of the mandatory adoption of IFRS on analysts’ earnings forecasts accuracy

Earnings number is the summary measure on which

analysts, the most important users of financial reports,

focus (Barker and Imam, 2008; Dechow et al 1998).

Thereby, to infer the effect of IFRS mandatory

adoption on earning quality, we use analysts forecast

properties rather than earning properties measure such

as earnings management largely used in last research.

A wide literature has addressed the issue of

relation between financial reporting quality and

analysts’ forecast accuracy. Most research in this field

provides evidence that increased disclosure level2 is

associated with decrease of information asymmetry

and hence higher analyst forecast accuracy (Lang and

Lundholm, 1996; Hope, 2003). Also, the increased

disclosure quality decreases the information

asymmetry (Healey and Palepu, 2001; Frankel and Li,

2004; Watrin and Ullmann, 2012). Financial

statements are the most important source of

information for different users, particularly, the

financial analysts (Capstaff et al, 1995; Barron et al,

2002; Barker and Imam, 2008). This implies that any

change in accounting information related to the

transition from domestic GAAP (Generally Accepted

Accounting Principles) to IFRS, is reflected in the

accuracy of analysts’ forecasts.

A growing body of literature claimed that IFRS

is a high quality accounting standard allowing

transparency and credibility of financial reports (Ball

et al., 2003; Van Tendeloo and Vanstraelen, 2005;

Kohlbech and Warfield, 2010). Using different

2 Level of disclosure is considered as proxy of disclosure

quality (Botosan, 1997; Beattie et al, 2002)

methods of measuring financial information quality,

several studies investigate the effect of IFRS adoption

on disclosure quality. Indeed, approximating earning

quality by earnings management and timeliness of

losses, Iatridis (2010) finds that the adoption of IFRS

is related to a decreased earnings management, more

timely loss recognition and consequently higher value

relevance of financial disclosure for British

companies. In addition, Barth et al (2008) report a

decrease in the practice of earnings management after

the switch to IFRS. Nevertheless, other studies,

focused on earnings management and timeliness of

losses, report a decrease of accounting quality after

transition to IFRS (Ahmed et al, 2013; Chen et al,

2010; JeanJean and Stolowy, 2008). Based on a

sample of Indian firms, Titas and Dipanjan (2012)

find a negative relationship between the adoption of

IFRS and earnings management. Hence, the earnings

management practice increases significantly after

IFRS transition.

Examining the literature on the effect of IFRS

adoption on analysts’ earnings forecasts provides

mixed evidence. Dask (2005) evidence shows lower

accuracy and higher dispersion among analysts’

forecasts for German firms which adopted

international accounting standards before mandatory

period. In addition, Bae et al (2008) find evidence that

the extent to which local GAAP differs from IFRS are

negatively associated with analysts’ forecasts

accuracy in the post-IFRS adoption period. However,

by measuring investor response to earnings, some

prior research document numerous capital benefits of

IFRS adoption including reduced cost of capital and

improved liquidity (Li, 2010; Daske et al, 2008),

greater analyst following and reduced analyst forecast

dispersion (Horton and Serafeim, 2010; Tan et al

2011). In addition, Byard et al (2011) study the

variation of the forecast error committed by analysts

after IFRS adoption. They find a decrease of the

absolute error value showing that accounting

information is becoming more relevant. This decrease

is very significant for IFRS mandatory adopting

countries whose local GAAP (Generally Accepted

Accounting Principles) are widely different from

those of the IASB conceptual framework. These

results were confirmed by Armstrong et al (2010)

concerning the mandatory adoption of IFRS in the

European context. These authors examine the reaction

of financial market to sixteen events related to the

adoption of IFRS in Europe. They find that investors

expect an incrementally improvement in the value

relevance of financial disclosure after the mandatory

transition to IFRS. In addition they conclude that

financial market reacts positively to any event

promoting the adoption of IFRS.

Voulgaris et al (2014) examine the effect of

IFRS on the type of performance measures that firms

use to evaluate and reward their managers. Their

findings suggest that, while under IFRS, accounting

earnings could be more informative for valuation


269

purposes, this might be achieved at the expense of

other purposes that accounting serves such as

stewardship or performance contracting.

Using a sample of 19 European countries where

UK firms are the most represented3, Jiao et al (2012)

analyzed the effect of IFRS mandatory adoption on

analysts’ earnings forecast accuracy. They document

that analysts’ earnings forecasts have become more

accurate and less dispersed after IFRS switch. So,

researchers conclude that international standards

allow an improvement in the value relevance of

disclosure.

La Bruslerie and Gabteni (2014) investigated the

relationship between mandatory and voluntary

information and whether the introduction of IFRS

influenced the content and level of discretionary

information disclosed by firms. Referring to 2003-

2008 period gives a long term perspectives and allow

them to identify communication policy. Their results

show that voluntary disclosure policies improve with

the introduction of IFRS. This study also shows that,

after IFRS, the discretionary communication policies

of French firms follow both a long term and short

term component to meet analysts’ demand for

information permitting an increase in earning’s

forecasts accuracy.

Following this literature, it is clear that the

question relating to the impact of IFRS on financial

statement disclosure quality was subject of

controversies. Accordingly, if the transparency and

the value relevance of financial statements improve

under IFRS, more accurate information will be

available to analysts which might lead to an

improvement in analysts’ earnings forecasts accuracy

(Tong, 2007; Cheong et al, 2010).

Our first objective in this research is to

investigate the impact of IFRS mandatory adoption on

analysts’ earnings forecasts in France a code law

country. To achieve this objective, we assume that

IFRS mandatory adoption helps analysts in

forecasting future earnings. Thus our first hypothesis

is:

H1: The mandatory adoption of IFRS in France

improves the analysts’ earnings forecasts accuracy.

2.4 IFRS enforcement factors

Much attention in current accounting research4 is

given to the effect of accounting standard especially

the international standards on disclosure quality.

Nevertheless, the quality of financial statements does

not depend on the quality of these standards alone.

Indeed, the quality of disclosure could be attributed to

both the quality of IFRS and their high enforcement

and implementation (Van Tendeloo and Vanstraelen,

2005; Ball et al, 2003; Li, 2010, Byard et al, 2011).

3 UK firms represent 37% of the sample

4 Zimmerman and Goncharov (2007), Titas and Dipanjan

(2012), DeFond et al (2011), Jones and Finley (2011)

Moreover, Hail and Leuz (2010) and Barth et al

(2008) suggest that lax enforcement of IFRS may lead

to a lower compliance to these standards, which

therefore limits their effectiveness in improving the

quality of disclosure.

Schipper (2005, P106) states that: “The quality

of financial reporting is crucially dependent on

vigorous enforcement that is separate from the

financial reporting standard setting function”. Hence,

we can deduce that the quality of IFRS is a necessary

but not sufficient condition to obtain high disclosure

quality.

Daske et al (2008) document heterogeneity

across firms in the economic effects of IFRS

adoption. This heterogeneity is related either to

differences in firms reporting incentives or corporate

governance factors. In addition, Jones and Finley

(2011) suggest that in the absence of effective

enforcement, the major impact of IFRS on decreasing

international reporting diversity could be much

reduced. Also, Brown and Tarca (2005) emphasize

the need of appropriate enforcement mechanisms to

ensure compliance with IFRS.

Alali and Foote (2012) support the regulatory

initiative of compliance and enforcement of IFRS

such as governance system in order to better financial

reporting transparency and trust which let analysts

more associated with accounting information than

speculations and rumors.

Furthermore, Zéghal et al (2011) examine

whether mandatory adoption of IFRS by French

companies is related to lower earnings management.

They also analyse two categories of enforcement

factors of IFRS: corporate governance and

dependence on international markets. They find that

mandatory adoption of IFRS has reduced significantly

the level of earnings management for firms with good

corporate governance and those depending on foreign

financial markets.

Similar to Zéghal et al (2011) we contribute to

this literature by examining the corporate governance

as IFRS enforcement factors and its impact on

improving earnings forecast accuracy after IFRS

mandatory adoption .

An extensive amount of research has examined

the effect of corporate governance on financial

reporting quality (Bédard et al, 2004; Peasnell et al,

2005; Jiraporn and Gleason, 2007; Zéghal et al, 2011;

Verriest et al, 2013). The board of directors is often

considered as one of the most important corporate

governance and its control role in firms is essential

and depends on several attributes as board size,

separation of the role of CEO and board chairman,

independence and competency of board members and

existence of an independent audit committee (Zhara

and Pearce, 1989; Vafeas, 1999).

Firms with more independent boards are likely

to engage in less fraud or earnings management and

are found to have better reporting quality (Xie et al,

2003; Jiraporn and Cleason, 2007; Peasnell et al,


270

2005; Beasley, 1996; Bédard et al, 2004). Moreover,

Wang and Campbell (2012) declare that the number

of independent board members significantly decreases

earnings management for companies without state

ownership.

Ebrahim (2007) finds that the relationship

between board independence and earnings

management is more significant for more active

boards, as measured by the frequency of annual board

meetings. Empirical evidence by Marra et al (2011)

indicates that, under international standards,

independent board and audit committee play

significant role in decreasing earnings management.

Audit committee effectiveness and independence

is positively associated with financial reporting

quality (Klein, 2002) and negatively related with

fraud (Carcello et al, 2011; Abott et al, 2004).

The Viénot’s reports 1995, 1999 in France

recommend the separation of decision- making and

control role. In addition, a number of research papers

has found a bad effect on financial statement quality

of combination of the two functions (Peasnell et al,

2005; Beasley, 1996; Bédard et al, 2004).

Another characteristic that seems to have a

significant influence on the board’s performance and

efficiency is the board size. Results of research that

has focused on the influence of board size on financial

statement quality are mixed. Some studies find a

positive relation between the number of directors and

disclosure quality (Xie et al, 2003; Kent and Stewart,

2008; Zéghal et al, 2011). In contrast, other studies

indicate that smaller boards are more efficient in

monitoring management, reducing managerial

discretion and improving disclosure quality (Beasley,

1996). From an agency theory view, larger board is an

effective corporate governance mechanism in

monitoring managers.

Board of directors needs to be active and to meet

frequently in order to carry out its role of monitoring

and ensuring high-quality and transparent reporting in

annual reports (Xie et al, 2003; Conger et al, 1998;

Vafeas, 1999). Using a sample of Australian listed

companies, Kent and Stewart (2008) find that

companies with more frequent board meeting have

more disclosure after IFRS transition.

Furthermore external audit quality is also a

guarantee of control management effectiveness and a

very important factor for good corporate governance.

In fact, Tsalavoutas (2011), Iatridis (2011) and

Dimitropoulos et al (2013) indicate that IFRS

compliance is positively associated with audit quality.

Prior studies focus on the post IFRS period to

analyze the effect of corporate governance on the

financial statement quality. In this sense, Goodwin et

al (2009) find that companies with stronger

governance show lower managerial forecast errors

stemming from IFRS adoption in Australia.

Previous literature has also considered the

importance of international experience of board

members (Luo, 2005). A company with high

internationally competent board members has the

opportunity to reduce the information costs of

globalization. Holm et al (2012) state that IFRS

implementation is related to the board international

competency and professional background in

accounting and finance. International experience and

competence can be accomplished by native board

members that have board membership subsidiaries or

by including foreign members on the board.

Verriest et al (2013) investigate the relation

between corporate governance and financial reporting

quality for first time IFRS adopters. They state that

(P66): “Stronger governance firms engage in more

transparent IFRS restatements, provide better

disclosure quality and comply with IFRS more

rigorously than weaker governance firms.” Their

results show also that firms with better functioning

and independent board and more effective audit

committees publish higher quality financial

statements.

Similarly, Zéghal et al (2011) show that the

independence and effectiveness of the board, the

existence of an independent audit committee, the

quality of external audit and the dependence on

foreign financial markets are important factors for the

implementation of IFRS in France.

From an agency perspective and based on

previous research evidence, we predict that mandatory

adoption of IFRS in France has greater and positive

effect on analysts’ earnings forecast accuracy when

firms have stronger corporate governance

mechanisms. Thus our second hypothesis is:

H2: The mandatory adoption of IFRS leads to a

better improvement in analysts’ earnings forecasts

accuracy when firm’s corporate governance is strong

and effective.

This hypothesis can be broken down as follow:

H2-1 The mandatory adoption of IFRS leads to a


accuracy when a firm’s board of directors is

independent competent and active.



accuracy when there is separation of the roles of CEO

and board chairman.



accuracy when a firm’s audit committee is

independent.



accuracy when external audit is of high quality.


271

H2-5: The board of directors’ size has a positive

effect on improving analysts’ earnings forecasts

accuracy after mandatory adoption of IFRS.

3 Empirical research:

In this section, we first provide a description of the

data and variables applied. Second, we present the

models used to test the hypothesis developed in the

previous sections. 3.1 Sample

The sample is drawn from the population of French

non-financial groups listed on the French stock

exchange during the period before mandatory

adoption of IFRS (2003-2004) and the period after

mandatory adoption of IFRS (2006-2007). Similar to

Zéghal et al (2011) and Jiao et al (2012), we eliminate

the transitory year 2005 because firms reports

differently according to IFRS1 that allows many

exemptions in order to facilitate transition to

international standards. In addition, we study the

period before 2008, date of financial crisis, to avoid

its effects on the implementation of international

standards and the application of fair value assessment.

The principal sources of data were obtained from

annual reports available in the SBF 250 and from the

IBES databases. Financial companies (41) are

excluded because of their specific regulation and their

special accounting practices. Also, we have excluded

firms without a December 31 fiscal year-end (50),

firms publishing their financial statements under IFRS

before 2004 (6), firms without necessary data to

calculate forecast accuracy (55). The final sample

consists of 98 companies.

3.2 Data and variables

Data are referred to corporate governance attributes

particularly board of directors characteristic and

analyst information for French publicly traded

companies.

3.2.1 Forecast Error

The dependent variable in our study is the

accurateness of forecasts. Nevertheless, following

previous research (Ashbaugh and Pincus, 2001; Jiao

et al, 2012) we use the reverse of accuracy namely

forecast error to measure forecast accuracy. Forecast

error is determined as the absolute value of the

difference between final consensus earnings forecast

and real earning scaled by the stock price at the end of

one year before the forecasted year

FE = Consensus.forecastt, i – Real EPS

P t-1, i

EPS: earning per share Consensus forecast retained in our study is the

final one and is defined as the average of available analyst earning forecast just before the announcement of annual earnings. Data concerning this variable is obtained from the database IBES. We examine the effect of our hypotheses on the forecast error through the following independent variables:

IFRS a dummy variable coded as 1 for years after 2005 and 0 otherwise.

Size (ln Assets): it has been argued in prior research that large firms are widely followed by analysts. Indeed, they are expected to be more transparent, disclosing more reliable information and providing financial analysts with access to some private information, which in turn lead to more accurate earning forecast (Brown et al, 1987; Hope, 2003; Lang and Lundholm, 1996; Jiao et al, 2012). The proxy for firm size is the natural logarithm of total assets [ln assets] (Godard, 2002; Fernández and Arrondo, 2005).

Performance volatility (σROE): earning forecast accuracy is largely affected by the volatility of firm’s performance. Indeed, it is not easy to predict a profit when firm performance is volatile. Therefore, it is likely that the accuracy of forecasts is lower for firms with more volatile performance. Hence we include this variable to control the performance volatility effect. This variable is calculated as standard deviation of return on equity (ROE) based on the five years before the forecast year (Jiao et al, 2012).

Number of analyst forecast (NEstimate): another variable that permit to control the analyst forecast accuracy is analyst following. In fact, the forecast accuracy improves when the number of analysts increases as there is more competition among them and, therefore, analysts will be more encouraged to forecast accurately (Lys and Soo, 1995; Jiao et al, 2012). Hence, it is expected that this variable will be negatively correlated with forecast errors. Following this studies, we measure this variable using natural logarithm of the number of analysts’ forecast included in the final consensus from IBES.


272

3.2.2.Board of directors attributes are measured as:

International competency (COMPETENT): Holm et al (2012) coded as 1 if one or more members of the board have international experience such as board membership in foreign firms and 0 otherwise. Due to the lack of variability, this variable will be measured by the percentage of foreign directors or board membership in foreign firms. According to prior studies (Holm et al, 2012; Verriest et al, 2013), it is expected that this variable will be positively correlated with earnings forecasts accuracy.

Independence of board (INDEP): the independence of board members improve the disclosure quality (Xie et al, 2003; Jiraporn and Cleason, 2007; Bédard et al, 2004). Hence, it is likely that this variable is positively associated with earnings forecasts accuracy. We measure board independence by the percentage of independent external directors serving on the board. (Abott et al, 2004; Beasley, 1996; Peasnell, 1995).

Independent audit committee (AUDIT COM): based on previous literature, it is expected that this variable will be positively correlated with earning quality and, particularly with the accuracy of earnings forecasts (Klein, 2002; Carcello et al, 2011; Abott et al, 2004, Xie et al, 2003; Zéghal et al, 2011; Holm et al, 2012). The same studies allow us to code this variable as 1 if the company has established an independent audit committee and 0 otherwise.

Separation of the roles of CEO and board chairman (SEP): following previous studies (Beasley, 1996; Peasnell et al, 2005; Xie et al, 2003), separation of the roles of CEO and chairman of the board was measured by a dummy variable that take 1 if there is separation of function and 0 otherwise.

External audit quality (EXT.AUDIT): Big 4 auditors have more knowledge, specialized personnel and IFRS-related experience and show higher requirement for compliance with accounting regulation and for higher accounting quality in financial reporting.

Moreover, they could provide greater assistance in the implementation and transition to IFRS compared to other audit firms. Hence, they should be considered as IFRS enforcement factors and contribute to the improvement of earning forecast accuracy. (DeFond and Jiambalvo, 1994; Van Tendeloo et Vanstraelen, 2005; Zéghal et al, 2011; Iatridis, 2011; and Dimitropoulos et al, 2013). This study is conducted in the French context where legislation requires for companies to appoint two auditors. So, this variable will be coded as 1 if there is at least one big 4 that audited the firm; 0 otherwise. This measure was also used by (Xie et al, 2003; Zéghal et al, 2011; Iatridis, 2011).

B.Size: From an agency perspective, larger boards are more efficient in monitoring management, reducing managerial discretion and improving disclosure quality. We, therefore, expect that board size will be positively associated with earnings forecasts accuracy. According to previous studies (Xie et al., 2003; Bédard et al., 2004; Zéghal et al, 2011), board size (B.SIZE) was measured by the number of directors serving in the board.

Frequency: board activity, measured by the number of board meeting. Frequency is an important dimension of board efficiency. Vafeas (1999) show that operating performance improves following years of abnormal board activity. Xie et al (2003) argue that board meeting frequency is an important factor in constraining the propensity of managers to engage in earnings management. Hence, we expect that board activity will be positively associated with earning quality disclosed.

Industry and Year Dummies: we also include industry and year dummies to control for unobservable factors associated with the characteristics of industries and years that might influence the analyst’s forecast accuracy.

3.3 Models In order to examine if mandatory adoption of IFRS improves the analysts’ forecast accuracy the following model was estimated.

M1: FE t,i = α0 + α1 IFRS t,i + α2 ln Assets t,i+ α 3 N.Estimate t,i + α 4σROE t−1, i+ α 5 Industry Dummies t, i

+ α 6 Year Dummies t, i +ε t,i.

To test our second hypothesis, we estimate the

Model 2 M2: FE t,i = β0 + β1 IFRS t,i + β2 ln Assets t,i + β3 N.Estimate t,i + β4 σROE t,i + β5 INDEP t,i + β6

COMPETENT t,i + β7 AUDIT.COM t,i + β8 B.Size t,i + β9 SEP t,i + β10EXT.AUDITt,i + β11 Frequencyt,i + β12 (IFRS*INDEP)t,i+ β13 (IFRS* COMPETENT) t,i + β14 (IFRS*AUDIT.COM) t , i + β15 (IFRS*B.Size)t,i + β16 (IFRS*SEP)t,i + β17 (IFRS*EXT.AUDIT)t,i + β18 (IFRS*Frequency) t,i + β19 Industry Dummies t, i + β20 Year

Dummies t, i + ε i.t

We summarize the definition of variables in the table below.


273

Variables Definition Expected sign

Forecast Error

Forecast Error is the error in analysts' consensus forecasts. It is the absolute

difference between the consensus forecast of EPS and actual EPS scaled by

the stock price at the end of year t−1

IFRS IFRS is a dummy, which equals to 1 for years after 2005 and 0

otherwise. -

ln Assets It is a firm’s size -

N.Estimate N.Estimate stands for the number of estimations contained in consensus

forecasts. -

σROE

It is a variable control for the volatility of firm performance.

It is calculated as the standard deviation of ROE based on the five years

before year t

+

INDEP Independence of board members measured by the percentage of independent

external directors serving on the board -

COMPETENT

International competency coded as 1 if one or more members of the board

have international experience such as board membership in foreign firms and

0 otherwise.

-

AUDIT.COM

Independent audit committee is code this variable as 1 if the company has

established an independent audit committee and 0 otherwise.

-

B. Size Board size measured by the number of directors serving in the board.

-

SEP

Separation of the roles of CEO and Chairman of the board was measured by

a dummy variable that take 1 if there is separation of function and 0

otherwise.

-

EXT.AUDIT External audit quality approximated by Big 4. This variable will be coded as

1 if there is at least one big 4 that audited the firm; 0 otherwise. -

Frequency Board activity, measured by the number of board meeting. -

IFRS* INDEP

Competent

AUDIT COM

B.Size

SEP

EXT.AUDIT

Frequency

Interaction term between the IFRS variable and each corporate governance

attributes. These variables are included to highlight the factors that contribute

to the implementation and enforcement of IFRS.

-

4 Results

This section, present the empirical results relating to

the first hypothesis. Next, we present the results of our

second model testing the second hypothesis.

4.1 Analysis of results relating to the first hypothesis

4.1.1 Comparison of forecast accuracy in the PRE

and POST IFRS mandatory adoption

Our first hypothesis to be tested is that mandatory

adoption of IFRS in France improves the analyst’s

forecast accuracy. Hence, we compare forecast

accuracy level between two periods: the period before

mandatory IFRS (PRE.IFRS: 2003-2004) and the

period after mandatory adoption of IFRS

(POST.IFRS: 2006-2007).

We begin this analysis by checking the

normality of variable in order to choose the

appropriate statistical test. The Kolmogorov-Smirnov

test show that the dependent variable “forecast error”

doesn’t follow the normal law. So, we used the

Wilcoxon non parametric test of mean equality.

Table 1. Forecast error: test of difference between PRE and POST

Mean

PRE. IFRS

Mean

POST.IFRS Wilcoxon test P-Value

FE(Forecast error) 0.0471 0.0132 11.829*** 0.000


274

The results of this test are presented in table 1.

Table 1 shows that mean of forecast error for the

POST.IFRS period is significantly smaller than for the

PRE.IFRS period.

Therefore, on average, the accuracy of analysts’

forecasts increases after the mandatory adoption of

IFRS by French companies.

4.1.2 Multivariate tests of forecast accuracy PRE

and Post IFRS

4.1.2.1 Descriptive statistics

Table 2 shows the descriptive statistics of the

variables. On average, earnings forecasts accuracy is

about 2% of stock prices, which is in line with prior

studies (Bae et al, 2008; Jiao et al, 2012). The number

of analysts forecasts ranges from 3 to 45 with on

average 10 forecasts underlying a consensus forecast.

On average, the earnings volatility is about 0.16 with

a Min of 0.001 and a Max of 13. The earnings

volatility is low; hence it is expected that this variable

has no effect on earnings forecast accuracy.

Table 2. Descriptive statistics

Variables Obs Mean Min Max Std deviation

FE(Forecast error) 392 0.0200698 0.0000549 0.9039548 0.0829078

ln Assets 392 20.97527 10.77553 27.12777 2.781205

σROE 392 0.1578444 0.001 12.70317 0.8841007

NEstimate 392 10.75719 3.000000 45.00000 2.114951

Table 3 presents the correlations between the

independent variables. The number of estimations

contained in consensus forecasts is negatively

associated with σROE and positively and significantly

associated with companies size (ln assets) which is in

line with prior researches suggesting that large firms

are highly followed by analysts (Jiao et al, 2012).

Table 3. Correlation matrix

FE IFRS ln Assets σROE NEstimate

FE 1

IFRS -0.2055*** 1

ln Assets -0.1940* 0.0795* 1

σROE 0.2204** -0.0802** -0.1396 1

NEstimate -0.1313*** 0.0409* 0.3775** -0.0076 1

In addition, Table 3 presents the correlations

between independent and dependent variables.

Correlation reports that forecast error is negatively

correlated with firm size and analyst coverage

(NEstimate). This result is consistent with previous

studies suggesting that analysts’ forecasts are more

accurate for firms with high analyst following and for

large firms (Lang and Landholm, 1996; Lys and Soo,

1995; Jiao et al, 2012). Furthermore, the coefficient of

variable “IFRS” is negative which indicates that after

mandatory IFRS adoption, analysts’ forecasts

accuracy are better. Moreover, the positive correlation

between forecast error and the performance volatility

(σROE) is expected. In fact, as the performance

volatility is high as the earnings forecasts are less

accurate. The correlations are relatively low

suggesting the absence of multicollinearity in the

multivariate regression. We also calculate Variance

Inflation Factors (VIFs) to determine the severity of

multicollinearity in the subsequent regression

analyses. VIFs above ten indicate a serious

multicollinearity problem (Belsley et al, 1980). We

find that none of the VIFs are above two, which

shows that multicollinearity does not pose problem to

our regression analyses.

4.1.2.2 Results of regression analysis:

Table 4 presents the results of regression analysis in

2003 to 2007. Regression 1 shows that IFRS has a

negative and significant (at the level 10%) effect on

analyst forecast error. In fact, the coefficient of this

variable is (-0.0302). This implies that the analysts’

forecast accuracy increases after mandatory adoption

of IFRS by French companies. Regression 2 presents

the results controlling for Industry Dummies.


275

Regression 3 presents the results controlling for both

Industry Dummies and Year Dummies effects. From

the first regression to the third one, IFRS is negative

and significant at the level 10% and increases in

magnitude. Overall, the findings are consistent with

our previous results showing that IFRS mandatory

adoption improve the level of earnings forecasts

accuracy (Zéghal et al, 2011; Jiao et al, 2012; Tan et

al 2011; La Bruslerie and Gabteni, 2014). They are

also in line with both agency and signalling theory

suggesting that the improvement of disclosure quality

in the financial statement after IFRS mandatory

adoption reduces the asymmetry information which

better the analysts’ earnings forecast accuracy.

Consequently, we can conclude that our first

hypothesis is accepted: mandatory adoption of IFRS

in France improves the analysts’ forecasts accuracy.

Table 4. Regression results Model 1

Regression 1 Regression 2 Regression 3

IFRS -0.0302*

(0.0053)

-0.0303*

(0.0053)

-0.1768*

(0.0058)

ln Assets -0.0014

(0.0025)

-0.0015

(0.0027)

-0.0010

(0.0027)

σROE 0.0157***

(0.0039)

0.0156***

(0.0039)

0.0157***

(0.0039)

NEstimate -0.0052*

(0.0028)

-0.0053*

(0.0029)

-0.0059**

(0.0029)

Const 0.1297**

(0.0467)

0.1484**

(0.0740)

0.1439*

(0.0744)

Industry Dummies No Yes Yes

Year Dummies No No Yes

Obs 392 392 392

R. squared 0.1015 0.1231 0.1409

Standard errors in parentheses; *significant at 10%; **significant at 5%; ***significant at 1%,

In addition, the results of three regressions show

that the coefficient of performance volatility (σROE)

is positive and significant at the 1% level. Therefore,

volatility of performance has a negative and

significant effect on analysts’ forecast accuracy.

Company size (ln assets) has a negative but

insignificant effect on the analysts forecast accuracy.

This finding is consistent with the study of Jiao et al

(2012) and Lang and Lundholm (1996). Nevertheless,

the number of analysts following (NEstimate) is

negatively and significantly related to the earning

forecast accuracy. According to prior studies’ findings

(Lys and Soo, 1995; Jiao et al, 2012), this result

shows that the increase in the analysts following

improves the accuracy of forecast earning.

4.2 Empirical findings relating to second hypothesis

In this section, we present model 2 used to test the

second hypothesis. Then, we check for the absence of

multicollinearity and finally we present the main

results.

4.2.1 Research model

We analyzed the following Model 2 in order to test

our second hypothesis.

M2: FE t,i = β0 + β1 IFRS t,i + β2 ln Assets t,i + β3 N.Estimate t,i + β4 σROE t,i + β5 INDEP t,i + β6

COMPETENT t,i + β7 AUDIT.COM t,i + β8 B.Size t,i + β9 SEP t,i + β10EXT.AUDITt,i + β11 Frequencyt,i + β12

(IFRS* INDEP)t,i+β13 (IFRS* COMPETENT) t,i + β14 (IFRS*AUDIT.COM) t , i + β15 (IFRS*B.Size)t,i + β16

(IFRS*SEP)t,i + β17 (IFRS*EXT.AUDIT)t,i + β18 (IFRS*Frequency) t,i + β19 Industry Dummies t, i + β20 Year

Dummies t, i + ε i.t

4.2.2 Descriptive statistics

Independence of board members on average is 43%.

The mean of board meeting frequency is about 8. On

average, the mean of the board size is 16 with a

minimum of 3 and a maximum of 22. These results

are similar to those of Godard and Shatt (2005). The

mean of board members competency is about 38%.

Table 5 shows that although 92.5% of firms in

the sample have an independent audit committee and

73% have been audited by Big 4, 95% of firms choose

the separation CEO and chairman roles.


276


Variables Obs Proportion Mean Min Max Std deviation

INDEP 392 - 0.4354683 0 0.9545454 0.2431233

COMPETENT 392 - 0.3777735 0 0.9090909 0.2397666

B.Size 392 - 16.04337 3 22 3.443465

AUDIT.COM 392 0.925 - - - 0.0244831

EXT.AUDIT 392 0.7295918 - - - 0.0224627

Frequency 392 - 8.77551 3 15 2.94721

SEP 392 0.95 - - - 0.0218984

The correlation analysis shows that corporate

governance variables are negatively correlated with

forecast error. It also shows that the interaction effect

between IFRS and corporate governance variables are

strongly and positively correlated with earnings

forecast accuracy (negatively with forecast errors).

This result showed that corporate governance is an

important factor that contribute to the improvement of

forecast earning accuracy after IFRS mandatory

adoption. It is notable that board size is positively

correlated with firm size (ln Assets), (AUDIT.COM),

(SEP) and (Frequency), suggesting that large firms

have large boards. It also indicates that large boards

might create audit committee and might separate

between the management and control. In addition, as

the size of board increases, the more active it

becomes.

The results of this analysis show that all the

correlation coefficients are below 0.7. Consequently,

we note the absence of serious problem of

multicollinearity. In addition, we calculate the

Variance Inflation Factor (VIF) which also tests for

the presence of collinearity between the explanatory

variables. VIF’s are below 1.8. Therefore, we can

deduce the absence of any multicollinearity problems.

4.2.3 Results of multivariate regression:

Table 6 presents the results of three regressions used

to test our second hypothesis. Regression 2 adds

industry Dummies to regression 1. Regression 3

presents the results controlling for both industry and

year Dummies. Three regressions show a positive and

very significant influence of the percentage of

independent outside directors (INDEP) on reducing

the forecast error. This finding implies that as the

board members are independents, the more accurate

the earnings forecasts are and the best quality of

financial disclosure we have. This result is in line with

those of Abott et al (2004) and Zéghal et al (2011)

studies. Table 6 also shows that international

competency of board members (COMPETENT) is

negative (-1.66) and significant at the 1% level. This

finding is consistent with prior studies (Holm et al,

2012; Verriest et al, 2013).

Furthermore, from regression 1 to regression 3,

board size, external audit quality and frequency of

board meetings are strongly and negatively related to

forecast error. The coefficients of these variables are

respectively about -0.007 (p-value < 0.01), 0.024 (p-

value < 0.01), 0.008 (p-value < 0.05). This is in line

with prior findings that suggest large and active

boards and Big 4 auditors contribute to the

improvement of financial reporting quality which

entail to better earnings forecast accuracy (Zéghal et

al, 2011; Xie et al, 2003; Dimitropoulos et al, 2013).

However, both separation of CEO and board chairman

roles and audit committee are insignificantly

associated with forecast errors. Hence, these variables

do not appear to have any significant effect on

increasing the level of earnings forecast accuracy. The

possible explanation for these results is the lack of

variation in practice relating to these variables among

the companies in our sample. As evidenced by the

descriptive analysis, most French firms now comply

with corporate governance practice recommended by

Viénot’s reports in striving to have independent audit

committee and to separate the CEO and board

Chairman roles.

From regression 1 to regression 3, the earnings

forecasts accuracy increase for firms with large,

independent, competent and active boards. In

addition, firms that have been audited by BIG 4

disclose financial information of better quality which

lead to more accurate earnings forecasts.

According to table 6, when the interaction effect

between IFRS and corporate governance variables are

included within regression model, the effect of IFRS

becomes highly significant. These results also provide

support for hypothesis H2-1 concerning the positive

and significant impact of IFRS mandatory adoption on

analysts’ earnings forecasts accuracy for companies

whose board is independent, competent and active.

These findings are in line with previous studies

(Verriest et al, 2013; Zéghal et al, 2011; Holm et al,

2012).


277

According to hypothesis H2-4, table 6 shows a

positive and very significant influence of the

interaction term between IFRS and external audit

quality (IFRS*BIG4) on increasing the earning

forecast accuracy. According to this table, the

coefficient of this variable is negative (-0.2032) in

regression 1; (-0.2035) in regression 2 and (-0.3025)

in regression 3. All these coefficients are significant at

1% level. Mandatory adoption of IFRS leads to a

better improvement in analyst’s earnings forecasts

accuracy when firm’s external audit is of high quality.

The findings of this analysis also show that the effect

of the interaction term between IFRS and board size

(IFRS*board size) on analyst’s earnings forecast

accuracy is positive and significant at 1% level. These

results provide support to our hypotheses H2-5. They

are consistent with prior research (Zéghal et al, 2011;

Kent and Stewart, 2008).

As opposed to hypothesis H2-2 and H2-3, the

interaction terms between IFRS and audit committee

(IFRS*AUDIT COMM) and between IFRS and roles

separation of CEO and Chairman (IFRS*SEP) remain

insignificantly correlated to analysts forecast

accuracy.



IFRS -0.1057*

(0.0455)

-0.1081*

(0.0457)

-0.2009*

(0.0671)

ln Assets -0.0010

(0.0018)

-0.0002

(0.0019)

0.0002

(0.0020)

σROE 0.0046**

(0.0034)

0.0048**

(0.0034)

0.0048**

(0.0034)

NEstimate -0.0019*

(0.0021)

-0.0011*

(0.0022)

-0.0016

(0.0022)

INDEP -1.0311***

(0.1941)

-1.0316***

(0.1947)

-1.0446***

(0.1956)

COMPETENT -1.0600***

(0.1861)

-1.0623***

(0.1864)

-1.0650***

(0.1874)

AUDIT.COM -0.0148

(0.0100)

-0.0150

(0.0100)

-0.0153***

(0.0101)

SEP -0.0281

(0.0176)

-0.0281

(0.0177)

-0.0281

(0.0177)

EXT.AUDIT -0.0234***

(0.0136)

-0.0233***

(0.0136)

-0.0241***

(0.0137)

B.Size -0.0069***

(0.0011)

0.0071***

(0.0012)

-0.0072***

(0.0012)

Frequency -0.0076**

(0.0066)

-0.0079**

(0.0067)

-0.0081**

(0.0067)

IFRS*INDEP -1.0639***

(0.3982)

-1.1064***

(0.4000)

-1.1067***

(0.4027)

IFRS*COMPETENT -1.0903***

(0.3745)

-1.1258***

(0.3761)

-1.1361***

(0.3792)

IFRS*AUDIT.COM -(0.0024)

(0.0172)

-0.0032

(0.0172)

-0.0037

(0.0173)

IFRS*SEP -0.0347

(0.0215)

-0.0344

(0.0216)

0.0345

(0.0218)

IFRS*EXT.AUDIT -0.2032***

(0.0238)

-0.2035***

(0.0239)

-0.3025***

(0.0245)

IFRS*B.Size -0.0014***

(0.0022)

-0.0016***

(0.0022)

-0.0017***

(0.0022)

IFRS*Frequency -0.0033**

(0.0101)

-0.0027***

(0.0102)

-0.0030***

(0.0103)

Const 0.3164***

(0.0413)

0.3849***

(0.0593)

0.3848***

(0598)



Obs 392 392 392

R. squared 0.3464 0.4509 0.5512

Standard errors in parentheses; *significant at 10%; **significant at 5%; ***significant at 1%


278

From regression 1 to regression 3 most

explanatory variables increase in significance and

magnitude. Controlling for industry and year effect

also implies an increase in R2

level from 34.64% for

regression 1 to 55.12% in regression 3.

4.3 Robustness tests

To ensure the robustness of the results, we test the

following model M3 for (2004-2006) period after

discriminating between high and low corporate

governance quality firms. We ranked our sample in

increasing order of board members independence and

competence. Then, we choose, for each year, the 20

highest corporate governance quality firms that have

simultaneously the highest level of board

independence and competence, BIG 4 auditors,

independent audit committee and that separate CEO

and Chairman roles. The 20 lowest corporate

governance quality firms are those with lowest level

of board independence and competence. These firms

also do not have separation of CEO and Chairman

roles, independent audit committee or BIG 4 auditors.

The discriminating process is similar followed in this

section is similar to the research methods used by

Zéghal et al (2011) and Elshandidy et al (2013).

M3: µ0 + µ1 IFRSt,i+ µ2 CG Qualityt,i + µ3 IFRS*CG Qualityt,i+ µ4 IndustryDummiest, i + µ5 Year

Dummiest,i+ ε i.

t

Where:

CG Quality: dummy variable that take 1 if

the corporate governance quality of the firm is high.

i,e if the firm with highest board independence and

competence has simultaneously BIG 4 auditors,

independent audit committee and separation of

management and control roles. It takes 0 when firms

with lowest board independence and competence do

not have BIG 4 auditors or independent audit

committee or separation of roles.



IFRS -0.0274*

(0.0146)

-0.0298**

(0.0146)

-0.1337**

(0.0201)

CG Quality -0.1484***

(0.0357)

-0.1552***

(0.0377)

-0.1642***

(0.0468)

IFRS* CG Quality -0.0290***

(0.0206)

-0.0370***

(0.0206)

-0.0380***

(0.0466)

Const 0.1491***

(0.0253)

0.1833***

(0.0690)

0.1809***

(0.0693)



Obs 80 80 80

R. squared 0.2745 0.2911 02961

Standard errors in parentheses; *significant at 10%; **significant at 5%; ***significant at 1%

Table 7 presents the results of regression

analysis for model 3 in 2004 (before IFRS) and 2006

(after IFRS). We focused on only to two years to

facilitate the selection procedure of subsample.

Regression 2 presents the results with Industry

dummies. It shows that IFRS has negative and

significant effect on analysts forecast error (-0.0298;

p-value < 0.05). Conversely, Regression1 shows that

IFRS has negative but less significant effect on

forecast error. This table also shows that corporate

governance quality is strongly and positively

correlated with analysts’ forecasts accuracy. From

regression 1 to regression 3, the effect of the

interaction term between IFRS and corporate

governance quality (IFRS*CG Quality) on earnings

forecasts accuracy is positive and significant at 1%

level. Regression 3 shows that this variable increases

in magnitude compared to regression 1. Overall, the

findings are consistent with our previous results

showing that mandatory adoption of IFRS improves

the analysts’ earnings forecasts accuracy for firms

with good corporate governance.

5 Conclusion

The purpose of this research was to examine if IFRS

mandatory adoption by French companies contributed

to the improvement of analysts’ earnings forecasts

accuracy. In addition, we analyzed enforcement

factors that contributed to the implementation of

IFRS.


279

Consistent with previous study, our results show

that mandatory adoption of IFRS by French

companies has improved the disclosure quality;

particularly the accuracy of earnings forecasts. In

addition, the independence and international

competency, the quality of external audit, the board

size and the frequency of meeting are important

factors for the implementation of IFRS in France.

These results are in line with prior research (Zéghal et

al, 2011, Verriest et al, 2013; Dimitropoulos et al,

2013; Holm et al, 2012).

Our study contributes to the current debate about

the quality of IFRS in several ways. First, unlike

previous research that focus on the effect of voluntary

adoption of IFRS (Barth et al, 2008; Van Tendeloo

and Vanstraelen, 2005), our paper examines the IFRS

mandatory adoption. Hence, this allows us to avoid

the sample selection bias. Second, our paper examines

the IFRS enforcement factors that guarantee effective

implementation of international accounting standards

which improve the earnings forecasts accuracy.

In highlighting the existence of improvement in

financial reporting quality, our results should be of

interest to all parties seeking to evaluate the costs and

benefits of IFRS mandatory adoption. We also expect

our results to be of interest to academics involved in

researching progress with international accounting

harmonization, to the French regulatory and

supervisory authorities, financial analysts, investors,

government, accounting setters and practitioners since

the study highlights the factors that have contributed

to the enforcement of IFRS in relatively newer

context of IFRS adoption such as France.

These findings should also be relevant for

international regulatory authorities and institutions

involved in the process (e.g. securities markets, IASB,

European commission) since the results provide

examples of how firms required to apply IFRS have

approached the process in a continental European

accounting system recognized by its regulatory

rigidity and legal outlook. They may help the IASB in

its efforts to encourage the worldwide adoption of

IFRS. They could be relevant for many countries

especially those that not yet decide and hope to move

to IFRS.

Further, our study presents some limitations. We

focused on value relevance of financial statements

approximated by earnings forecasts accuracy. So, we

did not refer in this study to other financial reporting

quality attribute such as reliability, comparability,

timeliness. Therefore, future research could analyse

the impact of IFRS mandatory adoption on these other

disclosure dimensions. Moreover, this study examined

only the corporate governance as enforcement factor

that contribute to the implementation of IFRS. We did

not examine other enforcement factors such as

dependence on foreign financial markets, culture and

institutional factors. Finally, we examine only the

French context. It’s interesting for future research to

study the effect of IFRS mandatory adoption for

several countries.

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COMMITMENT TO MARKETING STRATEGIES IN COOPERATIVE BUSINESS ARRANGEMENT: ROLE OF

APPROPRIATE INTELLIGENCE GENERATION AND INCLUSIVE PARTICIPATION

Joseph Musandiwa*, Mercy Mpinganjira**

Abstract

This paper empirically examines the influence of appropriate intelligence generation and inclusive participation in marketing strategy formulation on commitment of SME owner-managers operating in cooperative business arrangement. Data was collected using a structured questionnaire from 256 owner managers operating mini-bus taxi businesses in South Africa. The findings show that appropriate intelligence generation during marketing strategy formulation and inclusive participation in strategy formulation has significant positive influence on member commitment to marketing strategies in a cooperative. The study has significant managerial implications as it identifies factors that managers of SMEs involved in cooperative business arrangements can focus on in order to effectively manage member commitment towards marketing strategies that need to be implemented by all. Keywords: Commitment to Strategy, Intelligence Generation, Marketing Strategies, Inclusive Participation, Small and Medium Sized fFrms, Strategy Formulation. *University of Johannesburg, Department of Marketing Management, P.0 Box 524, Auckland Park 2006 **University of Johannesburg, Department of Marketing Management, P.0 Box 524, Auckland Park 2006

1 Introduction

Small and medium Sszed firms are widely considered

to be the ‘economic blood’ of many nations. This is

mainly because of the large contributions that such

firms make to the economic well-being of nations.

According to IFC (2010) report small and medium

enterprises (SMEs) make up approximately 90 percent

of all enterprises in the world and constitute a

significant part of industrial activity contributing over

50 percent to employment. Michala et al (2013)

reported that in OECD member countries SMEs make

up 95 percent of all enterprises and generate two-

thirds of employment. They pointed out that in the

European Union the number of SMEs is as high as 99

percent of all enterprises and that they contribute to

more than half of the value added created by

businesses. Reports from ASEAN and African region

paint similar pictures on the role of SMEs in

economies. For example Ata et al (2013) noted that

SMEs make up more than 98 percent of all enterprises

in the ASEAN region and contribute around 40

percent to their countries’ GDP. Up to 90 percent of

all businesses in the Sub-Saharan Africa region are

said to be SMEs and that collectively these enterprises

are estimated to account for about 50% of job creation

in the region (IFC 2014; Frimpong2013). Statistics for

South Africa show that SMEs account for 91 percent

of all formal businesses and contribute between 51

and 57 percent to the country’s GDP and 60 percent to

employment (Kongolo, 2010).

While the statistics show the important role

played by SME’s in many economies, the SME sector

is in many countries also associated with very high

failure rates more so amongst start-ups. A report by

Kgosana (2013) noted that global statistics show that

one out of every two small businesses fold within the

first year of operation. According to the report, in

South Africa the figure is as high as five out of every

seven businesses. The high failure rates of SMEs in

South Africa has been a matter of high concern to

stakeholders involved in small business development

including government. While high failure rates of

SMEs can be attributed to many factors Merrilees et al

2011 as well as Van Scheers (2011) pointed out that

poor marketing skills is one of the major contributing

factors. Stakeholders involved in small business

development in South Africa have over the years been

implementing programs aimed at reversing the trend.

One of these programs relates to promotion of

networking among small businesses through the

promotion of co-operative forms of business

operations.

Cooperative forms of business operations are

often advocated among SME’s because they are seen

to be helpful in reduce resource and capability

constraints that firms often face when they operate on

their own. The ability of cooperative model of


284

business operation to succeed largely depends on

among other factors, the level of commitment of

individual business owners to the group and the

groups’ plans (Bahinipati 2014; Rese and Baier 2011).

Keeping in mind that poor marketing is one of the

major acknowledged problem areas of small business,

this paper investigates how businesses in a

cooperative type of business relationship go about

generating intelligence for formulating their

marketing strategies and how this is related to

members’ commitment to formulated strategies. The

paper is based on a survey of practices among firms

operating in the mini-bus taxi industry in South

Africa. The specific objectives of the paper are to (i)

examine the extent to which firms follow appropriate

intelligence generation practices when developing

their marketing strategies (ii) investigate levels of

inclusive participation in marketing strategy

development (iii) examine if there is a significant

relationship between appropriate intelligence

generation in marketing strategy formulation and

commitment and (iv) examine if there is a relationship

between inclusive participation in marketing strategy

formulation and commitment to formulated strategies.

The paper has been structured such that the next

section provides a review of literature. This is

followed by the methodology section and presentation

of results respectively. Thereafter the results are

discussed and implications of the findings outlined.

The paper finishes by providing a summary of major

conclusions drawn from the findings, limitations of

the study and suggestions for future research.

2 Literature review

2.1 Why small businesses fail–A resource based view

There is consensus among researchers and

practitioners that the failure rates of small businesses

is too high and something needs to be done to look for

ways of reversing the trend. A review of literature on

studies in entrepreneurship development shows that

resource constraints are a major factor that can

explain small business failure. Small businesses

operate in the same market as their large counterparts,

often competing for the same customers but without

the resource endowments that large businesses often

have. Van Teeffelen and Uhlaner (2013) and Smit and

Watkins (2012) observed that small and medium sized

businesses often suffer from lack of adequate financial

and human resources. For this reason Smit and

Watkins (2012) cautions against viewing SMEs as a

smaller version of larger enterprises.

Due to the resource limitations that SME’s often

suffer from, it is prudent for scholars and practitioners

looking for solutions to the problem of high failure

rates to take a resource based perspective in

diagnosing the problem and offering solutions. The

resource based theory argues that firm competitive

advantage and performance are dependent on its

resource endowments. It is important when looking at

the argument associated with the resource based view

in relation to firm performance to note that the extent

to which resources can help explain competitive

advantage and performance is mainly to do with the

fact that resources are a source of firm capabilities.

Newbert (2007) in his review of empirical research on

the resource based view to the firm also pointed out

this fact, noting that capabilities rather than resources

are critical in explaining firm performance. This is

because resources on their own cannot do anything

and performance is a function of firm activities.

Commenting on capabilities Ireland et al (2013)

observed that firm capabilities are ‘based on

developing, carrying and exchanging information and

knowledge through the firm’s human capital’ p. 76.

Day (1994) focusing on marketing capabilities, noted

the need for firms to develop their market sense-

making and customer-linking capabilities if they are

to succeed. Keeping in mind the importance of

capabilities, the foundation of which is in human

resources as well as taking cognisant of the fact that

most SMEs do not have the capacity to employ highly

skilled human resources makes many scholars in

small business management to look at cooperative

forms of business ownership as one possible way of

dealing with the problem.

2.2 The resource advantage of cooperative forms of business

According to Ireland et al (2013) a cooperative

strategy is a means by which firms collaborate for the

purpose of working together to create competitive

advantages and achieve shared objectives. There are

different ways in which firms can pursue cooperative

strategy. For example firms can go for joint ventures,

non-equity strategic alliances or network alliances.

Firms can go for informal relations with other firms or

can go for formal alliances. Whatever form or name

firms use to describe their cooperative strategy what is

important is that they be able to benefit from relations

established especially in relation to enhancing their

competitive advantage. Research shows that there are

many potential benefits that firms can derive from

working in cooperation with others and not just on

their own. Konsti-Laakso et al (2013) for example,

found that by working with other firms through

business networks SMEs are able to tap into the

knowledge resources of others and enhance their

innovation capabilities. Another potential benefit

associated with cooperative strategies among SMEs

relates to increased opportunities for strong

cooperative branding and image enhancement

(Mäläskä et al 2011). Villa and Antonelli (2009)

remarked that one major characteristic of networked

organisations that justifies why networking benefits

SMEs comes from reduction of transaction costs

among the network members. This is because through

networking, a single firm does not have to commit all

resources needed to carry out an activity. By pooling


285

resources together firms can do more than is possible

if they were relying only on their own resources.

Potinecke et al., (2009) argued that ‘the qualitative

aspect of networks as a learning and knowledge

communities is in the long run, one of the most

effective competitive advantages that firms can in the

long run derive from engaging in cooperative

strategies. Hitt et al., (2000) pointed out that the main

focus of resource based view for firms in alliances is

on organisational learning.

2.3 Marketing capabilities and intelligence generation

The problem of marketing capabilities often

associated with small and medium sized firms is a

matter that needs serious attention. This is so

considering that capabilities inform what firms are

able to do in terms of marketing strategies that they

can pursue. Marketing strategies pursued in turn

influence a firm’s marketing performance. Ireland et

al, (2013) noted that strategies specify what firms

want to do in pursuit of sustainable competitive

advantage. They argued that intelligence generation is

critical for appropriate strategy formulation and that

this needs to involve analysis of a firm’s internal

environment so as to identify strengths and

weaknesses of a firm as well as analysis of the

external environment so as to identify opportunities

and threats. It also needs to involve integration or

matching of the strength, weaknesses, opportunities

and threats in strategy making so as to ensure

informed decision making (David, 2011; Lynch,

2012).

Strategies that are informed by high levels of

awareness of developments in the internal and

external environments are likely to better lead to

optimisation of a firm’s ability to take advantage of

opportunities facing it and minimise effects of

potential threats than those that are not. The process

taken can also help make it easy to justify choice of

strategies to those who need to be involved in

implementation. Wong (2005) noted that knowledge

has in the modern business world become a critical

driving force for business success. He observed that as

a result of the need for knowledge, significant

investments are being made by organisations in hiring

minds more than hands. Resource constraints that

most SMEs face make it difficult for them to

individually invest significantly in hiring minds.

However, by working together, small firms can tap

into each other’s knowledge resources and enhance

their capabilities to come up with marketing strategies

that are informed by higher quality intelligence

generation than may otherwise be possible.

2.4 Commitment in cooperative business

Ireland et al (2013) noted that if well managed,

cooperative strategies can be an important means for

firm growth and enhanced performance. They

however observed that cooperative strategies are often

difficult to manage effectively. This is because the

success of cooperative strategies heavily relies on the

commitment of all parties in the relationship (Cechin

et al 2013). Morgan and Hunt (1994) stated that

commitment is a key construct that differentiates

unsuccessful business relationships from successful

ones. It exerts significant influence on partners’

behaviours in a cooperative business relationship

(Borda-Rodriguez and Vicari 2013). Use of

cooperative strategy to enhance firm performance

demands that firms involved in the relationship be

committed not only to the relationship but also to the

strategies that need to be implemented. According to

Balogun and Johnson (2004) commitment to strategy

in an organisational context relates to the extent to

which employees including managers at different

levels comprehend and support the strategies of an

organisation. It can thus be argued that the ability to

manage the processes needed to secure positive and

pervasive commitment to strategy on the part of firms

involved in a cooperative business relationship is

critical to implementation success. Korsgaard et al

1995 noted the same. To this end, this paper examines

the role that appropriate intelligence generation and

participation during marketing strategy formulation

plays in influencing firms’ commitment to

cooperative marketing strategies.

2.5 Inclusive participation in marketing strategy formulation

Drawing on studies in business networking, Corsaro

et al (2012) as well as Johanson and Vahlne (2011)

pointed out that it is not uncommon for members of a

business network to occupy different positions in the

network. At the core of firm position in a network are

issues relating to the organisational structure put in

place to support the cooperative strategy. As noted by

Ireland et al (2013) organisational structure, with its

influence on the functional roles played by

organisational members, can exert significant impact

on the success strategies that organisations decide to

pursue. In particular research shows that while it may

be normal in some organisations for strategy

formulation to be the mandate of a few members

particularly those occupying top or central

management positions, organisations can enhance

strategy buy-in by those in lower levels if they were to

make the process as more inclusive as possible

(Aregbeshola and Munano 2012). Elbanna, (2008)

found that by involving more people, organisations

can easily commit their members to implement

strategic change. Participating in strategic planning is

known to increase personnel’s commitment to

strategy implementation because it clarifies and

explains company vision and strategy and fosters

comprehension of company strategy (Mantere and

Vaara, 2008). Walsh, (1995) noted that as the pace of

change accelerates it becomes more difficult for a

small group of senior managers to adequately


286

monitor, interpret, and respond to environmental

change.

3 Research methodology

The study followed a quantitative research approach

using a survey technique. This approach was preferred

because it enables the collection of data from a large

sample of the targeted study population (Burns and

Bush, 2010).

3.1 Population and sampling

The population of interest was owner managers of

SMEs operating in the mini-bus taxi industry in

Gauteng, South Africa on commuter basis specifically

short distance travel. Firms operating in the mini-bus

taxi industry follow a cooperative model of operations

in that the firms are required to be members of a Taxi

Association for them to be able to operate. Members

of each association are independently owned

businesses. Each Taxi Association is allocated a route

by government on which its members are supposed to

operate. Members of each association are responsible

for coming up with business strategies including

marketing strategies that its members are expected to

implement. The Gauteng region was selected for the

study due to the fact that it is the economic hub of

South Africa and has the largest number of registered

Taxi Associations as per the National Taxi body

SANTACO. A total of 108 registered taxi

associations’ operating in the Gauteng region were

identified and members from 64 associations agreed

to take part in the study.

Owner managers in each association were

identified and convenience sampling used to select

respondents. Using a historical sample size approach

in which previous studies on small and medium sized

firms were used as reference points and also bearing

in mind sample size requirements associated with

tools planned to be used for statistical analysis, the

initial target sample size was set at 250 respondents.

3.2 Data collection A structured questionnaire was used to collect the

data. The owner managers were approached at their

taxi association offices and asked to participate in the

study by responding to the questions in the

questionnaire. Participation in the study was voluntary

and respondents were informed accordingly before

data collection. The questionnaire made use of five

point scales to measure managers’ perceptions on

statement items associated with multi-item constructs

of interest in this paper. The constructs are appropriate

marketing mix strategy formulation, participation in

strategy formulation and commitment to marketing

strategies. Two scales were specifically used with one

measuring extent to which different factors were

considered in formulating marketing strategies i.e

items associated with appropriate strategy

formulation. This scale ranged from 1 = to a very

small extent to 5 = to a very large extent. The other

scale used was a Likert scale ranging from 1 =

strongly disagree to 5 = strongly agree and was used

for items relating to participation and commitment. It

should be noted that appropriate strategy formulation

was measured as a three dimensional construct

consisting of internal environmental analysis, external

environmental analysis and integration of internal and

external factors. At the end of the data collection

period a total of 256 usable responses were received.

3.3 Data analysis

The data was analysed using version 21 of Statistical

Package for Social Science (SPSS). Cronbach alpha

coefficients were used to assess the reliability of the

multi-item constructs measured in the study before

subjecting them to further analysis. The results of this

analysis are presented in table 1. The results show that

all the constructs had high levels of reliability. As per

Hair et al (2010) alpha coefficients of .7 and above are

indicative of high construct reliability. Descriptive

analysis was run in order to determine frequencies,

percentages, means and standard deviations. The

study also made use of correlation and multiple

regression analysis in order to examine the

relationship between commitment to strategy and

appropriate intelligence generation in strategy

formulation as well as participation in strategy

formulation.

Table 1. Reliability analysis

Construct Number of items Alpha coefficient

Appropriate intelligence generation for strategy

formulation

Internal analysis

External analysis

Integration of internal and external factors

4

6

3

.673

.721

.777

Participation in formulation of strategies 5 .822

Commitment to strategies 4 .838


287

4 Results

Table 2 presents findings relating to the extent to

which owner managers believed that their association

considered factors internal and external to the firms in

formulating their marketing strategies. Also presented

in the table are findings relating to participation in

strategy formulation as well as perceptions on

member commitment to formulated strategy.

Table 2. Means and standard deviations

Means Standard

Deviation

Appropriate intelligence generation for strategy formulation 4.46 .335

Internal analysis

In developing marketing strategies the association considers:

the skills and capabilities of staff (drivers and marshals) to meet customer

needs and requirements

the resources of association members needed to provide good customer

service

the number of taxi vehicles available to meet your market demands

the management abilities of members

4.48

4.45

4.44

4.57

4.45

.385

.572

.550

.497

.550

External analysis

In developing marketing strategies the association considers:

the needs of your customers

business opportunities as a result of changes in the market, e.g. new

housing development

the service that your competitors provide to customers

government policies such as permit system affecting your service offer to

customers

fuel price as a factor affecting the provision of your services to customers

threats to the business as a result of developments in the public transport

industry (e.g. introduction of BRT) that affect the provision of services to

customers

4.51

4.57

4.50

4.43

4.52

4.54

4.50

.323

.495

.501

.495

.508

.499

.501

Integration of internal and external factors

In developing marketing strategies the association:

considers internal and external environmental factors at the same time

with the aim of developing well informed strategies to service our

customers

generates its marketing strategy options by taking into consideration both

internal and external factors affecting our service offer

considers internal and external environmental factors to help better

evaluate our strategy options for providing good customer service

4.38

4.40

4.37

4.36

.419

.522

.508

.481

Participation in formulation of strategies 4.46 .389

Most members of the association participate in the strategy development

process

Members are expected to contribute to strategy development

Before making strategic decisions, the executive members give serious

consideration to what the owner managers have to say

When developing strategies the executive committee actively seeks

input from all members

Members are expected to attend strategy development meetings

4.46

4.49

4.43

4.43

4.50

.507

.501

.519

.497

.524

Commitment to strategies 4.44 .496

Members of the association:

are highly committed to our strategies

prioritize their tasks based on the formulated strategies Prioritize their

tasks based on the formulated strategies

feel obligated to support our strategies knowing that their business goals

are intimately linked to them

are willing to make personal sacrifices in undertaking our strategies

4.43

4.48

4.43

4.43

.641

.607

.583

.584


288

On strategy formulation, the findings show mean

values of above 4 for all items associated with internal

and external environmental analysis as well as

integration of internal and external factors. The

highest mean was found on external environmental

analysis (4.51) followed by internal environmental

analysis (4.48). At 4.38 integration had the lowest

mean of the three dimensions used to measure

appropriate intelligence generation for strategy

formulation. The overall mean for appropriate

intelligence generation was found to be 4.46 with a

standard deviation of .335.

Findings on participation point to inclusive practices

in strategy formulation. This is evidenced by the high

mean values (greater than 4) on all items used to

measure participation as well as on the overall

participation measure.

Results on commitment also show that the managers

believed that members of their association are

committed to strategies that they formulate. All the

items associated with this construct had mean values

of 4 and above with the overall mean value for

commitment being 4.44.

After examining the mean values, correlation analysis

was run in order to examine if there is a significant

relationship between commitment to strategy and

appropriate intelligence generation for strategy

formulation as well as level of inclusiveness as far as

participation in strategy formulation in concerned.

The results, presented in table 3, show a significant

positive correlation coefficient of .692 between

appropriate intelligence generation in strategy

formulation and commitment to strategy. They also

show a significant positive correlation coefficient of

.632 between participation in strategy formulation and

commitment to strategy.

Table 3. Correlation analysis - Intelligence generation, participation and commitment

Commitment to

strategy

Appropriate

intelligence

generation

Participation

Commitment to

strategy

Pearson Correlation

Sig. (2-tailed)

N

1.000

-

255

Appropriate

Intelligence

generation

Pearson Correlation

Sig. (2-tailed)

N

.692**

.000

252

1.000

-

253

Participation

Pearson Correlation

Sig. (2-tailed)

N

.632**

.000

255

.861**

.000

253

1.000

-

256

**. Correlation is significant at the 0.01 level (2-tailed).

Apart from running a correlation analysis, multiple

regression analysis was conducted in order to examine

the extent to which appropriate intelligence generation

during strategy formulation and participation in

strategy formulation working together explains

commitment to strategy. The results according to table

4 show that the two factors together account for 49.9

percent of the variance in commitment to strategy

(R2= .499). The standardised beta coefficients

associated with the two independent variables show

that appropriate intelligence generation contributed

more to explaining commitment to strategy than

participation. Specifically, the results show that

appropriate strategy formulation had a standardised

beta value of .453 while participation in strategy

formulation had a beta value of .278.

Table 4. Commitment to marketing strategies – Multiple regression analysis

Model R R Square Adjusted R Square Std. Error of the estimate

1 .706 .499 .495 .334

Model Independent variable Unstandardised coefficients

Standardised

coefficients - Beta t Sig.

B Standard Error

1 (Constant) 1.43 .281 .508 .612

Appropriate Intelligence

generation .635 .124 .453 5.123 .000

Participation in strategy

formlulation .333 .106 .278 3.142 .002


289

5 Discussion and implications Efforts aimed at promoting small business

development through cooperative business strategies

are likely to have limited chances of success in the

absence of commitment on the part of managers of the

businesses involved. As pointed out by Cechin et al

(2013) the importance on commitment in businesses

relationships cannot be over emphasised. While in

large organisations firms have a lot of freedom on

who to enter into business relationship with, the same

may not always be the case with small and medium

sized firms. Stakeholders in promotion of small

business development including government are often

actively involved in promoting cooperative forms of

business operations among small and medium sized

firms. In some cased special incentives may be

earmarked only to those operating under cooperative

forms of businesses. While there are many potential

benefits associated with small businesses working

together, for such relations to succeed special efforts

need to be taken to establish and nurture high levels of

commitment on the part of those involved.

While commitment is a broader concept that can

be looked at from different perspective, this paper

focused on commitment to marketing strategies. As

noted by Merrilees et al 2011 as well as Van Scheers

(2011) lack of marketing skills and capabilities is one

of the major barriers that impede performance among

small and medium sized firms. By working together,

SMEs can tap into each other’s knowledge resources

and come up with more informed marketing

strategies. The findings in this study show that in

order to gain the commitment of all firms involved in

a cooperative relationship to marketing strategies

managers can look at the intelligence generation

process that they follow in formulating the strategies.

They also need to examine participation of members

in the strategy formulation process.

In terms of appropriate intelligence generation,

the findings show that when strategy is appropriately

formulated in terms of taking the time to analyse

internal and external factors and integrating these, one

can expect improved confidence in what is developed.

Improved confidence in formulated strategies is

important in ensuring that businesses can commit to

the implementation of the strategies as one would

normally not commit to implementation of strategies

that they have no confidence in (Korsgaard et al

1995). Findings showing positive influence of

participation on commitment to strategy are in line

with Aregbeshola and Munano (2012) findings from

studies in large organisations that show that the

involvement of more than just top management in

strategy formulation helps speed up strategy buy in of

other managers. While this is so, members of

cooperatives need to be aware of the fact that

inclusive processes come with their own challenges.

Some of the challenges they are likely to face relate to

time management and consensus building. More

inclusive strategy development sessions are likely to

press more demands on managers’ time than would be

the case if only a few were involved. In terms of

consensus building, the challenge would relate to how

to manage conflicting interests or ideas that members

may put forward. If not well managed, strategy

formulation sessions can end up being sources of

division amongst members as those whose ideas may

not be taken on board may end up harbouring bad

feelings. With such feelings they may end up being

less willing to devote their resources to

implementation of strategies formulated and/or may

be less willing to contribute their ideas in future

strategy formulation sessions.

The findings in the study also have implications

on those involved in promotion of SME’s particularly

those promoting cooperative forms of business among

SME’s. Such stakeholders need to appreciate the fact

that much as by working together SME’s are likely to

benefit from a larger pool of resources including

access to knowledge needed for enhanced business

performance, special interventions are likely to be

required from their part to help ensure that

cooperatives function successfully. One important

area in which intervention to this effect can be

provided is through provision of training workshops

focusing on developing leadership and management

capabilities of the managers. Most SME’s operate in

such a way that the owner is largely accountable to

him or herself. By bringing together many firms, a

cooperative form of business arrangement changes the

operations dynamics commonly associated with being

a small business owner. Cooperatives bring in the

need for some management and leadership skills that

one would need if managing a large business

including skills in consensus building and discipline

management. By operating together in a cooperative,

firms have the opportunity to build an image in the

market place that can be to the advantage of everyone

involved. At the same time, where there is lack of

high levels of cooperation, coordination and discipline

a bad image in the market is likely to result. This bad

image may actually result for bad market practices by

a few members of a cooperative but may affect the

image of all members.

Apart from management and leadership skills, it

would also be beneficial to train SME on issues

relating to appropriate strategy formulation. The

findings in this study actually show that while

inclusiveness in strategy formulation is important in

ensuring commitment, its explanatory power on

commitment to strategy is less than that of appropriate

intelligence generation in strategy formulation. In this

regard, managers can be trained on how they can go

about scanning their business environments in order to

detect opportunities and threats in the market as well

as to understand their strengths and weaknesses so

that they can be proactive in dealing with possible

challenges. While it is often impossible to always

accurately predict the future, skills in proper


290

intelligence generation can assist in making it possible

for SME’s to be able to make reasonable projections

and be better prepared for dealing with projected

developments in the business environment. Ireland et

al (2013) pointed out that success in business is

commonly associated with proactive business

practices. This is because proactive managers unlike

reactive ones, more effectively plan for potential

problems and opportunities before they develop.

6 Conclusion

Small and medium sized firms are an important part

of the development of many economies. As a result

governments around the world look out for ways in

which they can promote small business development.

Due to resource disadvantages that most SMEs face,

cooperative forms of business operations are often

viewed as a possible means of managing this problem.

While it cannot be disputed that working in

cooperation with others can be more beneficial to

SMEs unlike working alone, the ability of cooperative

working relationships to deliver on the expected

benefits largely depends on the extent to which

members are committed to working together for the

benefit of all. This entails the need for SMEs to be

able to rise above individual interests and commit to

common strategies that will benefit all. This study

investigated factors that can contribute to enhancing

commitment to marketing strategies among firms

operating in a cooperative business arrangement. The

specific factors examined are appropriate intelligence

generation in strategy formulation and participation in

strategy formulation. From the findings it can be

concluded that appropriate intelligence generation, as

defined by consideration of internal and external

factors as well as integration of these in formulating

marketing strategies, has significant influence on

levels of managers’ commitment to marketing

strategies formulated for implementation by members

of a cooperative. It can also be concluded that

inclusive participation in marketing strategy

formulation significantly helps in ensuring that

managers commit to cooperative marketing strategies.

A review of literature shows that while

cooperatives are encouraged in the SME sector, there

is lack of studies focusing on how firms operating

under such forms of business arrangements can

enhance their chances of success. By investigating

SME’s operating in a cooperative type of business

arrangement, this study contributes to understanding

how commitment to marketing strategies in a

cooperative business arrangement can be enhanced. It

should however be pointed out that while the study

makes contributions to the understanding of strategy

formulation and its impact among SME’s in

cooperatives, the study is not without limitations. One

limitation relates to the fact that the sample is based

on SME’s operating in a single industry i.e mini-bus

taxi industry in South Africa. The findings may thus

not be generalised to firms operating in other

industries. Another limitation relates to the fact that

the study focused on SME’s operating in Gauteng,

South Africa. The findings may thus not be

generalised to SMEs operating in the same industry

but based in other parts of the country. These

limitations provide opportunities for future research.

The study can be replicated in other parts of the

country or other countries in order to ascertain the

influence of appropriate intelligence generation and

participation in strategy formulation on cooperative

member commitment to strategies. Future research

can also focus on investigating other factors, other

than those examined in this study, that can help

explain commitment to strategies among members of

cooperatives.

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PRODUCTIVITY AND STOCK PRICE REACTION TO SPIN-OFF DECISION

Manojj M.*, Mridula Sahay**

Abstract

In corporate governance, spinoff decision is made either to focus on a specific area of business or to get rid of businesses with low profit margin. Separation of some management assets for a better management of existing assets referred to as a spin off. The spun off or subsidiary company is formed by issuing new shares to the existing shareholders while losing some original or parent company shares. By doing so, shareholders’ value might be lost. With a sample of 65 companies spun off since 2009, this paper analyse the stock price movements of the spun off and the parent company and productivity in terms of turnover of the spun off company. From the analysis, there has been an increase in both productivity and stock price. This paper also emphasizes how corporate governance in spin off decisions can protect shareholders’ value. Keywords: Spin Off, Turnover, Stock Price, Corporate Governance, Shareholders **MBA 2nd Year Student, Amrita School of Business, Amrita University, Coimbatore Tamil Nadu, India **Amrita School of Business, Amrita Vishwa Vidyapeetham, Coimbatore – 641112, Tamil Nadu, India

1 Introduction A spin off decision is nothing but a formation of a

new company by sale or distribution of shares of a

parent company. The new company, which we often

refer to as spunoff or subsidiary is formed by the

assets of parent company. The assets include

employees, technology, clients, furniture and

financial assets. The shareholders receive a certain

amount of shares in the subsidiary company

equivalent to what they had in the parent company.

After that the shareholders can buy or sell either

company shares independently. Usually, a spin off

decision is made by a company with several

businesses. A spin off decision is made either to

narrow down to a specific business and leave out

other relatively irrelevant businesses or to get rid of

low profit margin business.

This decision is made so that both companies

after separation can focus on their own narrowed-

down business and increase profits mutually. But in

the case of spin off the company is risking the value

of the shareholders. The shareholders are forced to

take a risk of getting new shares of the spunoff

company. The productivity in terms of turnover and

efficiency of the new company is unknown and it’s

like investing in a start-up, making the shareholders’

value at risk.

Major task of corporate governance is to protect

shareholders value. This paper mainly focuses on

whether shareholders get benefited by the spin off

decision made by 65 companies since 2009 on the

basis of two parameters, ‘stock price and

productivity’, and come to a conclusion whether

shareholders’ value is protected by a spin off

decision.

First section of this paper gives a brief

introduction about what is spin off, why it is done

and what is the risk of doing so. Second section of

this paper covers the review of related papers and

journals which gave lots of insight about the study.

Third section describes the results of the analysis.

The last section concludes the study and gives further

scope for research in this area.

2 Literature review

Wei et al. (2010) researched whether shareholder

structure alters the interest of investors. The research

of corporate governance regards the separation of

ownership and control as a basic proposition. Wei et

al. (2010) prove that the transformation of different

shareholding structures constantly harms or protects

the interests of investors.

Bistrova and Lace (2011) emphasize that

accounting frauds, research and development cost

cuts, agency problem-these factors tend to lead to

short-term gains, while providing poor long-term

performance to equity investors and created as mode.

According to the model, the key elements, which

succeed maximum long term return of the company,

are plausible corporate governance structure, high

earnings quality and high innovative potential.

Wang (2013) states that while controlling

shareholders who don't have trading rights, they may

engage in expropriating activities that would

http://www.scopus.com/authid/detail.url?authorId=55316990800&eid=2-s2.0-84905089076




293

compensate for the lack of trading rights but don't

care too much about stock volatility. The findings of

Wang (2013) show the scope of agency problems,

test the value of trading rights and provide evidence

that supports for the changes in corporate governance

of companies.

Ma and Zhou (2013) highlight the relation

between information quality and information

disclosure. It finally concludes by saying good

corporate inside governance can play positive role

and enhance the positive correlation.

Shrivastava and Rao (2015) explain the cause

for spinoffs is due to two reasons. One is synergies

and the other is dissonance within the team. Some

find it necessary to team up with others to create

synergy and some find it difficult within a team. But

in both cases they need a compliment for their work

and knowledge.

Nokolowa (2014) explains spinoff made by an

employee with innovation and information about the

new wing of operation in a business. Developing an

idea in a spinoff allows the parent firm to offer a

performance-based contract, which mitigates the

adverse selection problem but also decreases the

firm's incentives to invest in the project. Even they do

so because they don’t want to lose the idea or talent.

Lin and Young (2014) examine whether firms

manage earnings before pursuing corporate spinoffs

with a sample of 226 completed spinoffs between

1985 and 2005 a significant positive relation is found

between income-increasing earnings management

and the announcement period returns for focus-

increasing spinoffs.

Rubera and Tellis (2014) compare the

performance of 145 spinoffs and 121 buyouts

companies that occurred in the United States between

1996 and 2005, divested to commercialize

innovations. This study provides three critical

findings: i) spin offs have higher profits in the two

years after divestiture; afterwards, buyouts have

higher profits; ii) strategic emphasis (investment in

R&D versus marketing) is the mechanism that

explains the diverging profitability of spinoffs and

buyouts over time; this occurs through two routes: a

one-step mediated effect via strategic emphasis; a

two-step mediated effect via strategic emphasis and

radicalness.

Dahl and Sorenson (2014) find that

entrepreneurs with industry experience came from

younger, smaller, and more profitable parent firms,

and that they recruited more experienced employees,

worked harder, and placed less value on having

flexible hours. The recruitment of more experienced

employees and the greater effort exerted appeared to

account for at least some of the performance

advantage associated with prior industry experience.

Tahn and Walkar (2006) find it with the sample

of 102 spin offs from year 1985-1997, post spinoff,

relative valuation measures increase a significantly

greater extent than for peer firms. These findings are

consistent with the view that agency problems are a

contributing factor in firms maintaining value

destroying diversification strategies.

Chemmanur et al. (2014) research paper shows

that post spinoffs there must be an evident increase in

productivity of the spunoff company. Those plants

which are not acquired either by parent company or

other companies are said to have more productivity.

3 Analysis and findings

The 65 sample has been taken for this study. These

are the companies spun off since August 24, 2009.

Every company are listed in different stock

exchanges all over the world mostly in United States

and Europe. The companies are still running and are

traded independently in stock markets like NASDAQ

and NYSE. The samples are collected from website,

http://www.stockspinoffs.com/recent-spinoffs/ and

the data for these samples are collected from

https://in.finance.yahoo.com/q/hp?s=ASPS and

https://in.finance.yahoo.com/q/is?s=ASPS&annual

This study checks whether shareholders’ value

are protected by analysing two important parameters:

I) to analyse whether the shareholders get benefits

from the stocks of the spunoff company or not; and

II) to analyse whether the productivity of the spunoff

company increases after spin off.

I. To analyse whether the shareholders get

benefits from the stocks of the spunoff company or

not

The spunoff company’s value is unknown at the

beginning. Even then the shareholders are convinced

to take the new company shares by compromising the

parent company shares. So share price is an important

parameter in concluding shareholders’ value

protection. In this research paper, we analyse with

two year data for parent company, one year before

the spinoff and one year stock price of parent

company from the date of spin off. For the parent

company the average of stock price before the spinoff

and average of stock price after the spinoff are

calculated. By the difference we ensure whether the

return is positive or negative. The calculation is as

follows:

Parent company return = Average closing price of one year after spin off – Average closing price one year

before spinoff

If the result is positive, then the shareholders are

considered as benefitted by the share price

http://www.stockspinoffs.com/recent-spinoffs/

https://in.finance.yahoo.com/q/hp?s=ASPS

https://in.finance.yahoo.com/q/is?s=ASPS&annual


294

movements and corporate governance body’s

decisions on spinning off really helped the parent

company to focus on a narrowed business.

If the result is negative, then the shareholders

are considered not benefitted by the share price


decision on spinning off didn’t help the parent

company in the short run.

Coming to the spunoff company, the calculation

is a bit different, because we need to only check, if

there is a hike in stock price after the spinoff, or not.

If there is an increase in stock price, then the

shareholders are considered benefited. If there is a

continuous decrease in the stock’s value, then

shareholders are considered not benefited. For the

spunoff company, we analyse one year data of stock

price from the date of spinoff. The average of first

month close price of the stock and maximum value of

the stock in the year are calculated. By the difference

we ensure whether the return is positive or negative.

The calculation is as follows:

Spun-off company return = Maximum price of the stock in a year since spinoff - average price of the stock

for the first month

If the result is positive, then the shareholders are

considered as benefitted by the share price


decisions on spinning off really helped the subsidiary

company to focus on a narrowed business.

If the result is negative, then the shareholders

are considered not benefitted by the share price


decision on spinning off didn’t help the subsidiary

company and the shareholders.

The calculation is done so because, average of

the first month gives the base price of the new stock

irrespective of volatility and highest price is found

for one year considering the fact that the spunoff

company took enough time to give profits.

After finishing these calculations for the whole

sample, we find out number of companies giving

positive returns to shareholders and number of

companies giving negative returns to the

shareholders. The next step is to find the percentage

of returns, because the companies in the sample are

listed in different stock markets all over the world.

By seeing negative return companies’ percentage and

positive return companies’ percentage we come to a

conclusion that shareholders’ value is protected or

not by the spinoff decision.

However, there are limitations in the method

used most important is the negligence of volatility.

We neglect volatility knowing and assuming the fact

that volatility always increases with many

announcements but not limited to dividend issuing,

stock splits, national budgets, bonus shares, etc.,

II. To analyse whether the productivity of the

spunoff company increases after spin off

Most of the company takes spinoff decision to

get rid of the less productive business or businesses

in mature state (no more growth can be expected

from the business). Shareholders of the parent

company are sometimes given the shares of less

productive business and spun off. Shareholders’

value is affected and put in risk. Thus productivity is

a huge factor to be considered while ensuring

shareholders’ value protection. Here we only analyse

the productivity of the spun off company because that

is the point where shareholders’ value is at risk. Two

year revenue is taken and checked whether the

revenue is increased after spinoff or not. Same

procedure as the stock price returns is followed for

concluding that shareholders’ value is protected or

not. First we find out number of positive and negative

productivity. Next we find the percentage growth in

revenue. By analysing the positive productivity

percentage and negative productivity percentage, we

come to a conclusion whether shareholders’ value is

protected or not by the spinoff decision.

If the second year productivity > first year

productivity, then the shareholders’ value are

considered to be protected and corporate governance

body’s decisions on spinning off really helped the

subsidiary company to focus on a narrowed business.

If the second year productivity < first year

productivity, then the shareholders are considered not

benefitted and corporate governance body’s decision

on spinning off didn’t help the subsidiary company

and the shareholders.

The calculations are done so because the

productivity difference of two years shows exactly

whether the company is growing, irrespective of

seasonal sales.

4 Conclusions & Limitations 4.1 Conclusions

i) Due to spinoff the parent company stocks

prices are so volatile and the results we got from the

analysis is that out of 65 companies thirty three

companies’ stock price is going down at an average

of 35% for the next one year and thirty two

companies’ stocks are going up by an average of 37%

for the next one year. Also almost half of the

companies’ stocks are decreasing for one year from

the date of spinoff. This indicates that a spinoff

doesn’t help the parent company in the short run.

This drastic fall of parent companies’ stock price is

mainly due to reduction in assets that is given to the

spun off company.

ii) Due to spin off the subsidiary company

stock prices are also volatile but the results we got


295

from the analysis is that out of 65 companies, none of

the companies’ stock price is going down. Instead, all

the 65 companies’ stock prices are going up by an

average of 70%. Normally, 70% increase in a stock

price within a year is something abnormal. Thus the

shareholders are getting abnormal returns from the

spunoff decision made by the corporate governance

system. This also indicates that the spinoff decision

helped the spunoff company to focus on the specific

narrowed business that too it is evident within one

year.

iii) Due to the spinoff, let us see what happens

to the productivity of the spunoff company. From the

sample of 53 companies, forty six companies are

showing increase in productivity within the

immediate next year. Seven companies’ productivity

decreased at an average of 8% in the first year which

implies that those companies didn’t go well in the

first few years or spinoff decision failed and there is

no productivity after that. But other than that 45

companies (after rejecting any abnormal returns, here

altisource residential corp. with increase of 4244%

over first year), which showed increase in

productivity increased with an average of 56% which

is far more than the 8% decrease of failed spun offs.

This indicates that shareholders’ value is protected by

the corporate governance system most of the time

while taking a spinoff decision.

4.2 Limitations

Almost thirty two of the parent companies’ stock

price went down due to asset loss to spunoff

company but there is no data evidence to prove

that and is beyond the scope of this paper.

Also we don’t know what support other than

financial support is given by the parent company

to spun off company which increased the

productivity and share price. All we proved is

spun off company got both better productivity and

an increasing productivity with stock data and

income statements.

Productivity is proved to be increasing with only

first two years of data from income statement.

What happened to the company in the long run is

not discussed.

All we tried to prove is the shareholders are given

shares of the new company which has a potential

to grow.

And due to the data being recent data is not

available for 65 samples for productivity but got

only 53 companies’ productivity data.

References 1. Ahn S. and M. D. Walker (2006). Corporate

governance and the spinoff decision Journal of

Corporate Finance ISSN: 0929-1199

2. Bistrova, J. , Lace, N. (2011).The model of

sustainable shareholder value International Business

Information Management Association Conference,

IBIMA 2011 Code 106712

3. Chemmanur, Thomas J.., Krishnan, Karthik.,

Nandy, Debarshi K. (2014), The effects of corporate

spin-offs on productivity Journal of Corporate

Finance 27 (2014) 72–98

4. Dahl, M. S. , Sorenson, O. , (2014).The who, why,

and how of spinoffs Oxford University Press on

behalf of Associations ICC Volume 23, Issue 3, June

2014, Article number dtt032, Pages 661-688

5. Lin Y. C., Yung, K., (2014). Earnings management

and corporate spinoffs Review of Quantitative

Finance and Accounting Volume 43, Issue 2, July

2014, Pages 275-300

6. Ma X., Zhou L., (2013). Information disclosure,

information quality, and controlling large

shareholders International Conference on Services

Science and Services Information Technology

Code 103190

7. Nikolowa, R (2014). Developing new ideas: Spin-

outs, spinoffs, or internal divisions Journal of

Economic Behaviour and Organization Volume 98,

February 2014, Pages 70-88

8. Rubera G. , Tellis G.J. , (2014). Spinoffs versus

buyouts: Profitability of alternate routes for

commercializing innovations Strategic Management

Journal Volume 35, Issue 13, 1 December 2014,

Pages 2043-2052

9. Shrivastava M. , Rao T.V.S.R. (2015). Organisational

synergies, dissonance and spinoffs International

Journal of Economics and Business Research Volume

9, Issue 1, 1 January 2015, Pages 54-64

10. Wei S. , Xia Y. , Liu T., Wang. (2010). Shareholding

structure, stakeholder conduct and business

investment International Conference on E-Product E-

Service and E-Entertainment, ICEEE2010

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tradable shares reform in China International

Conference on Management Science and Engineering

Code 99367










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296

THE RELATIONSHIP BETWEEN CAPITAL STRUCTURE AND FINANCIAL PERFORMANCE OF FIRMS LISTED ON THE

NAIROBI SECURITIES EXCHANGE

Odhiambo Luther Otieno*, Sam Ngwenya**

Abstract Until now, researchers are not in consensus, whether it is the capital structure that influences performance or performance that influences capital structure or both. The main objective of this study was to establish the relationship between capital structure and financial performance of firms listed on the NSE by employing a generalised linear model (GLM) as an improvement on ordinary least regression (OLS). The results of the study revealed that efficient and profitable firms employ more debt than comparable firms that are less profitable possibly because profitable firms’ exposure to financial risk is low. There results also indicate that firms that use more debt outperformed those that use less debt. Keyterms: Capital Structure; Financial Performance; General Linear Model; Ordinary Least Regression; NSE *Department of Accounting and Finance, University of Nairobi, PO Box 30197, NAIROBI, KENYA **Department of Finance, Risk Management and Banking, School of Management Sciences, PO Box 392, UNISA, 0003, Preller Street, Muckleneuk Ridge, Pretoria

1 Introduction Research in finance discipline has a history of

examining capital structure choices and linking debt

capital to level of firm performance. The decision on

the amount of debt that a firm uses to finance its

assets and activities is a managerial decision.

However, in modern corporations, managers are

separated from owners, an arrangement that results

into agency costs (Hannah, 2007; Jensen and

Meckling, 1976). It is then hypothesised that

managers who are not owners might not be as

committed as owners would want them to be

(Crawford, 2007; Mark, 2004; Jensen and Meckling,

1976; Berle and Means 1932). The challenge then is

to come up with organization structures that inspire

managers to maximise the value to the shareholders

of the firm. However, agency model could have a

positive or negative impact on firm performance, and

like in any model, the justification lie on whether the

benefits exceed the costs of the models (Dobbin and

Jung, 2010).

The link between agency cost i.e. managerial

choices and impact of those choices on performance

is critical to current and potential investors to

discourage investors from investing in awfully

governed firms (Giannetti and Simonov, 2006).

Intuitively investors will ignore poorly managed firms

within adequate returns, unless they can turn them

around (Christian, Karl and Francis, 2009). In

addition, the economy as a whole benefit from well

managed micro units, in line with the structure-

conduct-performance approach which states that

industry's performance and by extension, the

economy depends upon the conduct of firms within

the economy (Edwards, Allen and Shaik 2009;

Carlton and Perloff, 2004; Scherer and Ross, 1990).

Therefore, there is a need for a model that reconciles

managers and shareholder's interests in a corporation

in the area of financial decisions. Achieving goal

congruence between managers and owners requires

that managers are monitored. Manager’s motivation

to self-interest requires an appropriate disciplinary

device and effective positive incentives.

Managers must make capital structure and profit

planning decisions that add value to the shareholders.

Determining the right balance between debt and

equity financing means weighing the costs and

benefits of debt and equity, to make sure that the firm

does not have debt it cannot repay and at the same

time, the combination of debt and equity should

minimise the cost of capital. The proposition is that

potential debtholders will invest in profitable,

financially sound and growth firms such that firm

performance is the key to the amount of debt capital

an individual firm will employ. The other proposition

is that debt capital forces managers to manage cash

flow to be able to meet the firm’s debt obligations.

Therefore, debt holders have the potential to play a

disciplinary role, thus improving performance.

Since researchers are not in consensus whether it

is the capital structure that influences performance or


297

performance that influences capital structure or both

(Margaritis and Psillaki, 2010; Margaritis and

Psillaki, 2007). One may argue that debt capital

would reduce agency costs. However, it can also

induce agency benefits if there are visible differences

in performance across different levels of capital

structure and visible differences in capital structure

across different levels of performance. Thus

managers would look at performance in managing

debt levels and vice versa. The resulting proposition

is that capital structure decisions are relevant and not

irrelevant as stated in Modigliani and Miller (M&M)

(1958) On the Nairobi Securities Exchange (NSE),

there are large differences in leverage ratios and the

question then is, if the capital structure decision is not

important, how does one explain variations in

leverage ratios? This study establishes which of these

possibilities prevail on the NSE.

Methodological issues arise from studies on capital

structure choices. Different methodologies result into

different interpretation of factors that explain capital

structure decisions. Some previous studies employed

statistical techniques that make it difficult to establish

whether the effect of capital structure on performance

responds to different capital choices, or whether the

effect of performance on capital structure responds to

different performance levels. Onwuegbuzie, Johnson

and Coluns (2009) recommend that more than one

statistical method should be used as part of a

validation process to help ensure that variance

explained culminates from the underlying phenomena

or trait and is not afunction of method. However, of

significance to managers would be whether poor

performance is explained in terms of sub optimal

capital structure choices or capital structure is

explained in terms of level of capital structure. This

require grouping of firms into levels of performance

and levels of borrowing. Grouping is frequently used

for inferring the association between two variables

(Kutner, Nachtsheim, Neter and Li, 2005; Lys and

Sabino, 1992).

The main objective of this study was to establish

the relationship between capital structure and

financial performance firms listed on the NSE by

employing a generalised linear model (GLM) as an

improvement on ordinary least regression (OLS).

OLS based studies focus only on the test of

significance of predictor coefficients but do not use

levels of performance to predict levels of leverage

and vice versa. GLM enabled the determination of the

relationship between capital structure and

performance by considering levels of performance

and levels of capital structure. The remainder of this

study is structured as follows: Firstly, a literature

study presents the theoretical foundation of the

relationship between capital structure and financial

performance. Secondly, the sample, variables and

methodology employed are outlined. Thirdly, the

analysis is carried out, and lastly the results of the

analysis and the recommendations are outlined.

2 Capital structure and firm performance

This study gravitated around the relevancy and

irrelevancy of capital structure decisions, precisely

the effect of debt capital on the value for the

shareholders of the firm. O’Brien, Parthiban, Toru

and Andrew (2014) observing the lack of consensus

on the impact debt on firm performance stated that

while agency theory predicts that debt should lead to

higher performance for diversifying firms, transaction

cost economics (TCE) predicts that more debt will

lead to lower performance for firms expanding into

new markets.

The importance of debt capital to issuing firms

is debatable from the time Modigliani and Miller

(1958) pointed out that in perfect markets, and based

on the law of one price, capital structure does not

matter because it does not add value. The law of one

price implies that a good must sell for the same price

in all locations (Mankiw, 2011; Lamont and Thaler,

2003), otherwise arbitrageurs will come into the

market and eliminate differences in prices of identical

assets. The finance manager's interpretation would be

that in perfect capital markets, all financial decisions

will not impact on the value of the firm, and in

finality irrelevant. The then Modigliani and Miller

(1958) proposition worked well with the proof that

while leverage increases the risk and cost of equity,

the firms weighted cost of capital (WACC) and total

value are indifferent towards capital structure choices

(Van Horne and Wachowicz, 2009).

However, the conclusion that a firm’s choice of

capital structure is inconsequential is inconsistent

with the observation that firms invest significant

resources both in terms of managerial time and effort,

legal fee and investment banking fees, to manage

their capital structures (Berk and Demazro, 2011).

The main justification of the deployment of such

resources is that the choice of leverage is of critical

importance to a firm’s value, and that individual firms

have an optimum capital structure (Berk and

Demazro, 2011).

Harvey, Lins and Roper (2004) study the extent

debt capital mitigates agency costs to create

shareholder value. Gamba and Triantis (2014)

examine the effectiveness of debt covenants in

alleviating financial agency problems, concluding that

the presence of debt capital and enforcement of debt

covenants significantly alters dynamic financing and

investment policies, and is an important element of

structural models. These prescriptions define a new

role for debt, and presented testable propositions.

The testable theory predicts performance as a

factor in explaining the use of debt, the meaning of

this is that productive and money-making firms will

use more debt (Margaritis and Psilaki, 2010). It is

also possible that efficient firms may use less debt to

minimise their exposure to financial risk (He and

Matvos, 2012). In addition, the franchise value

hypothesis suggests that the more profitable and


298

liquid the firm is, the lower the leverage (Cheng and

Tzeng, 2011; Margaritisa and Psillak, 2007; Berger

and Bonaccorsi, 2006). A capital structure study in

Ghana reported positive associations between debt

ratio (capital structure) and firm size and growth,

while asset tangibility, risk, corporate tax and

profitability are negatively related to the debt ratio

(Abor and Biekpe, 2005). Abor, and Biekpe, (2009)

report variables such as firm's age, size, asset

structure, profitability, and growth as influencing the

capital structure choices of small and medium

enterprise (SMEs) in Ghana. Therefore, the first,

second hypotheses and their alternatives of this study

are stated as follows:

H01: Firm performance does not have a

significant effect on leverage,

H11: Firm performance has a significant effect

on leverage

H02: Leverage does not have a significant effect

on performance

H12: Leverage has a significant effect on firm

performance.

The first hypothesis analyses the effects of

performance on capital structure taking into account

two competing hypothesis (Berger and Bonaccorsi di

Patti, 2006). The two competing hypotheses are

profitability (return) – risk hypothesis; and franchise

– value hypothesis. The profitability (return) – risk

hypothesis stipulates that profitable firms have lower

expected bankruptcy costs thus are able to employ

more debt than comparable firms that are less

profitable. While under the franchise – value

hypothesis, the proposition is that profitable firm will

employ less debt to protect the firm from debt

induced liquidation. In the second hypothesis we

assess the role of debt capital on reducing agency

costs, and in so doing, improving performance

(Dobbin and Jung, 2010; Christian, Karl and Francis,

2009; Zwiebel, 1996; Jensen and Meckling, 1976). If

leverage mitigates agency costs, then one expects

leverage to improve firm performance. It is also

possible that high levels of leverage increase agency

cost thus impairing firm performance.

3 Research objectives

The main objective of this study was to investigate

the relationship between capital structure and

financial performance of firms listed on the NSE by

employing a generalised linear model (GLM) as an

improvement on ordinary least regression (OLS).

4 Research methodology 4.1 Data collection

The population of the study consisted of all

companies listed on the NSE during the period 1990

to 2012. Due to their unique capital structure, firms

classified as financial institutions were left out,

leaving a sample of 37 firms. The study relied on

secondary data extracted from the annual reports

supplied firms listed on the NSE. Share price listings

were found at NSE and Capital Markets Authority

(CMA). The study employed panel data, i.e., instead

of a firm being a unit of observation, firm and each

firm year became an observation as was in Faleye,

Hoitash and Hoitash (2011). The comfort in

extracting information from annual reports is that

they are subjected to an audit by reputable audit

firms, while the comfort in using market data is that

such data is on public domain and is subjected to

public scrutiny. However, where returns per share are

to be calculated, they were adjusted for dividends

paid, share splits and right issues.

4.2 Definition of variables and hypotheses

The variables used in this study to measure capital

structure and performance were identified by making

use of canonical correlation, and reject return of

assets (ROA) as a performance indicator. The

variables used as indicators of performance are book

value to market value and asset turnover, and total

debt to total asset as an indicator of capital structure

or leverage.

The GLM procedure is used to provide

regression analysis and analysis of variance for level

measured variables (Rutherford, 2011). In the first

hypothesis the GLM is used to test the null hypothesis

about the effect of performance and ownership

structure on the means of different groupings of the

debt ratio. In the second hypothesis the GLM is used

to test the hypothesis regarding the effect of capital

structure and ownership structure on the means of

various groupings of performance. Furthermore, the

GLM is used to establish the interaction between

independent variables. In this GLM model, the

dependent variable which could be an indicator of

capital structure or performance, depending on

hypothesis being tested, is a covariate, but the

independent variables can be any level that defines

groups; that is, dichotomous, nominal, ordinal, or

grouped interval. In this study, all independent

variables are grouped variables (Rutherford, 2011).

5 Results and findings

5.1 Descriptive statistics of grouped performance and capital structure indicators

The information in Table 1 confirmed the adequacy

of the sample size, the larger the sample size, the

better for GLM. The large numbers of cases within


299

each category of the independent variable ensure a

reasonably stable mean for each cell when analysing

observational data. The book value to the market

value ratio is interpreted in terms of positive growth,

no growth, and negative growth. A book value to

market value of less than one means the market value

is greater than one and indicates growth in a firm

share. A book value to market value of less than one

is interpreted as a decline in growth and a book value

to market value of less than one is interpreted as a

positive in growth. From 851 cases, a total of 708

cases are included for the analysis. Therefore, a total

of 510 cases had no growth and negative growth.

However, the average growth factor (positive growth

stocks), (book to market value is 0.252) is a high

3.968 or 397 percent.

Table 1. Descriptive statistics of grouped performance and capital structure indicators

Mean

StDev

Number

Level of Book to Market Ratio

Positive Growth <1

No Growth =1

Negative Growth > 1

Total

0.252

0.931

3.995

1.702

.

0.221

0.280

4.913

3.174

198

288

222

708

Ownership Structure

Shareholdings 20percent to 50percent

Shareholdings 51percent to 100percent

Shareholdings Below 20percent

Total

34.409

64.434

14.821

52.029

8.772

11.373

2.523

18.594

276

437

15

728

Total Debt to Total Assets

High Debt ratio 0.45 to 2.03956

Medium Debt ratio 0.3515 to 0.44781

Low Debt ratio 0 to 0.34278

Total

0.675

0.399

0.196

0.406

0.226

0.027

0.091

0.263

257

125

326

708

Lev Asset Turnover Ratio

Low 0.073 - 0.6882

Medium 0.6926 - 1.1073

High 1.114 - 10.1856

Total

0.4545

0.8917

2.0581

1.1321

0.1513

0.1192

1.0653

0.9192

234

234

232

700

Ownership structure in this study captures the

percentage of shares held by top shareholders, in each

firm over the period 1990 to 2012. There is evidence

of concentrated ownership in the firms, that is, 437

cases out of 728 cases over 23 years, show

shareholding of over 51 percent. This gives such a

single shareholder an absolute control and is evidence

of absence of dispersed ownership. The concentration

of ownership is confirmed by the structure of

ownership where only 15 cases show the ownership

below 20 percent and that the average shareholding is

52.029 percent.

Capital structure (the total debt to the total asset

ratio), has three measurement levels, high debt ratio

ranging from 0.45 to 2.03956, with a mean of 0.675

and a standard deviation of 0.226, relating to 257

cases out of 708 cases; medium debt ratio ranging

from 0.3515 to 0.44781, with a mean of 0. 399 and a

standard deviation of 0.027, relating to 125 cases out

of 708 cases; and low debt ratio ranging from 0 to

0.34278, with a mean of 0.196 and a standard

deviation of 0.091, relating to 326 cases out of a 708

cases.

The standard deviation shows that the level of

dispersion of grouped levels is highest for a high debt

ratio, that is, firms classified as using substantial

amounts of debt to finance their total assets. The

mean of the levels is different from a high 0.675 to

0.399 and 0.196 for high, medium, and low use of

debt respectively. On average, the firms listed on the

NSE use 40.565 percent debt capital to finance their

assets. However, the standard deviation of 26.257

percent shows substantial variation in the use of debt

by firms' overtime. The debt to the asset ratio of

greater than 0.5 indicates that equity position by

owners is less than 50 percent, while a debt ratio of

one or more mean that the firm is technically

insolvent and there were few such cases.

The asset turnover indicates the rate at which a

firm generates the turnover (sales) from asset base.

To group the cases, the indicators are ranked and

divided into three equal groups, and this explains why

there are almost 234 cases within each group. The

average asset turnover ratio is 1.132. From canonical

analysis this ratio emerges as a superior indicator of


300

performance in building a relationship between

performance and capital structure.

5.2 Influence of book value to market value on the total debt to total assets ratio

The question that arises is, “Does the book value to

market value (performance) have an impact on the

total debt to the total asset ratio - capital structure?”

The test is whether the average of the total debt to the

total asset ratio, between the growth firms (the book

value to the market value ratio < 1), no-growth firms

(the book value to the market value ratio = 1), and

negative growth firms (the book value to the market

value ratio >1) are significantly (statistically)

different. Table 2 provides statistics for each

combination of factors in the model, performance

(book to market ratio) and ownership structure

(shareholdings). The N column in Table 2 shows that

there are unequal cell sizes. Over the year majority of

firms offered is either zero growths (288) or no

growth (222), with those with growth totaling 198.

The standard deviation does not appear homogenous

if we take interaction into account.

The result shows that firms with positive

growth, (where market values exceed book value) on

average financed 43.6 percent of their assets with

debt capital; no-growth firms on average financed

39.55 percent of their assets with debt capital; and

negative growth firms on average use the least

amount, financed 39.16 percent of their assets with

debt. There appears to be no performance effect on

capital structure because for each class of

performance, the debt usage is approximately 40

percent (positive g <1 = 43.608 percent; no-growth

percent; and negative g > 1 = 39.163 percent).

Table 2. Performance (Book to Market Ratio) on capital structure - dependent variable: Total debt to total

assets

Categorised Ownership

Structure

Level of Book Value to Market Value

Ratio Mean

Std.

Deviation N

Shareholdings 20 percent to

50 percent

Positive Growth <1 0.4162

6 0.210122 75

No Growth =1 0.3627

4 0.268151

12

9

Negative Growth > 1 0.3286

5 0.319771 69

Total 0.3688

3 0.269185

27

3

Shareholdings 51 percent to

100 percent


1 0.320123

11

3

No Growth =1 0.4202

7 0.223603

15

4


4 0.231942

15

3

Total 0.4291

0 0.255703

42

0

Shareholdings Below 20

percent


4 0.331983 10

No Growth =1 0.4798

5 0.060441 5

Total 0.4191

8 0.271785 15

Total


8 0.283402

19

8

No Growth =1 0.3955

3 0.244356

28

8


3 0.265067

22

2

Total 0.4056

5 0.262571

70

8

From table 2 it is observed that firms in which

the largest shareholder held 20 percent to 50 percent

of the share capital on average financed 36.88 percent

of their assets with debt capital, and firms in which

the largest shareholder held more than 51 percent (51

percent to 100 percent) of the share capital on average


301

financed 42.91 percent of their assets with debt

capital. Firms in which the largest shareholder held

below 20 percent of the share capital on average


capital.

Firms in which the largest shareholder held 20

percent to 50 percent of the share capital coupled with

a positive growth on average financed 41.63 percent

of their assets with debt capital, firms in which the

largest shareholder held below 20 percent of the share

capital coupled with positive growth on average


capital. Firms in which the largest shareholder held

more than 51 (51 percent to 100 percent) of the share

capital coupled with positive growth financed 45.34

percent of their assets with debt capital.



no-growth financed 36.274 percent of their assets

with debt capital, firms in which the largest

shareholder held below 20 percent of the share capital

coupled with no-growth on average financed 47.985

percent of their assets with debt capital. Firms in

which the largest shareholder held more than 51

percent (51 percent to 100 percent) of the share

capital coupled with no-growth on average financed

42.03 percent of their assets with debt capital.



negative growth on average financed 36.88 percent of

their assets with debt capital, firms in which the

largest shareholder held below 20 percent of the share

capital coupled with negative growth appeared not to

use debt to finance their assets. Firms in which the

largest shareholder held more than 51 percent (51

percent to 100 percent) of the share capital coupled

with negative growth on average financed 42 percent

of their assets with debt capital.

5.3 Homogeneity of variance test – book value to market value on debt ratio

This test confirmed if the differences in capital

structure (the total debt to the total asset ratio) by

performance (book to market ratio), ownership

structure (shareholdings) and interaction term

(ownership structure*book to market ratio) are

statistically significant. Table 3 depicts the results of

the Levene’s test of equality error variances.

Table 3. Levene’s test of equality error variances: department ariable: Total Debt to Total Assets

F df1 df2 Sig.

1.752 7 700 0.094

Tests the null hypothesis that the error variance of the dependent variable is equal across groups.

a. Design: Intercept + OwnStrCa + LeBtM + OwnStrCa * LeBtM

The significance result for homogeneity of variance is

> 0.05; that is, 0.094, which indicates that the error

variance of the dependent variable is equal across the

groups.

5.4 Tests of between-subjects effects - dependent variable: total debt to total assets The results of tests between subject variables with the

total debt to the total asset ratio as dependent variable

and book value to market value as predictor variable

and ownership structure are presented in Table 4. The

equation for the model is:

SS corrected model = SSOwnStrCa + SSLeBtM + SSOwnStrCa * LeBtM

1.008a = 0.606 + 0.201 + 0.127

The significance value for ownership

(OwnStrCa) is 0.012, is significant at <0.05;

therefore, affect capital structure, but there is no

effect of book value to market value (p = 0.230) on

capital structure. The null hypothesis that "the mean

total debt to a total asset ratio was not equal across all

categories of the book value to market ratio" is

rejected. There is also no discriminating effect of

interaction term (OwnStrCa * LeBtM) on capital

structure. The hypothesis that "the mean total debt to

the total asset ratio was not equal across all categories

of ownership structure (OwnStrCa)” is not supported

by data; and the overall corrected model, F value =

2.11 and p-value of 0.040 are significant. The

partial eta squared presented in Table 4 confirmed

that except for the intercept, all other partial eta

squares are either trivial or small. Therefore, the

statement that "membership in categories defined by

book value to market value class identification

accounts for a reasonable amount of the differences in

the total debt to the total asset ratio" is not supported

by the data.


302

Table 4. Tests of between-subjects effects - dependent variable: total debt to total assets

Source

Type III

Sum of

Squares

Df Mean

Square F Sig.

Partial Eta

Squared

Corrected Model 1.008a 7 .144 2.111 0.040 0.021

Intercept 21.926 1 21.926 321.526 0.0001 0.315

OwnStrCa 0.606 2 0.303 4.444 0.012 0.013

LeBtM 0.201 2 0.100 1.472 0.230 0.004

OwnStrCa *

LeBtM 0.127 3 0.042 0.620 0.602 0.003

Error 47.735 700 0.068

Total 165.245 708

Corrected Total 48.743 707

a. R Squared = .021 (Adjusted R Squared = 0.011)

5.5 Post Hoc Analysis- book value to market value on total debt to total assets

Post hoc multiple comparison tests help determine

which means differ. This is critical for the study

because the objective during this stage is to establish

the impact of performance (book to market ratio) on

capital structure (total debt to total assets) taking into

account the different performance levels (positive

growth, no growth and negative growth). The result

of post-hoc analysis is in Table 5.

The next three statements are possible

interpretation of the post-hoc effects. Each one should

be verified independently for significance in terms of

pair-wise comparisons, and the results are presented

in Table 5. The first statement was that a group within

the book value to the market value ratio categorised

as “positive growth used more debt than the other

group within the book value to the market value ratio

categorised as no growth (=1). However, the

difference of -0.041 between the two groups has a p-

value of 0.21. Therefore, is not significant.

The second statement was that a group within

the book value to the market value ratio classified as

“no growth (=1) used more debt than the other group

within the book value to the market value ratio

classified as negative growth ( >1). However, the

difference of 0.004 between the two groups is

associated with a p-value of 0.19, which is greater

than the critical value of 0.05; the difference is not

significant.

The third statement was that a group within the

book value to the market value ratio classified as

“positive growth ( <1) used more debt than the other

group within the book value to the market value ratio

classified as negative growth ( >1. However, the

difference of -0.04 between the two groups is

associated with a p-value of 0.985, which is greater

than the critical value of 0.05; therefore, the

difference is not significant.

Table 5. Multiple comparisons - total debt to total assets ratio by level of book to market ratio Tukey HSD

(I) Level of Book to

Market Ratio

(J) Level of Book to

Market Ratio

Mean

Difference

(I-J)

Std.

Error Sig.

95 percent Confidence

Interval

Lower

Bound

Upper

Bound

Positive Growth <1 No Growth =1 -0.04054 0.024108 0.213 -0.01608 0.09717

Negative Growth > 1 0.04444 0.025526 0.191 -0.01551 0.10440

No Growth =1 Positive Growth <1 -0.04054 0.024108 0.213 -0.09717 0.01608

Negative Growth > 1 0.00390 0.023323 0.985 -0.05088 0.05868

Negative Growth > 1 Positive Growth <1 -0.04444 0.025526 0.191 -0.10440 0.01551

No Growth =1 -0.00390 0.023323 0.985 -0.05868 0.05088

Based on observed means. The error term is Mean Square (Error) = 0.068.

Tukey's HSD (honest significant difference test) test

is appropriate because the interest to the researcher is

to find means that are significantly different from

each other (Kinnear and Gray, 1999). The

homogeneous subsets' output is generated along with

post hoc tests and show, which pair of groups has

significantly distinct means on the dependent

variable. Subset output would not be interpreted if the

main effect was not significant. Table 6 depicts the

Turkey’s HSD test.


303

Table 6. Tukey HSD

a,,b,,cTotal debt to total assets ratio by level of book to market ratio

Level of Book to Market Ratio N Subset

1

Negative Growth > 1 222 0.39163

No Growth =1 288 0.39553

Positive Growth <1 198 0.43608

Sig.

0.162

Means for groups in homogeneous subsets are displayed.

Based on observed means.

The error term is Mean Square (Error) =0.068.

a. Uses Harmonic Mean Sample Size = 230.287.

b. The group sizes are unequal. The harmonic mean of the group sizes is used. Type I error levels are not

guaranteed.

For each grouping variable, there are variations

in capital structure (debt ratio), and the result in Table

6, show that cases of negative growth > 1 has a debt

ratio 0.392, case of no-growth = 1 have a debt ratio

of 0.396 while cases of positive growth <1 has a debt

ratio of 0.436. If we ignore the statistical test of

significance, and from the ranking, it appears that

performance has some influence on capital structure.

This is because cases of improved book value to

market value are associated with more use of debt.

However, given that means are all listed under one

subset, and with a p-value of 0.162, it follows that the

set of means are not statistically significantly

different from each other. Furthermore, because all

scores for the amount of debt used (see subset 1 in

Table 6 above) across different levels of growth can

be rounded to 40 percent, confirm no difference in

total debt to the total asset ratio (capital structure) if

the book value to market value is used as a grouping

variable.

5.6 Influence of asset turnover ratio (performance) on total debt to total assets ratio (capital structure)

The asset turnover ratio was the first ranked indicator

of performance as per canonical correlation analysis.

At this stage of analysis, the question then is, “Does

the asset turnover ratio (as a performance indicator)

have influence on the total debt to the total asset ratio

(capital structure)?

The different classes of asset turnover ratio and

the total debt to the total asset ratio are presented in

Table 7. The dependent variable is the total debt to

the total asset ratio, and the independent variables are

asset turnover ratio and ownership structure. The

result showed that firms with a low asset turnover, on

average financed 28.15 percent of their assets with

debt, while firms with a medium asset turnover ratio

financed 39.66 percent of their assets with debt; and

firms with a high asset turnover ratio financed 54.68

percent of their assets with debt. The data confirmed

that, in this market, on the average firm financed

40.79 percent of their assets using debt capital.

On examination of the asset turnover ratio

(performance) there appears to be a performance

effect (asset turnover effect) on capital structure. The

variation in the total debt to the total asset ratio

(capital structure) is easily visible across asset

turnover ratio levels. Therefore, the NSE data

confirms that low usage of debt is associated with low

asset turnover ratio (performance) and that firms with

a debt ratio above 54.68 percent outperform those

with the medium and low debt ratio.

When the asset turnover ratio is used as an

indicator of performance, the data on the NSE support

the performance risk hypothesis, that is, more

profitable, or that more efficient firms use more debt.

The data fail to confirm the franchise value

hypothesis that stipulates that firms might prefer to

lower the total debt to the total asset ratio to reduce

their exposure to financial risk. Therefore, the data

support the hypothesis that the population means for

low asset turnover ratio, medium asset turnover ratio

and high asset turnover ratio with respect to total debt

to total assets ratios (capital structure) are not equal

taking into account ownership structure.

Levene’s (1960) test for equality of variance is a

criterion for satisfying this assumption, and the result

presented in Table 8. The significance level for

homogeneity of variance of 0.0001 confirmed that the

error variance in the dependent (the total debt to the

total asset ratio- capital structure) variable is not equal

across the groups (asset turnover ratio); therefore, the

assumption to the ANOVA test has not been met. The

data reject the hypothesis that the population

variances for low asset turnover ratio, medium asset

turnover ratio and medium asset turnover ratio with

respect to the total debt to the total dependent variable

are equal.


304

Table 7. Performance (Lev Asset Turnover Ratio) on capital structure - dependent variable: total debt to total

assets

Categorised Ownership Structure Lev Asset Turnover Ratio Mean Std.

Deviation N

Shareholdings 20percent to

50percent

Low 0.073 - 0.6882 0.21975 0.171092 116

Medium 0.6926 - 1.1073 0.39050 0.168437 83

High 1.114 - 10.1856 0.57820 0.334240 74

Total 0.36883 0.269185 273


100percent

Low 0.073 - 0.6882 0.34727 0.255778 116

Medium 0.6926 - 1.1073 0.39237 0.183122 142

High 1.114 - 10.1856 0.53606 0.280333 154

Total 0.43338 0.256300 412

Shareholdings Below 20percent Low 0.073 - 0.6882 0.05043 0.034182 2

Medium 0.6926 - 1.1073 0.51884 0.235918 9

High 1.114 - 10.1856 0.37930 0.270803 4

Total 0.41918 0.271785 15

Total Low 0.073 - 0.6882 0.28151 0.226391 234

Medium 0.6926 - 1.1073 0.39657 0.181080 234

High 1.114 - 10.1856 0.54680 0.298641 232

Total 0.40790 0.263214 700

Table 8. Levene's Test of Equality of Error Variancesa - Dependent Variable: Total Debt to Total Assets

F df1 df2 Sig.

5.888 8 691 0.0001

Levene's Test of Equality of Error Variances

tests the null hypothesis that the error variance of the

dependent variable is equal across groups.

a. Design: Intercept + OwnStrCa + Lev Asset

Turnover Ratio + OwnStrCa * Lev Asset Turnover

Ratio

The results of “Tests of Between-Subjects

Effects” presented in Table 9 is to confirm if the

relationship between the asset turnover ratio, and the

total debt to the total asset ratio is

statistically significant. In the model in Table 9, the

values of intercept, asset turnover ratio (LeAssTurn)

and interaction term (OwnStrCa * LeAssTurn) are

statistically significant because their significance

level is greater than the cut off level of < 0.05;

therefore, these variables have effect on capital

structure. Ownership structure (OwnStrCa) (p =

0.126) has no effect on capital structure. The overall

corrected model, F value = 21.46 and p-value of

0.0001 are statistically significant. The null

hypothesis that "the mean total debt to the total asset

ratio (capital structure) was not equal across all

categories of the asset turnover ratio" is supported by

data. The statistical test confirmed a relationship

between the predicted variable (capital structure) and

predictor variable (performance); and that the

different categories of the independent variable

performance (asset turnover ratio levels - low,

medium, and high) are linked to the different average

scores on the dependent variable (capital structure).

However, this does not tell us which component of

the asset turnover ratio, whether low, medium and

high, behaves differently.

Effect size measures the strength of a

phenomenon. The partial eta squared measure of

effect size of the relationship between asset turnover

ratio and total debt to the total asset ratio is presented

in Table 9. Based on Cohen's criteria for effect size,

except for the intercept, all other partial eta squares

are small, but much higher than in the case of the

book value to the market value ratio. The statement

that "membership in categories defined by asset

turnover ratio categories accounts for a reasonable

amount of the differences in average total debt to the

total asset ratio" is therefore, marginally supported.


305

Table 9. Tests of between-subjects effects - dependent variable: total debt to total assets

rce

Type III

Sum of

Squares

Df Mean

Square F Sig.

Partial

Eta

Squared

Corrected Model 9.638a 8 1.205 21.461 0.0001 0.199

Intercept 12.695 1 12.695 226.141 0.0001 0.247

OwnStrCa .233 2 0.117 2.076 0.126 0.006

LeAssTurn 1.013 2 0.507 9.026 0.0001 0.025

OwnStrCa *

LeAssTurn

1.215 4 0.304 5.411 0.0001 0.030

Error 38.790 691 0.056

Total 164.896 700


a. R Squared = 0.199 (Adjusted R Squared = 0.190)

5.7 Interpretation of the post-hoc effects – asset turnover ratio with total debt to total asset ratio

The next three statements are possible interpretation

of the post-hoc effects. Each one is verified

independently for significance in terms of pair-wise

comparisons, and the results presented in Table 10.

The first statement was a group within asset turnover

ratio categorised as a low asset turnover ratio used

more debt than the other group within the asset

turnover ratio categorised as a medium asset turnover

ratio. The difference between the means of -0.112

between the groups has a p-value of 0.0001, is

therefore, significant.


asset turnover ratio, categorised as the medium asset

turnover ratio, used more debt than the other group

within the asset turnover ratio categorised as the high

asset turnover ratio. The difference between the group

means of - 0.150, has a p-value of 0.0001, and is

statistically significant.

The third statement was that a group within

asset turnover ratio, categorised as a low asset

turnover ratio, used more debt than the other group

within the asset turnover ratio categorised as a high

asset turnover ratio. However, the difference of 0.265

between the groups with a p-value of 0.0001, which is

less than the critical value of 0.05 is statistically

significant. Therefore, the null hypothesis that the

population means for low asset turnover ratio

(performance), medium asset turnover ratio and

medium asset turnover ratio with respect to the total

debt to total assets ratios as dependent variable

(capital structure) are not equal taking into account

ownership structure is supported by the data.

Therefore, performance, when the asset turnover ratio

is used as an indicator of performance has an effect

on debt usage.

Table 10. Multiple comparisons - total debt to total assets ratio by Lev asset turnover ratio Tukey HSD

(I) Lev Asset

Turnover Ratio

(J) Lev Asset

Turnover Ratio

Mean

Difference

(I-J

Std.

Error

Sig. 95 percent

Confidence Interval

Lower

Bound

Upper

Bound

Low 0.073 - 0.6882

Medium 0.6926 -

1.1073

High 1.114 - 10.1856

Medium 0.6926 - 1.1073

High 1.114 - 10.1856

Low 0.073 - 0.6882

High 1.114 - 10.1856

Low 0.073 - 0.6882

Medium 0.6926 - 1.1073

-.11506*

-.26529*

.11506*

-.15023*

.26529*

.15023*

0.021904

0.021951

0.021904

0.021951

0.021951

0.021951

0.0001

0.0001

0.0001

0.0001

0.0001

0.0001

-0.16650

-0.31685

0.06361

-0.20179

0.21373

0.09867

-0.06361

-0.21373

0.16650

-0.09867

0.31685

0.20179

Based on observed means, the error term is Mean Square (Error) = 0.056. *.

The homogenous subsets test from total debt to

total assets ratio with the asset turnover ratio. The derived groups are used to predict total debt to the

total asset ratio (capital structure) and to establish if there are significant capital structure variations between the groups. The means that are listed under


306

each subset comprise a set of means that are not significantly different from each other, but in this case, as shown in Table 11, are under different subsets; because each group is under a different

subset. We conclude that the total debt to the total asset ratio for groups within the asset turnover ratio is significantly distinct.

Table 11. Homogenous subset total debt to total assets ratioTukey HSD

a,,b,,c

Lev Asset Turnover Ratio N Subset

1 2 3

Low 0.073 - 0.6882 234 0.28151

Medium 0.6926 - 1.1073 234

0.39657

High 1.114 - 10.1856 232

0.54680

Sig. 1.000 1.000 1.000

Means for groups in homogeneous subsets are

displayed. Based on observed means, the error term is Mean Square (Error) = 0.056. a. Uses Harmonic Mean Sample Size = 233.330. b. The group sizes are unequal. The harmonic mean of the group sizes is used. Type I error levels are not guaranteed. c. Alpha = 0.05.

Poor asset turnover ratios are associated with low usage of debt. That group financed only 28.15 percent of the assets with debt capital; whereas cases of a high asset turnover ratio are associated with more usage of debt, as that group financed 54.68 percent of the assets with debt capital. The null hypothesis that the population means and variance for low asset turnover ratio (performance), medium asset turnover ratio and medium asset turnover ratio with respect to the total debt to the total asset ratio (capital structure) are not equal taking into account ownership structure is supported by the data.

5.8 Influence of total debt to total asset ratio (capital structure) on book value to market value performance The basic statistics for each combination of factor and covariate in the model, capital structure (debt ratio levels) and ownership structure (shareholdings) as the predictor variable with the book to market value as the independent variable are in Table 12. The result showed that firms with a high debt ratio have on average the highest book value to the market value ratio (growth) of 1.486, and that not much difference in the book value to the market value ratio between the medium debt ratio (with the book value to the market value ratio of 2.11) and a low debt ratio (with the book value to the market value ratio of 1.71), that is, if rounded to one decimal point, (see total section in Table 12). The best performance is associated with a high debt ratio.

It appears that ownership structure has influence on performance. Firms in which the largest

shareholder held 20 percent to 50 percent of the share capital on average had a book value to the market value ratio of 1.19; firms in which the largest shareholder held more than 51 percent (51 percent to 100 percent) of the share capital on average had the lowest book value to the market value ratio of 2.077, and firms in which the largest shareholder held below 20 percent of the share capital on average had the highest book value to market value of 0.45. The best performance is associated with dispersed shareholding; and it is possible that the shares of such trade frequently.

Firms in which the largest shareholder held 20 percent to 50 percent of the share capital coupled with a high debt ratio had an average book value to the market value ratio of 0.968; firms in which the largest shareholder held below 20 percent of the share capital coupled with a high debt ratio had an average book value to the market value ratio of 0.432; and firms in which the largest shareholder held more than 51 percent (51 percent to 100 percent) of the share capital coupled with a high debt ratio had an average book value to the market value ratio of 1.816. The best bet then would be a firm where shareholding is dispersed (shareholdings below 20 percent) with a substantial amount of debt in capital structure.

Firms in which the largest shareholder held 20 percent to 50 percent of the share capital coupled medium debt ratio had an average book value to market value of 1.194; firms in which the largest shareholder held below 20 percent of the share capital coupled medium debt ratio had an average book value to the market value ratio of 1.025; and firms in which the largest shareholder held more than 51 percent (51 percent to 100 percent) of the share capital coupled with a medium debt ratio had an average book value to the market value ratio of 2.601. The best bet then would be a firm where shareholding is dispersed (shareholdings below 20 percent) with the medium amount of debt in capital structure.


307

Table 12. Descriptive statistics capital structure (debt ratio) on performance - dependent variable: book value to

market value ratio

Categorised Ownership Structure Categorised Total Debt to Total

Assets Mean

Std.

Deviation N

Shareholdings 20 percent to 50 percent

High Debt ratio 0.45 to 2.03956 0.9682 0.8330 87


1.1944 1.0135 41

Low Debt ratio 0 to 0.34278 1.3274 1.1492 145

Total 1.1929 1.0466 273

Shareholdings 51percent to 100 percent



2.6017 6.2202 82

Low Debt ratio 0 to 0.34278 2.0722 3.9269 176

Total 2.0768 3.9891 420

Shareholdings Below 20 percent



1.0250 0.3889 2

Low Debt ratio 0 to 0.34278 0.2600 0.1720 5

Total 0.4540 0.3556 15

Total



2.1149 5.1052 125

Low Debt ratio 0 to 0.34278 1.7131 3.0096 326

Total 1.7016 3.1735 708

Firms in which the largest shareholder held 20 percent to 50 percent of the share capital coupled with a low debt ratio had an average book value to the market value ratio of 1.327; firms in which the largest shareholder held below 20 percent of the share capital coupled with a low debt ratio had an average book value to the market value ratio of 0.260; and firms in which the largest shareholder held more than 51 percent of the share capital coupled with a low debt ratio had an average book value to the market value ratio of 2.072. The best bet then would be a firm where shareholding is dispersed (shareholdings below

20 percent) with a low amount of debt in capital structure. The homogeneity of variance test confirms the differences in variances in performance (book value ratio to the market value ratio) predicted by capital structure (across categories of the total debt to the total asset ratio), ownership structure (shareholdings) and interaction term (ownership structure* total debt to the total asset ratio). Levene’s (1960) test for equality of variance is a criterion for satisfying this assumption, and the result presented in Table 13.

Table 13. Levene's test of equality of error variances a dependent variable: book to market ratio

F df1 df2 Sig.

6.042 8 699 0.0001

The significance result for homogeneity of variance is <.05, which shows that the error variance of the dependent variable is not equal across the groups, that is, the assumption of the ANOVA test has not been met.

The results of tests between subject variables with the book value to the market value ratio as dependent

variable and total debt to the total asset ratio as predictor variable and ownership structure as a control variable are presented in Table 14. Since there is more than one independent variable for this analysis, the entries for the “Corrected Model” and the variable will not be identical.


308

Table 14. Tests of between-subjects effects - dependent variable: book value to market value ratio

Source Type III Sum of

Squares Df

Mean

Square F Sig.

Partial Eta

Squared


Intercept 153.427 1 153.427 15.485 0.0001 0.022

OwnStrCa 150.905 2 75.453 7.615 0.001 0.021

TDtTAca 3.824 2 1.912 0.193 0.825 0.001

OwnStrCa * TDtTAca 9.838 4 2.459 0.248 0.911 0.001

Error 6925.827 699 9.908

Total 9170.405 708


The significance value of intercept, ownership

structure (OwnStrCa) values (ownership) are

significant (<0.05), therefore, these variables have

effect on the book value to the market value ratio

(performance). However, there is no effect of the total

debt to the total asset ratio (TDtTAca) (p = 0.825) on

the book value to the market value ratio

(performance). The null hypothesis that "the mean

book value to the market value ratio was not equal

across all categories of the total debt to the total asset

ratio” is not supported by the data. The result showed

that there is no effect of interaction term (OwnStrCa *

TDtTAca), (p = 0.911) on the book value to the

market value ratio (performance). However,

ownership structure (OwnStrCa) has effect (p =

0.001) on book value to the market value ratio

(performance); therefore, the hypothesis that “the

mean book value to market value was equal across all

categories of ownership structure (OwnStrCa)” is not

supported by the data. The overall corrected model, F

value = 2.455 and p-value of 0.013 are statistically

significant. On the basis of Cohen's criteria, all partial

eta squares are trivial. The statement that membership

in categories defined by total debt to total asset ratio

class identification accounts for the differences in the

average book value to the market value ratio is not

supported by the data.


interpretation of the post-hoc effects. Each statement

is verified independently for significance in pair-wise

comparisons, and the results are presented in Table

15. The first statement was, a group within the total

debt to the total asset ratio categorised as “high debt

ratio” outperformed (showed a better book value to

market ratio) the other group categorised as “medium

debt ratio." However, the difference between the two

groups’ means of -0.629 showed a significance p-

value of 0.160, is greater than the critical value of

0.05; therefore, the difference between the means is

not statistically significant.

The second statement was, a group within the

total debt to the total asset ratio categorised as

“medium debt ratio” post a better performance

(showed a better book value to market ratio) those

classified as “low debt ratio." The groups' mean

difference of 0.402 has a p-value of 0.446, which is

greater than the critical value of 0.05. The difference

is not statistically significant.

The third statement was, a group within the total

debt to the total asset ratio categorised as “low debt

ratio” post a better performance (book value to

market ratio) than those classified as “high debt ratio”

. The groups' mean difference of 0.227 has a p-value

of 0.663, which is greater than the critical value of

0.05. The difference is not statistically significant.

The 95 percent confidence intervals reported to

confirm that the differences among the means are by

chance. Therefore, as far as the data for this study,

there are no visible differences in performance across

different categories of debt levels. If we stop the

study at this point, then the conclusion is that debt

capital has no influence on performance; therefore,

debt capital fails to reinforce corporate governance.

Table 15 depicts the multiple comparisons book to

market ratio Turkey HSD.

The final test is the homogenous subsets' test,

and the results are presented in Table 16. However,

given that means are all listed under one subset, it

follows that the means are not significantly different

from each other, and the p-value of 0.113, is greater

than 0.05, confirmed no difference in book value to

market value (performance) if the total debt to the

total asset ratio (capital structure) is used as a

discriminating variable.


309

Table 15. Multiple comparisons book to market ratio Tukey HSD

(I) Categorised Total Debt to

Total Assets

(J) Categorised Total Debt to

Total Assets

Mean

Difference

(I-J)

Std.

Error Sig.

95percent

Confidence

Interval

Lower

Bound

Upper

Bound

High Debt ratio 0.45 to

2.03956

Medium Debt ratio 0.3515 to

0.44781 -0.629 0.343 0.160 -1.435 0.177

Low Debt ratio 0 to 0.34278 -0.227 0.263 0.663 -0.844 0.390


0.44781

High Debt ratio 0.45 to 2.03956 0.629 0.343 0.160 -0.177 1.435

Low Debt ratio 0 to 0.34278 0.402 0.331 0.446 -0.376 1.180

Low Debt ratio 0 to 0.34278

High Debt ratio 0.45 to 2.03956 0.227 0.263 0.663 -0.390 0.844


0.44781 -0.402 0.331 0.446 -1.180 0.376

Table 16. Book value to market value Tukey HSDa,,b,,c

Categorised Total Debt to Total Assets N

Subset

1

High Debt ratio 0.45 to 2.03956 257 1.48599

Low Debt ratio 0 to 0.34278 326 1.71313

Medium Debt ratio 0.3515 to 0.44781 125 2.11488

Sig.

0.113

5.9 Influence of total debt to total assets ratio on asset turnover ratio

The statistics presented in table 17 capital structure

(total debt ratio) has a discriminating effect on

performance (assets turnover ratio). Firms with a high

debt ratio have on average an asset turnover ratio of

2.32, and there is sizable difference in the average

asset turnover ratio between firms with medium debt

ratio (2.21) and firms with a low debt ratio (1.66).

The average ratio in all cases is two (2).

Ownership structure marginally influenced the

asset turnover ratio. Firms in which the largest

shareholder held between 20 percent to 50 percent of

the share capital on average had an asset turnover

ratio of 1.85, firms in which the largest shareholder

held more than 51 percent (51 percent to 100 percent)

of the share capital on average had an asset turnover

ratio of 2.09; and firms in which the largest

shareholder held below 20 percent of the share capital

on average had an asset turnover ratio of 2.13. There

may be an interaction effect between capital structure

and ownership structure, because the mean

differences in the asset turnover ratio by the debt ratio

vary between ownership structures.



a high debt ratio (the total debt to the total asset) had

an average asset turnover ratio of 2.32; firms in which

the largest shareholder held below 20 percent of the

share capital coupled with a high debt ratio had an

average asset turnover ratio of 2.25, and firms in

which the largest shareholder held more than 51

percent of the share capital coupled with a high debt

ratio exhibit an average asset turnover ratio of 2.31.

These averages appear not to be significantly

different.



a medium debt ratio had an average asset turnover

ratio of 2.05. Firms in which the largest shareholder

held below 20 percent of the share capital coupled

with a medium debt ratio had an average asset

turnover ratio of 2.50 and firms in which the largest

shareholder held more than 51 percent of the share

capital coupled with a medium debt ratio had an

average asset turnover ratio of 2.28.



a low debt ratio had an average asset turnover ratio of

1.50. Firms in which the largest shareholder held

below 20 percent of the share capital coupled with a

low debt ratio had an average asset turnover ratio of

1.80; and firms in which the largest shareholder held

more than 51 percent of the share capital coupled

with a low debt ratio had an average asset turnover

ratio of 1.79. The best bet then would be a firm where

shareholding is dispersed (shareholdings below 20

percent) with a low amount of debt in capital

structure.


310

Table 17. Capital structure (debt ratio) on performance dependent variable: asset turnover ratio

Categorised Ownership

Structure Categorised Total Debt to Total Assets Mean

Std.

Deviation N


50percent

High Debt Ratio 0.45 to 2.03956 2.32 0.755 87

Medium Debt Ratio 0.3515 to 0.44781 2.05 0.773 41

Low Debt Ratio 0 to 0.34278 1.50 0.708 145

Total 1.85 0.821 273


100percent



Low Debt Ratio 0 to 0.34278 1.79 0.783 168

Total 2.09 0.805 412

Shareholdings Below 20percent



Low Debt Ratio 0 to 0.34278 1.80 0.837 5

Total 2.13 0.640 15

Total



Low Debt Ratio 0 to 0.34278 1.66 0.761 318

Total 2.00 0.816 700

The best bet for performance sensitive investors

would be a firm where shareholding is dispersed

(shareholdings by the top investors is below 20

percent) and with a medium amount of debt in capital

structure because at that level, the highest asset

turnover ratio of 2.50 is posted. This suggests

existence of an optimal capital structure.

The homogeneity of variance test confirms the

differences in variances in performance (the asset

turnover ratio) predicted by capital structure (across

categories of the total debt to the total asset ratio),

ownership structure (shareholdings) and interaction

term (ownership structure* total debt to the total asset

ratio). Levene’s test for equality of variance is a

criterion for satisfying this assumption, and the result

presented in Table 18.

Table 18. Levene's test of equality of error variancesa - dependent variable: Lev asset turnover ratio

F df1 df2 Sig.

1.674 8 691 0.101

Levene's Test of Equality of Error Variances,

tests the null hypothesis that the error variance of the

dependent variable is equal across groups. a. Design:

Intercept + OwnStrCa + TDtTAca + OwnStrCa *

TDtTAca.

The significance result for homogeneity of

variance is >0.05, which shows that the error variance

of the dependent variable is equal across the groups,

that is, the assumption of the ANOVA test has been

met.

The relationship between the predicted variable

(the asset turnover ratio as a performance indicator)

and predictor variable (grouping variable - total debt

to the total asset ratio as a capital structure indicator)

if confirmed, is evidence that distinct categories of

the independent variable. The statement is correct if

the relationship is statistically significant in the “Tests

of Between-Subjects Effects." The results of tests of

between-subjects effects in Table 19. The tests

confirm there is an effect of total debt to total assets

ratio (capital structure) (TDtTAca) (p = 0.0001) on

the asset turnover ratio (performance). The null

hypothesis that "the mean asset turnover ratio was not

equal across all categories of total debt to total assets”

is supported by data." There is no effect of interaction

term (OwnStrCa * TDtTAca), (p-value = 0.239).

Ownership structure (OwnStrCa) has the effect on the

asset turnover ratio, p = 0.030; therefore, the null

hypothesis that "the mean asset turnover ratio value is

equal across all categories of ownership structure

(OwnStrCa)” is not supported by data. The overall

corrected model, F value = 16.905 and p-value of

0.0001 are statistically significant. On the basis of

Cohen's criteria, all partial eta squares are small. The

statement that "membership in categories defined by

the total debt to the total asset ratio as class

identification accounts for the differences in the

average asset turnover ratio" is marginally correct.


311

Table 19. Tests of between-subjects effects - dependent variable : asset turnover ratio


interpretation of the post-hoc effects. Each one is

verified independently for significance in the table of

pair-wise comparisons in Table 20. The first

statement was that a group within the total debt to the

total asset ratio that was categorised as a “high debt

ratio” outperformed (showed a better asset turnover

ratio) the other group categorised as a “medium debt

ratio”. The mean difference between the groups of

0.11, has a p-value of 0.391 is therefore, not

statistically significant.

Table 20. Multiple comparisons asset turnover ratio - Tukey HSD

(I) Categorised Total Debt to Total

Assets

(J) Categorised Total

Debt to Total Assets

Mean

Difference

(I-J)

Std.

Error Sig.

95percent

Confidence

Interval

Lowe

r

Bound

Upper

Bound

High Debt Ratio 0.45 to 2.03956

Medium Debt Ratio

0.3515 to 0.44781 0.11 0.082 0.391 -0.09 0.30

Low Debt Ratio 0 to

0.34278 0.66* 0.063

0.000

1 0.51 0.81

Medium Debt Ratio 0.3515 to

0.44781

High Debt Ratio 0.45

to 2.03956 -0.11 0.082 0.391 -0.30 0.09

Low Debt Ratio 0 to

0.34278 0.55* 0.079

0.000

1 0.36 0.74

Low Debt Ratio 0 to 0.34278

High Debt Ratio 0.45

to 2.03956 -0.66* 0.063

0.000

1 -0.81 -0.51

Medium Debt Ratio

0.3515 to 0.44781 -0.55* 0.079

0.000

1 -0.74 -0.36


the total debt to the total asset ratio categorised as

“medium debt ratio” outperformed (showed a better

asset turnover ratio) the other group categorised as

“low debt ratio." The mean difference between the

two groups of 0.55, showed a p-value of 0.0001 is

therefore, statistically significant.

The third statement was, a group within the total

debt to the total asset ratio that categorised as “low

debt ratio” outperformed (showed a better asset

turnover ratio) the other group categorised as “high

debt ratio”. However, the mean difference of -0.66,

between the two groups’ showed a p-value of 0.0001,

and is statistically significant. Based on preceding

findings, capital structure (the total debt to the total

asset ratio) has a discriminating effect on

performance (asset turnover ratio). This is unlike the

case when the book value to market value is a

performance indicator.

The homogenous subsets' tests of the asset

turnover ratio by total debt to total assets ratio result

are presented in Table 21. From the results, there is

evidence that debt ratios have a discriminating effect,

that is, different debt levels are associated with

different levels of performance. Firm or cases with a

low debt ratio are associated with the lowest asset

turnover ratio.

Source

Type III

Sum of

Squares

Df Mean

Square F Sig.

Partial

Eta

Squared


Intercept 396.402 1 396.402 702.852 0.0001 0.504

OwnStrCa 3.978 2 1.989 3.527 0.030 0.010

TDtTAca 9.797 2 4.898 8.685 0.0001 0.025

OwnStrCa * TDtTAca 3.115 4 .779 1.381 0.239 0.008

Error 389.718 691 .564

Total 3258.000 700



312

Table 21. Tukey HSDa,,b,,c - asset turnover ratio

Categorised Total Debt to Total Assets N Subset

1 2

Low Debt ratio 0 to 0.34278 318 1.66

Medium Debt ratio 0.3515 to 0.44781 125

2.21

High Debt ratio 0.45 to 2.03956 257

2.32

Sig.

1.000 0.328

Means for groups in homogeneous subsets are

displayed.

Based on observed means, the error term is

Mean Square (Error) = 0.564.

6 Summary and conclusion

Until now, researchers are not in consensus, whether

it is the capital structure that influences performance

or performance that influences capital structure or

both (Margaritis and Psillaki, 2010; Margaritis and

Psillaki, 2007). One may argue that debt capital

would reduce agency costs, however, it can also

induce agency benefits if there are visible differences

in performance across different levels of capital

structure and visible differences in capital structure

across different levels of performance. Thus

managers would look at performance in managing

debt levels and vice versa. The resulting proposition

is that capital structure decisions are relevant and not

irrelevant as stated in Modigliani and Miller (1958).

On the Nairobi Securities Exchange, there are large

differences in leverage ratios and the question then is,

if the capital structure decision is not important, how

does one explain variations in leverage ratios? The

main objective of this study was to establish the

relationship between capital structure and financial

performance of firms listed on the NSE by employing

a generalised linear model (GLM) as an improvement

on ordinary least regression (OLS).

Two hypotheses were tested during the study.

The first hypothesis (effect of performance on

leverage) is based on two theories, namely: return -

risk hypothesis and franchise value hypothesis

(Margaritis and Psilaki 2010; Berger and Bonaccorsi

di Patti, 2006). The second hypothesis was the

influence of debt on performance (effect of leverage

on performance), this hypothesis stipulates that debt

capital can have a positive or negative influence on

performance (Cheng and Tzeng, 2011; Margaritis and

Psillak, 2008).

The results of the analysis on the first hypothesis

confirms that efficient and profitable firms employ

more debt than comparable firms that are less

profitable possibly because profitable firms’ exposure

to financial risk is low (propensity to be bankrupt is

low). There is no evidence to support the franchise

hypothesis that more efficient firms use less debt as

suggested in Margaritis and Psillak, (2008), and

Lai, Lin and Wen, (2005). However, the data only

show statistically significant relationship if asset

turnover ratio and not the book value to the market

value ratio is used as a performance indicator to

predict usage of debt capital. The results confirm the

existence of concentrated equity ownership on firms

listed on the NSE as pointed out by He and Matvos

(2012).

With regard to the second hypothesis, the

results, after controlling for ownership structure,

indicate that firms that use more debt outperformed

those that use less debt. Therefore, the data on the

NSE support the efficiency hypothesis that the use of

debt capital alleviates agency costs so as to improve

firm performance (Mishkin 2010; Margaritis and

Psillak, 2007; Tirole, 2006; Jensen, 1986; Jensen and

Meckling, 1976). Such a finding negated the original

hypothesis in Modigliani and Miller (1958) that

capital structure decision is irrelevant and would

imply the existence of an optimum capital structure

on the NSE.

7 Managerial implication and recommendations

In a number of studies, ROA and ROE are used as

measures of performance to assess the relationship

between performance and capital structure. In this

study, asset turnover ratio and book value to market

values as measures of performance was employed to

investigate the relationship between capital structure

and performance and that the appropriate measure of

usage of debt is the total debt to the total asset. The

study adds to the theory of choice of variables to

employ in studies of capital structure. The theory is

that the choice of indicators of both capital structure

and performance is contingent on the data employed

and could vary from country to country.

It is therefore recommended that managers

should be aware that asset turnover ratio could best

relate positively to borrowing levels, and that

performance and capital structure are important

concepts in managing firms. In addition, book value

to market value has a suppressing effect on the level


313

of borrowing. It further recommended that

researchers conducting studies on the relationship

between capital structure and performance should not

only depend on ROE and ROA as measures of

performance, but should explore other performance

indicators by applying canonical correlation. This is

because the choice of variables is contingent on the

data set employed.

8 Limitations of the study

The limitation of this study is that data was limited to

non-financial firms listed on the NSE for the period

1990 to 2012, inclusion of financial firms would

allow for generalisation of the findings.

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315

SOCIAL CAPITAL INTERVENTIONS AT FIRM LEVEL AFFECTING PERFORMANCE IN THE ZIMBABWEAN MANUFACTURING

SECTOR

Patience Siwadi*, Collins Miruka**, Florence Achieng Ogutu***

Abstract

Social capital research has largely focused on developed economies and there is conflict of acceptance on the legality of some network relations across cultures. This study pioneered the interventions at firm level aimed at building social capital for company performance in the Zimbabwean manufacturing sector. This was in an effort to provide evidence of the need for network relations to enhance business performance. A survey method was used to collect data to confirm empirically the social capital interventions existing in the sector. Using an econometric model, 10 social capital variables were regressed to determine importance of the interventions. The bivariate results indicated that networks, level of trust and entertainment were significantly associated to firm performance. On the multivariate level, trust, presences of an entertainment budget and government liaison were positively associated with firm performance. It was concluded that investment in social capital through entertainment budget created profitable relationships which if nurtured builds trust which reduces transaction costs thus affecting the bottom line. So social variables which were significantly associated with performance worked in a symbiotic, cyclical nature. Keywords: Social Capital, Networks, Trust, Performance, Return on Assets *Graduate School of Business Leadership, Midlands State University, P Bag 9055, Gweru ** Graduate School of Business and Government Leadership, North-West University, Mafikeng Campus *** Graduate School of Business and Government Leadership, North-West University, Mafikeng Campus

1 Introduction

Research has traditionally focused on three types of

capital, namely natural, physical and human capital

and these were considered the basis for economic

development and performance (Zhang & Fung 2006)

It is now recognized that these three types of capital

can only partially determine the process of economic

growth the important missing link being social

capital. There is growing empirical evidence that

these traditional forms of capital need to be

augmented with social capital in order for sustainable

economic development to be achieved. Prior to the

1990s, social capital seemed to be a preserve for

sociologists and subsequent work was by political

scientist. Later social capital research and discussions

have made inroads into economic analysis and other

scientific disciplines as it is now being recognized as

the missing link in the process of business growth and

performance.

Social capital is viewed differently in the

developing and the developed world where some

associations are viewed as corrupt relations while in

some economies it is viewed as critical for business

performance. The social capital-performance

relationship has therefore hardly been examined with

more focus being given rather to its legality and

morality. With no known theory to base on, there is

motivation to create space for social capital in one

sector in Zimbabwe. This research therefore seeks to

pioneer the social capital interventions at firm level

that affect performance in the Zimbabwean

manufacturing sector thus providing much needed

knowledge on social capital in the Sub-Saharan

Africa with specific reference to Zimbabwe. The

research utilizes an econometric model to regress 10

social capital variables across data from 62 operating

firms. To the best of our knowledge it is one of the

first attempts to use panel data to deal with firm

heterogeneity and bring out more objective results in

the social capital scenario. Antecedent research has

been largely qualitative and this study seeks to

provide empirical evidence of social capital

interventions.

The rest of the paper is organised as follows.

Section 2 provides an overview of the Zimbabwean

manufacturing sector; Section 3 reviews the social

capital environment in the Zimbabwean

manufacturing sector. Section 4 reviews the prior

literature on the impact of social capital on firm

performance. Section 5 describes the research


316

methodology. Section 6 reports empirical results,

while section 7 concludes.

2 Zimbabwean manufacturing sector

The Zimbabwean manufacturing sector started in the

1940s and grew in the backdrop of sanctions during

the Unilateral declaration of Independence (UDI)

where the white minority government declared

independence from England. This resulted in

international sanctions and the country adopted an

import substitution strategy which resulted in a

proliferation of products with very little attention paid

to quality and international competition.

Manufacturing is a key sector in the

Zimbabwean economy which at its peak in 1999 was

the major contributor to GDP at 22% (Zimbabwe

Statistics Agency 2010). In as much as the sector

faced a downturn from 2000 to 2009 during the years

of Zimbabwe’s worst economic woes it is still being

recognized by government as a key to economic

recovery. The sector is one of the 4 wealth

generating sectors and is important to the Zimbabwe

economy as it responsible for converting at least 60%

of agricultural and mining output and in turn at least

40% of its output is consumed by the afore mentioned

sectors (Ministry of industry and commerce 2011) .

In the government’s industrial policy development

framework (2011 to 2015), the government has clear

objectives for the manufacturing sector which are; to

restore the sector’s contribution to GDP of Zimbabwe

from the current 15% to 30% and its contribution to

exports from 26% to 50% by 2015.An average real

GDP growth of 15% is targeted under this

framework. Table 1 below shows the contribution of

manufacturing to the economy.

Table 1. Manufacturing contribution to the Zimbabwean economy 2010

Manufacturing Aspect Contribution to economy 2010

Contribution to GDP 13.37%

Employment 15%

Exports 26%

National output 15%

Economic growth 2.7%

Capacity utilization 44%

Source: Zimbabwe Statistics Agency (ZIMSTAT) 2011

The manufacturing sector is divided into light

and heavy industries further subdivided into 8

subsectors producing a range of more than 6000

products from food, textiles, chemicals to rubber and

tyre manufacturing. Their contribution to the

economy differs and agricultural processing

dominates the sector. The major subsectors are food

and beverages, clothing and textiles, leather and

leather products, fertilizer, chemicals and

pharmaceuticals, timber and wood, motor industry,

and non-metal products, plastic and packaging and

rubber and tyre manufacturing. The Government

through the Industrial Development framework has

identified six priority sectors as the pillars for growth

in the manufacturing sector namely Agro-processing

(Food and beverages, Clothing and Textiles, Wood

and Furniture), Fertilizer Industry, Pharmaceuticals

and s industry (Industrial Development Framework

2011, p.14).

The sector has been under a lot of pressure from

2000 and to date companies are still closing down or

operating under 40% capacity. The study was

motivated by a need to examine other means that can

direct the recovery of the manufacturing sector and

enable it to fit into a highly competitive global

village.

3 Social capital status in Zimbabwe manufacturing sector.

Generally firms in similar pursuits network together

and connect with their suppliers, bankers key

customers and other key stakeholders. The question is

are Zimbabwean companies in the manufacturing

sector part of any networks at all. It was encouraging

to note that the majority of businesses were

networked. Networks provide organizations with

information, ideas and resources to perform better

(Wu 2008; Gulati & Sytch 2007). It can be posited

that the more networks the business has the higher the

probability of it performing better. This networking is

not a futile pursuit as at least 49% of the

organizations get their business from networks. This

rather low benefit from networks could be a typically

Zimbabwean phenomenon as organizations are

known to keep information close to their chest and

networking is closely associated with corruption

which has been rife during and after the economic

challenges from 1999 to 2008. Foreign firms are by

nature more exposed than local firms ( Wignaraja

2007). Further analysis was therefore carried out to

determine the correlation between ownership and

business from networks. In tandem with empirical

evidence, Zimbabwean manufacturing firms show a

significant relationship between firm ownership and

business from networks.


317

Manufacturing organizations have relationships

at an informal level which can be deemed weak or

strong. The value of the ties is in their strength. This

refers to the intensity of reciprocal obligations of the

network players as it provides the necessary

lubrication for transactions and exchange of

information and resources. The stronger they are the

more influence they would have on the firm

performance. There seems to be distribution of the

number of ties possessed by the firms in the sample

range from none to more than 10. The sample was

across 6 subsectors in the manufacturing sector

involved in producing vastly different products thus

the ties would be few and difficult Chiripanhura

(2010) . It was further noted that those firms who are

locally owned have more ties than those which are

foreign owned or with mixed ownership. Further to

that, even though the ties are few, they are strong.

This might mean that they have an influence on the

operations of the firm. The manufacturing firms in

Harare which is the study area co-locate by default

through the local authority which is the Harare City

Council so land use laws and not by design as in

deliberate clusters. Therefore knowledge may not be

transferred or available to all as a public good and

thus the value of the strength of the ties.

The level of trust in the networks is critical in

the social capital discourse. The level of trust ranges

from fair to very high in the sector and this may

indicate an ability to work together. This result seems

to be in tandem with the fact that all the companies

are in the manufacturing sector and the bonding social

capital is in sync with high levels of trust. Trust is

fostered with frequency of interaction. The majority

of the firms interact fairly frequently which would

benefit their performance.

Another networking platform is business

associations. Organizations join different business

associations which have a myriad of functions, from

advocacy, linkages and to voicing concerns to

government. In many cases there are umbrella

associations like the Confederation of Zimbabwe

Industries (CZI) in Zimbabwe which takes care of the

interests of all member manufacturing companies. At

least 90% of the firms are members of one association

or another.

The array of membership is influenced by the

spread of the subsectors. Also worthy of note is the

fact that some industries coerce players to join

associations and this inflates membership figures.

While in some subsectors membership is truly

voluntary and thus some firms do not find it

necessary to join them thus the probable reason why

some firms are not members of any association.

Donations to different institutions and causes

has been viewed in social capital literature as

investment in social capital (Zhang & Fung 2006;

Putnam 2000). Firms in Zimbabwe are not new to

this phenomenon as donations are requested for

causes ranging from charitable to political. Almost all

the companies (96%) donated something in the four

year period. In Zimbabwe it is prudent to donate to

such national events like the Independence day

celebrations, Heroes day celebrations and Christmas

cheer fund for the less privileged. Companies feel that

they are seen in good light by the government if they

‘participate’ in politically driven donations. The

donations recorded ranged from $100 to $300 000 per

year with larger firms tending to spend more than

smaller firms.

Entertainment is also viewed as investment in

social capital (Zhang and Fung 2008). The majority

of organizations (97%) have allocated funds for

entertainment which amounted to at least 1% of their

total budgets to entertainment. This will translate into

quite a substantial amount of money for larger firms

with high turnovers. This probably indicates the

seriousness attached to building social capital by the

firms.

Though institutions in emerging markets are not

fully functional, liaison with government officials can

be a source of valuable information and policy shifts

that can affect organizations. Larger organizations in

Zimbabwe are known to employ government liaison

officers whose mandate is to create very close and

profitable relationships with relevant government

ministries. It is thus a form of investment in social

capital as government decisions have a potentially

serious effect of the operations of firms. Zimbabwe

has witnessed its greatest policy shifts since

independence in 1980 which have heralded a lot of

uncertainty in the economy and such liaison has

become priceless as businesses need up to the

moment information to maintain competitive

advantage. It is evident that the majority of the firms (

93%) liaise with government from fair to great

extent, fair extent (39%), good extent ( 26% ) and to a

great extent ( 29%). In Zimbabwe government is the

largest consumer of both goods and services and such

capital can stand organizations in good stead.

4 Prior literature on social capital

Social capital theory postulates that both internal and

external networking relationships provide resources

and information on best practice to their

organizational benefit. Early writers on social capital

(Bourdieu 1986, Lin 2001) as cited by Acquaah

(2007) define social capital as ‘ sum of resources

actual or virtual that accrue to an individual or an

organization as a result of the development of

personal and social networking relationships.’ Adler

and Helfat (2003) later defined social capital as

‘social relationships that confer influence control and

power’. They further posit that social ties a leader

has, allows them to acquire different useful

information which can be used for the good of the

business. This suggests dependence which enhances

the performance of relationships and therefore

organizations.


318

The influence of social capital on firm

performance has been well documented in literature.

The influence may not be direct because social capital

works as a catalyst in converting the networks into

other forms of capital which can be considered the

raw material for economic wealth and in turn

contributes to firm performance (Wu 2008). The

results from studies to date confirm that social capital

may result in capital accumulation, skill acquisition,

innovation, the transfer of information and

technology, and reduced transaction costs. In

addition, social capital may facilitate the management

of common property and provision of public goods,

increase investment, and reduce the social costs of

crime, corruption and other forms of non-cooperative

conduct. Alternately, low levels of social capital may

impede economic activity by limiting the viable range

of transactions (including the exchange of ideas),

particularly in an environment of social polarization

(e.g. income inequality or ethnic tension). The

evidence to date also indicates that social capital has a

diminishing marginal rate of return (i.e. social capital

is more valuable in developing countries (Wallis,

Killerby & Dollery 2004).

Social capital reduces transaction costs and

helps the diffusion of new knowledge and adoption of

new technologies. Depending on the quality of

information, in terms of its detail, accuracy, and

timeliness and exchange process, social capital can be

instrumental in the performance of a firm (Gulati &

Sytch 2007). Social capital may also facilitate

production through greater provision of public goods,

improved management of common property

resources, and lower social costs.

Davidsson and Honig (2003) find a significant

positive association between social capital and

performance. According to the resource-based view,

a firm’s competitive advantage is achieved by

controlling the endowment of rare, valuable, non-

substitutable, and inimitable resources and

capabilities (Tödtling 2008). However, in today’s

increasingly dynamic business world, more and more

firms are starting to find themselves trapped in the

uninviting situation that their existing firm-specific

resources and competencies are no longer sufficient

to maintain their competitive advantages.

To out-perform their competitors, firms are

increasingly motivated to seek harmonizing resources

and develop new capabilities through collaboration

with other firms and even longstanding competitors in

the form of both informal and formal networks such

as strategic alliances. Social capital is a critical source

of knowledge and skills for the creation of the

inimitable value-generating resources that are

intrinsic in a firm’s network of relationships. It allows

people to benefit from knowledge accumulated by

close contacts and associates. With the growing

importance of the role of business networks in

enhancing a firm’s competitive advantage, the social

capital–performance relationship has emerged as a

prominent research area of strategic management

(Gulati et al 2000).

5 Research methodology

The net effect of social capital depends on the balance

of the social capital variables. Following onto the

study of Chinese firms by Zhang and Fung (2006,

p.200), the variables of networks, investment in social

capital and membership to business associations were

selected and included in the regression model. These

form the backbone of social capital. Worthy of note is

the fact that empirical studies around the world have

not come up with conclusive results on the effect of

social capital on firm performance (Wu 2008, p.122).

The majority of studies hardly find any social capital

variables significantly explaining firm performance.

The relationships between social capital, variables

and organizational outcomes using return on assets as

a proxy were therefore tested using stepwise bivariate

and multivariate linear regression analysis.

To date the manufacturing sector is dwindling

and the companies still operating only 40% are at

more than 80% capacity. Using data from 75% of

such firms (62 companies), the following model was

estimated :

ROA= 𝑆𝐶𝑡

Where

ROA = Return on Asserts measuring operating

performance

The model was expanded to reflect the 11 social

capital variables as suggested by Zhung and Fung

(2006:200.)

ROA =α+𝛽1𝑃𝑁 + 𝛽2𝐵𝑁 + 𝛽3𝐵𝑇+ 𝛽4𝑆𝑇 + 𝛽5𝑇 + 𝛽6𝐼 + 𝛽7𝐵𝐴 +𝛽8𝐷𝑂 +𝛽9𝐸𝑁 + 𝛽10𝐸𝐵 + 𝛽11𝐺𝐿

Where

𝛼 𝑎𝑛𝑑 β = the parameters to be estimated

PN= Presence of networks in the firm

BN= Proportion of business from the networks

BT= Business ties a firm has

ST= The strength of the ties

T= Level of trust in the ties

I= Frequency of interaction

BA= Membership to business associations

D= Donations made

EN= Presence of an entertainment budget

EB= Entertainment budget as a proportion to the

firm budget

GL= Government liaison

The characteristics of the variables and the

literature support are given in the table below.


319

Table 2. Social Capital variables

Variable Description Reference

Presence of networks - Identification firm’s social capital Zhang and Fung 2008:

Expenditure on network creation - -Donations

-Purchase of gifts

-Entertainment budget

Number of ties - Quantifying of the ties a firm has Maurer et al 2012:166

Strength of the ties - Dependability of the ties

Frequency of interaction - Social capital is maintained by periodic

interaction

Level of trust - Trust is a backbone of social capital

development

Maurer et al 2012:166

Affiliation to industry associations - A fast way of obtaining bridging social

capital

Zhang and Fung 2008:202

6 Results

6.1 Multicolinearity for social capital variables

Linear regression requires the absence of a problem

of multicolinearity between the independent variables

introduced in the same model (Bouaziz 2012). As

validity of the data is indicated by a lack of

multicolinearity the correlation matrix shows that the

Pearson correlation between the different independent

variables is moderate as the correlation is not more

than 0.8 as suggested by Kumar and Singh (2011) as

indicated by the table (3) below. This implies the

absence of multicollinearity problem between the

variables.

Table 3. Correlation matrix for social capital variables

Profit

Busine

ss

from

networ

ks

Ties

Streng

th of

ties

Trust Intera

ct

Associati

ons

Donatio

ns

entertainm

ent Budget

Gover

nment

liaiso

n

Profit 1.000

0

Busines

s from

network

s

0.161

8 1.0000

ties 0.074

7 0.1063

1.00

00

Strengt

h of ties

-

0.040

4

-

0.1843

0.47

82

1.000

0

Trust 0.147

0 0.2149

0.11

60

0.314

5

1.00

00

interact 0.040

6 0.2793

0.19

83

0.443

7

0.42

35

1.000

0

Associa

tions

-

0.078

8

0.1139 0.03

74

0.066

7

0.18

40

0.159

5 1.0000

donatio

ns

0.022

6

-

0.0196

-

0.01

85

-

0.031

5

-

0.04

42

-

0.047

4

-0.0103 1.0000

Entertai

nment

-

0.150

4

0.0373

-

0.17

56

-

0.188

1

-

0.09

63

-

0.011

6

0.0770 -0.0353 1.0000

Budget

-

0.104

7

0.0580 0.07

56

0.121

3

0.36

83

0.083

1 0.3456 -0.1227 0.1665 1.0000

Govern

ment

liaison

0.094

6 0.1551

0.12

11

0.252

6

0.41

99

0.636

5 0.1902 -0.1326 0.0738 0.1538

Source: Primary data


320

The absence of multicolinearity validates the following regression results.

Table 4. Bivariate and multivariate regression results

Bivariate analysis Multivariate analysis

profit coef Z p>|z| Coef Z p>|z|

Business from

networks 0.512992 1.71 0.087 0.7444159 1.38 0.167

Ties 0.0937587 0.087 0.385 0.1717482 0.94 0.348

Strength of ties -0.0153387 -0.15 0.882 -0.1716176 -0.87 0.386

Trust 0.2626041 1.78 0.075 0.4504325 1.97 0.049

Interact 0.0638382 0.50 0.614 -0.3098879 -1.18 0.239

Association -0.0338353 -0.98 0.325 0.0280156 -0.78 0.438

Donations 0.4707993 0.74 0.457 0.6095788 0.29 0.772

Entertainment -0.3317818 -1.97 0.048 0.3482575 -1.44 0.151

Budget -0.263772 -1.20 0.229 -0.6877001 -1.92 0.055

Government

liaison 0.0443869 0.33 0.738 0.4915136 1.70 0.090

Source: Primary data

6.2 Presence of business networks

Networks are the backbone of Social Capital theory

as they can provide avenues that lead to new

investments, new business, access to valuable

resources and information that is not in the public

arena and thus reducing transaction costs (Hitt et al

2007). Networks differ in structure and importance

across countries. In western Africa networks with

local traditional leaders are deemed important while

in the Chinese context networking with government

is critical which same networks are termed as

corruption by the Western countries (Zhang and Fung

2008; Acquaah 2007, Szeto &Wright 2006). The

statistics indicate that business networks exist and

there is some business stemming from these networks

which make them important in the Zimbabwean

context. The result found business from networks

positively associated with firm performance which

was in tandem with (Dicko et al 2010) who found the

same result. Kirchmaier (2008) noted a negative and

insignificant association between the CEO’s networks

and firm performance positing that the CEO’s

networks do not necessarily further the interests of the

stakeholders, rather his own.

6.3 Trust within the networks

Trust is viewed as the glue that holds interacting

firms together as it builds confidence in the exchange

among network members. This is confidence in the

players’ intentions, in the information passed, in the

reliability of the information and confidence in the

capabilities of the associates. An inquiry into the

levels of trust in the networks sought to establish the

strength of the bonds as it is one of the core aspects of

social capital. Empirical evidence As far back as 1998

in a study carried out by Zaheer (1998) it revealed

that there is a positive relationship between trust and

firm performance. He pointed out that trust reduces

transaction costs as the legal system only becomes the

call of last resort where trust is high. The results

agreed with this as trust is positive and significant to

firm performance. Later studies by Fussel et al

(2006), Wu (2008) and Berulava (2013) also found

the same result. Interestingly, these studies were

carried out in different economies, Fussel (2006) in

United States of America, Wu (2008) in China and

Berulava across 28 transitional economies all have

the same outcome which seem to make trust a

universal attribute in social capital construct.

6.4 Network ties

Ties are developed through informal, interpersonal

mechanisms to circumvent the limitations of

institutions especially in emerging markets Sheng et

al (2012). Ties can be political or business and this

study sought to determine if such ties existed in the

Zimbabwean manufacturing scenario. Being a

developing country in which institutions have several

limitations it was interesting to note the role and

strength of such substitutes as informal ties. The

statistics indicate a lack of commitment to ties as the

majority of firms have less than 5 such ties. The

regression between ties and firm performance. This

was in tandem with Kirchmaier (2007) who noted that

ties are generally personal and mainly connected to

the CEO. It was noted that network ties are negative

and not significant to firm performance. When


321

individuals in a firm are well connected it may not

necessarily translate into benefits to the firm. On the

contrary, Sheng et al (2012) in a study of Chinese

firms found ties positive and significant to firm

performance. In agreement, Fussel et al (2006) found

the same result as well as Wu (2008) and even Peng

and Luo (2000). Interestingly, the majority of the

studies which noted a positive and significant

association were carried out in China where the

concept of guanxi which are personal connections

especially with government officials s highly

regarded as a critical means of opening ‘closed doors’

a concept based on favour, trust and unwritten norms

of reciprocity (Szeto, Wright & Cheng 2006).

6.5 Frequency of interactions

These are on-going repeated transactions between

network players. This interplay provides an interface

for the growth of trust and exchange of business

codes and resources (Wu 2007). The frequency of

interaction has a bearing on the amount of

information, resources and knowledge exchanged.

Continued interaction also builds reciprocity which is

a critical aspect in sustainability of relationships and

thus the increase in social capital. The examination of

the frequency of interaction was an attempt to

determine how this social capital intervention was

viewed in the Zimbabwean manufacturing sector.

Statistics indicate fairly high frequency of interaction

but the analyses found no positive association

between interactions and firm performance.

Zimbabwe being a highly political country, it seems

as if the interactions may be on other issues which do

not necessarily have a bearing on aspects that affect

the bottom line and thus not significant to firm

performance.

6.6 Entertainment

Earlier work by Putnam (2000) and later work by

Zhang and Fung (2006) agree that investment in

social capital takes place over a period of time.

Having an entertainment budget is noted by Zhang

and Fung (2006) as such an investment which bears

fruit in the form of exchanges of information and

resources and generally strengthening ties. It was

noted that entertainment is not significantly related to

firm performance Contrary to these findings Zhang

and Fung (2006) found entertainment positive and

significant to firm performance. Allocating funds for

entertainment can be viewed as investment in social

capital but investments are known to bear fruit after a

period of time. So even though larger firms in

Zimbabwe allocate at least 1% of their budgets to

entertainment the exact impact on performance may

never be known. The Chinese firms on the other

hand are likely to follow the norms of gift giving and

entertainment so revered in that culture in their

development of guanxi.

6.7 Donations

This is another form of investment in social capital as

pointed out by Putnam (2000) and later work by

Zhang and Fung (2006). The researcher sought to

examine the level to which firms were investing in

social capital as donations is a probable intervention.

Statistics indicate that donations are highly regarded

as 96% of the firms donated something in the 4 year

period. There was however no positive association

between donations and firm performance. This is

contrary to (Zhang and Fung 2006) in their study of

Chinese firms that donating was positive and

significant to firm performance. The business

donations in Zimbabwe have been closely associated

with political favour -seeking and may not be

regarded as a means of building social capital. It is an

investment which may or may not bear fruit which is

a probable explanation for this insignificant

relationship.

6.8 Membership to associations

Organizations can build their social capital by being

members of industry associations which in Zimbabwe

can cover particular subsectors and other times

industry as a whole. The majority of firms belong to

one association or another, the highest being 10. In

Zimbabwe associations are mainly for advocacy and

lobbying and their direct influence on firm

performance may not me quantifiable. Membership to

associations was not positively associated with firm

performance. This is in tandem with Zhang and Fung

(200) who also found membership negative and not

significant to firm performance. The result seems to

imply that membership to associations was viewed as

a means of having the voices of the manufacturing

being heard but not a genuine network for business

development or an investment in building social

capital.

6.9 Government liaison

The government of Zimbabwe is responsible for all

legislation and policy setting and interpretation. It is

also one of the largest consumers of goods and

services. Thus liaison with government can have

profound effects on being viewed in a favourable

position by ‘the powers that be’. The multivariate

regression analysis noted that government liaison was

positively associated with firm performance. This was

in tandem with Peng and Luo (2000) in a study of

Chinese firms found government liaison positive and

significant to firm performance. Contrary to this,

Dicko and Breton (2012) in a study of Canadian firms

noted that government liaison is negative though

significant to firm performance. The probable reason

is that in China having the culturally based guanxi is

actually good for business while in Canada having

political affiliations influences the firm negatively.


322

7 Concluding remarks

In the absence of a well-developed theory about the

multidimensional nature of social capital, variables

suggested by several studies were utilized to establish

the social capital interventions at firm level for

business performance. There were however common

threads among the variables and those selected

pertained mainly towards the existence of networks,

network management in terms of interactions and

trust, and investment in social capital. Performance

was noted to be influenced by three of the variables

namely presence of business from networks, trust in

the network and presence of an entertainment budget.

The results noted that the social capital variables that

are significant to firm performance act in a cyclical

manner which has a direct impact on the inflows to

the firm and thus critical to firm performance.

Business from networks ensures that the

network is beneficial to the firm in providing

profitable relationships. On the aspect of trust,

literature notes that, the higher the trust the lower the

transaction costs thus clearly affecting the firm’s

bottom line. Furthermore availing funds for

entertainment denotes investment in social capital

which increases the number of networks which in turn

increases interaction which is necessary for building

of trust. This cyclical relationship finally affects firm

performance. It can be recommended therefore that

firms in the manufacturing sector can invest in social

capital interventions that affect performance and

enhance the chances for recovery of the sector and the

country as a whole.

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324

BANK DISCLOSURE PRACTICES: IMPACT OF USERS’ PERSPECTIVE OF FINANCIAL GOVERNANCE

George Hooi*, Pran Boolaky**

Abstract

This paper investigates the influence of the legal framework, national income and quality of financial governance on bank disclosure practices at a macro level. 104 developed and developing countries were examined in 2004. The findings indicate that in addition to investor protection and national income, quality of financial governance (accounting and audit) is positively associated with bank disclosure practices globally. Furthermore, this paper has explored and extended La Porta et al.’s (1998) findings on the association between national income and the quality of a country’s accounting standards to the banking disclosure model. Keywords:Investor Protection, National Income, Quality of Financial Governance, Banking Disclosures, Transparency JEL Classification: G21, G34, M41, O57 * Department of Accounting, Finance and Economics, Griffith University, Australia ** Department of Accounting, Finance and Economics, Griffith University, Australia

1 Introduction

With the climate of uncertainty due to the recent

global financial crisis, global investors are concerned

that the banking industry is not as transparent

compared to non-banks despite the fact that banks are

more regulated. Transparency through banking

disclosures is important for value relevant information

(Bischof and Daske 2013) and critical in determining

the risk profile for valuating banks and consequently,

will have major implications on the country’s

economic and financial stability. To date, research

into banking disclosures have been limited to

performance studies that looked at the information

content of market risk disclosures (Berkowitz and

O’Brien 2002; Estrella, Park and Peristiani 2000;

Hirtle 2003; Jorion 2002) and the significance of

disclosures on cost of equity (Poshakwale and Courtis

2005). In other words, the extant literature on banking

disclosures have been limited to as a determinant for

firm performance and risk models. Our study will be

the first to investigate the determinants of banking

disclosures with global indices which have never been

used for this industry- specific analysis despite the

fact that the latest dataset were developed about a

decade ago.

Thomas and Brown (2006) argue that

transparency is a powerful tool that can be used to

monitor progress on the objectives of financial

exclusion and to ensure effective targeting of

resources but the level disclosure varies among

countries based on their level of economic

development. Extant literature on information

disclosure has concentrated principally on earnings

announcements (Beyer et al. 2010). Grossman (1981),

using the representation theorem, established the

fundamentals of full disclosure in his seminal work on

the informational role of warranties and private

disclosure about product quality (see also Milgrom

1981). The theorem suggests if the sender’s

preferences are monotonic in the receiver’s action,

then the sender reveals its type in every sequential

equilibrium with verifiable messages. Seidman and

Winter (1997) used the same theorem to provide

evidence that the action of sender varies with its type.

Their works were mainly at firm level using

microeconomic data. The type(s) of sender at firm

level obviously implies firms size, industry belonging,

its market capitalisation, its age, its growth to mention

a few. Using the same line of logic, we argue that at a

country level the type(s) of sender would imply the

size of a country, the stage of economic development

it has achieved, its main economic activities and the

national income. This means that whether the country

is rich, emerging or poor, rich economies have more

resources to disclose more information as opposed to

poor countries. We further argue that because the

receivers of information in a developing country are

less reactive to the disclosure of information,

disclosure level by banks may be less. Moreover, a

country with a low national income has other

priorities over transparency (Nobes 1998). For

example, a poor country will give more priority to


325

poverty alleviation than focusing as how to improve

disclosure practices by banks.

Accounting literature has shed more light on

disclosure practices by firms including banks by

investigating the determinants of both mandatory and

voluntary disclosure (Bhattacharya and Ritter 1983;

Dye 1985; Healy and Palepu 2001), and has also

provided the rationale for mandatory minimum

disclosure regulation (Admati and Pfleiderer 2000;

Dye 1985). All these works pertain to firm level

within an industry or a small sample of countries. As

yet there is no work on the determinants of disclosure

by banks at country level and in particular at a global

dimension as our study.

Recent empirical studies have suggested that

national culture and investor protection are significant

determinants in the theoretical framework for the

transparency of international banking operations

(Hooi 2007, 2012). Hooi (2012) argue that bank

regulators such as the Basel Committee should

consider cultural and legal factors in harmonising

complex international banking regulations in a highly

competitive global economy. The objectives of this

paper are twofold. First, to further contribute to this

new area of research by incorporating a more

extensive dataset of 104 countries compared to only

17 developed and developing countries used in Hooi’s

(2012) banking disclosure model. This will be the first

study to use the latest global indices to better

understand the determinants of banking disclosures at

the macro level. Moreover, the research implications

can provide valuable insights for policymakers in

global banking institutions and regulators such as the

Bank for International Settlements (BIS) and the

Financial Stability Board (FSB). Second, to explore

and extend La Porta et al.’s (1998) findings on the

association between with national income and the

quality of a country’s accounting standards to the

banking disclosure model. We believe that the

inclusion of national income and quality of financial

governance may improve the explanatory power of

the global disclosure model.

It is important to note that a major trade-off by

incorporating 104 countries in this study is to exclude

national culture in the model due to its limited data

availability of about 50 countries (Hofstede 2001).

This means that for this study, the legal dimension

will be the main determinant for the banking

disclosure model from a global perspective.

Findings from this paper contribute to the

literature in a number of ways. We have extended the

frontier of knowledge on the predictors of banking

disclosure practices by using a larger dataset

comprising 104 countries, as opposed to extant

literature which have used only 17 countries for

Hooi’s (2012) banking disclosure model and 41

countries for La Porta et al.’s (1998) accounting

quality model. Interestingly, investor protection is

found to be significant only for common law countries

and national income only for civil law countries. This

finding aligns with that of La Porta et al. (1998) who

contended that common law countries have relatively

stronger investor protection than civil law countries.

More importantly, national income was found to be a

significant determinant of banking disclosure

practices in which banks in richer countries are more

transparent than poorer countries. Moreover, the

quality of financial governance is a significant factor

for the disclosure practices of banks across the globe.

Research implications of this study can provide

valuable insights for policymakers in harmonising

complex international banking regulations for

institutions and regulators such as the BIS and FSB.

This paper is organised as follows. The

background section will address issues on investor

protection, bank disclosure practices, the conceptual

framework and hypotheses formulation followed by

sections on design and discussion. Finally, the

conclusion section summarises the findings and their

implications.

2 Background 2.1 Investor protection

This study will use the seminal work of La Porta et al.

(1997, 1998) to better understand the role of legal

dimensions in banking disclosures. La Porta et al.

(1997, 1998) argue that a country’s legal system, in

particular commercial law is not built from scratch but

rather relies on borrowed ideas from the available set

of legal traditions. Legal traditions have been broadly

categorised as either common law or civil law, with

civil law countries further divided into three families

of legal systems i.e. German, French and

Scandinavian (David and Brierly 1985; Reynolds and

Flores 1989). Common law originated in Great Britain

and is widely adopted in former English colonies

including the United States, Canada, Australia and

New Zealand. It is derived from decisions made by

judges to resolve specific disputes. These rulings are

often incorporated into legislations. In contrast, civil

or code law which is a derivative of the Roman law

tradition, relies on statutes and comprehensive legal

codes. Unlike common law, these rules are developed

by legal scholars and enacted into commercial code

law.

In a series of studies, La Porta et al. examine

whether there are underlying differences across these

legal traditions in laws and enforcement of laws that

protect investors, and whether these differences can

explain the development and structure of financial

markets across countries. La Porta et al. (1998)

document that legal tradition is an important factor in

determining the nature and enforcement of investor

protection laws across countries, and that the

civil/common law dichotomy is highly correlated with

these laws. La Porta et al. (1998) find that common


326

law countries have the strongest investor protection

and French civil law countries the weakest protection,

with German and Scandinavian civil law countries

located in the middle.

Some of the documented features of stronger

investor protection laws include the one-share one-

vote rule, the solicitation of proxies by mail (making

it easier to mount challenges to directors), cumulative

voting or proportional representation of minorities on

boards of directors, mechanisms to legally safeguard

minority investors, preemptive rights to new share

issues (to maintain proportional holdings), and the

ability to call an extraordinary shareholders’ meeting.

Stronger enforcement is evaluated by examining

factors including the overall efficiency of the legal

system, adherence to the rule of law, risk of asset

expropriation, repudiation of contracts by

governments, and the corruption of government.

La Porta et al. (1998) demonstrate that investor

protection laws are generally stronger in common law

countries compared to civil law countries. La Porta et

al. (1997, 1999, 2000a, 2000b) also document that

legal tradition affects financial markets, with stronger

investor protection laws resulting in more developed

financial markets. Hence, investor protection is a

significant factor in contributing to the development

and well being of financial markets, mainly through

the enforcement of shareholders’ rights. For example,

Johnson et al. (2000) show that corporate governance

measurement, particularly investor protection explain

the extent of exchange rate depreciation and financial

market decline during the Asian financial crisis better

than standard macroeconomic variables. It follows

that more developed financial markets lead to greater

external financing opportunities, and to more

widespread (less concentrated) ownership structures

which create potential agency problems. However,

timely and transparent accounting information can

resolve agency problems based on information

asymmetry between the firm and outside investors

(Ball et al. 2000). Therefore, greater public disclosure

of accrual-based accounting is part of the corporate

governance system in countries with strong investor

protection laws to meet the need for timely and

transparent accounting information.

2.2 Bank disclosure practices

Banks are considered as public interest entities with

multiple stakeholder groups interested in the contents

of their reports (Day and Woodward 2004). Around

the globe banking activities are regulated by ‘hard’

and ‘soft’ laws. Hard laws means the Banking Act(s)

of each country which monitors banking activities and

‘Soft’ laws are Pronouncements, Policy Briefs or

Code of Best Practices issued by global institutions

such as the Organisation for Economic Co-operation

and Development (OECD). In addition to the specific

banking law(s) of a country, the BIS issues Core

principles called the Basel Core Principles which

regulate banking practices. Both the hard and soft

laws require banks to increase their accounting

disclosures that entices to better transparency and

stronger market discipline that could reduce banking

crisis.

Extant literature identifies the role and impact of

financial reporting during financial crises (Barth and

Landsman 2010; Autore et al. 2009). Bhattacharya

and Purnanandam (2010) investigate risk taking by

banks and suggest that the stakeholders are informed

after the events have occurred whereas Beltratti and

Stulz (2010) argue that some banks perform better

during the credit episode due to increased risk

reporting requirements and better risk management.

Current research suggests that the subsequent

collapse of international banks during the global

financial crisis are partly due to the fact that these

banks have failed to provide full disclosure of their

operations (Abraham et al. 2008; Demyanyk and

Hasan 2009; Barth and Landsman 2010; Jin et al.

2011). Due to pressures from clients and the financial

community, many countries around the globe have

reviewed their banking regulations in order to increase

disclosures in their financial reports. For example, in

the US the Federal Deposit Insurance Corporation

Improvement Act of 1991 imposed new corporate

reporting, auditing and governance reforms on

depository institutions with assets greater than $500

million, but increased to $1 billion in 2005 (Murphy

2004). Moreover, these regulations aim at increasing

transparency in the financial reports of banks and

related institutions. Basel II and the OECD release on

“Corporate Governance of Banks” require for better

disclosures by banks so as to better portray the overall

risk position of banks. This view is also supported by

Nier and Bauman (2006) who also contends that in a

high disclosure jurisdiction banks will not venture in

excessive risks.

2.3 Conceptual framework

This subsection presents a conceptual framework that

supports the hypotheses and also the links between the

variables. Accounting literature suggests that many

factors influence the quality of accounting and

auditing among countries which we therefore argue

will impact on the disclosure practices in financial

reports of banks (Hatfield 1996; La Porta et al. 1998;

Nobes 1998; Boolaky 2012). La Porta et al. (1998)

reveals the relationship between legal systems and

quality of accounting. They also emphasise on the

impact of investor protection including minority

interests on company-level accounting. Nobes (1998)

demonstrates how the level of economic development

influences accounting of a country which is further

confirmed in extant literature (see also Larson 1993;

Boolaky 2012). Soderstrom and Sun (2007) uses a

number of factors which impact on accounting


327

quality. In this paper, we are focusing on three

institutions of legal system, economic development

and quality of financial governance as determinants of

bank disclosure practices. This is conceptualised in

Figure 1. The conceptual framework is used to

develop hypotheses for testing in this study. The next

subsection addresses the hypotheses development.

Figure 1. Conceptual framework

(1): Legal system

(2): Quality of financial governance

(3): Economic development

2.4 Hypotheses formulation It has been argued that the country’s legal origin is an

important factor in accounting disclosures (Gray

1988). More importantly, the country’s legal system

can either directly or indirectly influence accounting

disclosures. Obviously, accounting disclosures

represent the formalisation of the direct legal

influence of the Corporations Act. La Porta et al.

(1998) argue that investor protection can indirectly

influence accounting disclosures. This is because

strong legal protection for investors would encourage

minority investors to enter the stock market and

consequently, there will be a greater dispersion of

ownership. It is from the dispersion of ownership that

demands transparency.

Prior research has found that common law

countries are associated with higher accounting

disclosures than civil law countries (Jaggi and Low

2000; Hope 2003). This is partly due to the fact that

common law countries have stronger investor

protection laws and more developed financial markets

than civil law countries (La Porta et al. 1997, 1998).

Moreover, Ball et al. (2000) argue that firms in civil

law countries tend to operate by small number of

agents and there is close relationship between agents

and principals, which does not encourage

transparency. Since disclosures is a proxy for

transparency, it is reasonable to extend the

characteristics of accounting disclosures to banking

disclosures because the basic difference between them

is that banking disclosures is specific to the banking

industry. We hypothesise:

H1: There is a positive association between common

law countries and banking disclosures

Hooi (2007, 2012) argue that investor protection

complements Gray’s (1988) secrecy/transparency

theoretical framework. With the support of La Porta et

al. (1998), we hypothesise:

H2: There is a positive association between investor

protection and banking disclosures


328

Larson (1993) suggests that there is a

relationship between economic growth and the

accounting and reporting practices and infers that

countries with high growth rate have more transparent

financial reports. La Porta et al. (1998) found that

quality of accounting standards have a positive

association with national income measured in log of

GNP per capita. In other words, richer countries have

higher quality of accounting standards. Nobes (1998)

extends the argument by suggesting that the more

developed the equity market the better should be the

financial reporting in this jurisdiction. Boolaky (2012)

contends that a country experiences different stages of

economic development which therefore requires

different level of reporting systems and hence

different disclosure level. All these studies have

referred to national income as an indicator of

development. Our study investigates the disclosure

practices by banks in 104 countries with different

stages of economic development whose national

income level also varies. We argue that it is very

likely that disclosure practices by banks in these

jurisdictions would also vary. Based on the above, we

hypothesise:

H3: There is a positive association between national

income and banking disclosures

It is reasonable to argue that quality of financial

governance in terms of accounting and auditing

standards can influence the disclosure model. La Porta

et al. (1998) suggest that for investors to be informed

about the company they invest, basic accounting

standards are needed to render the company’s

disclosure interpretable. They further argue that the

contracts between managers and investors rest on the

verifiability of some measures of assets and incomes.

We adopt the International Financial Reporting

Standards and International Standards on Auditing to

determine the quality of accounting and auditing

respectively. La Porta et al. (1998) on the other hand,

only addressed the accounting quality index which

was constructed based on what was reported in the

companies’ reports thus being more of the preparers’

view of accounting in the country. In other words, we

use a different perspective on the quality of financial

governance which was based on the users’

perceptions. These perception indices are valid and

reliable due to the fact that they have been collected

and collated scientifically over 30 years for the

purpose of empirical research in social science and for

policymaking in many national, regional and

international institutions (Boolaky and O’Leary 2011;

Boolaky 2012; Boolaky et al. 2013). More

importantly, this perspective has not been considered

in the context of banking disclosure research.

Our argument is that the strength of accounting

and reporting of a country therefore influences

disclosure practices. This resonates with Boolaky

(2012) and Boolaky et al. (2013) that a country with a

strong auditing and reporting system will be more

transparent than a country with a weak auditing and

reporting system.

We hypothesise:

H4: There is a positive association between

accounting quality and banking disclosures

H5: There is a positive association between audit

quality and banking disclosures

3 Design

3.1 Data

The selection of countries was determined by the data

availability from Huang (2006) for the composite

bank disclosure indices and World Economic Forum

(cited in Cornelius, 2005: 20-21) for the investor

protection indices. Consequently, a maximum of 104

countries are available for the study for the financial

year 2004 which is the similar period used in Hooi’s

(2012) firm-level study. The national index of bank

disclosure is composed of only traditional commercial

banks, savings bank and cooperative banks in about

180 countries in which the index values range

between 0 and 100 with higher values indicating

better transparency and disclosure practices of the

banking systems. “The disclosure indices are first

created for individual banks based on their disclosure

practices, using a checkbox approach, and then

national indices are created by taking the asset-

weighted average of the bank-level disclosure indices.

A total of more than 20,000 banks are included in

calculating these indices.” (Huang 2006: 33).

The composite disclosure index is based on six

disclosure categories i.e. loans, other earning assets,

deposits, other funding, memo-lines and incomes. The

loans category mainly includes breakdown of loans by

maturity, type, counterparty, credit risk and problem

loans. The other earning assets category includes the

breakdown of securities by type and hold purpose.

The deposits category includes the breakdown of

deposits by maturity and type of customer. The other

funding category includes the breakdown of money

market funding and long-term funding. The memo-

lines category includes the disclosures of capital ratio,

reserves, contingent liabilities and off-balance sheet.

Finally, the incomes category includes the breakdown

of non-interest income and disclosure of loan loss

provisions.

The investor protection index is adapted from a

global competitiveness report (World Economic

Forum 2004), labelled as the law protection of

minority shareholders in Cornelius (2005). The legal

dimension of common law which is a dichotomous

variable is partly adapted from La Porta et al. (1998).


329

For this study, it is reasonable to correspond La Porta

et al.’s (1998) common law index with the 2004

disclosure model since they are relatively stable in the

long run. Finally, the national income index is adapted

from the World Bank’s country classification report

(cited in Kasteng et al., 2004: 55-57) where low, low-

medium, medium, high income countries are

represented by indices of 1, 2, 3 and 4 respectively.

3.2 Model

Cross-sectional OLS regression analysis will be

applied to the total sample of 104 countries. The

global disclosure model shall regress with the legal

dimension which is the main determinant in terms of

common law and investor protection i.e. to test H1

and H2.

DSCc = a0 + a1COMc + a2IVPc + (1a)

DSC = disclosure

COM = common law

IVP = investor protection

a1 – a2 = coefficients of the explanatory

variables

Subscript: c = country level

A subsample analysis shall be applied to test H3:

DSCc = a0 + a1COMc + a2IVPc + a3INCc (1b)

DSC = disclosure

COM = common law


INC = income


variables


To better understand the influence of investor

protection and national income among countries based

on legal origin, this study shall regress by splitting the

sample between common and civil law countries.

Consequently, the samples for regressing common

and civil law countries are 35 and 69 respectively.

There are predominantly three categories of civil law

namely French, German and Scandinavian (La Porta

et al. 1998). However, due to insufficient data of all

those categories, the study is not able to test the

significance of legal origins of civil law. The quality of financial governance variables of

accounting and audit are based on IASB and IFAC

databases on international financial reporting

standards and international standards on auditing

respectively. Table 1 summarises the characteristics of

all variables. Consequently, disclosure model 2 will

be used to test H4 and H5 with 80 countries:

DSCc = a0 + a1COMc + a2IVPc + a3INCca4ACCc+ a5AUDc (2)

DSC = disclosure

COM = common law


INC = income

ACC = accounting quality

AUD = audit quality


variables


Table 1. Variable summary

Variable Description Source Year Sample Model Status Expected Relationship

DSC Bank disclosure Huang (2006) 2004 104 1 and 2 Dependent

COM Common law La Porta et al. (1998) 1998 104 1 and 2 Regressor positive

IVP Investor protection Cornelius (2005) 2004 104 1 and 2 Regressor positive

INC National income World Bank 2004 104 1 and 2 Regressor positive

ACC Accounting quality IASB (2004) 2004 80 2 Regressor positive

AUD Audit quality IFAC (2004) 2004 80 2 Regressor positive


330

4 Discussion 4.1 Descriptive analysis

Table 2 presents data on bank disclosure indices for

80 countries categorised by legal origins. The table

suggests that countries of Scandinavian origin are the

most transparent in the sample with the highest

average disclosure score followed by German,

English, French and Civil-other. Further analysis (not

shown in a table) confirms that the disclosure

averages compared between English and

Scandinavian and English and German are significant

at 1% and 5% respectively. Moreover, Table 2 shows

that the average investor protection between

Scandinavian and all other legal origins are significant

at 1%. This may suggest that Scandinavian countries

with the strongest investor protection have demanded

the highest level of banking disclosure practices.

Table 3 compares the significance of legal

origins for investor protection between La Porta et al.

(1998) and this study using the equality of means

tests. La Porta et al. (1998) constructed its own

investor protection index called anti-director rights

which measures how strongly the legal system favours

minority shareholders against managers or dominant

shareholders in managerial decisions including the

voting process. The anti-director rights index per

country can range from zero to six and is computed by

adding 1 when (1) the country allows shareholders to

mail their proxy vote to the firm; (2) shareholders are

not required to deposit their shares prior to the general

shareholders’ meeting; (3) cumulative voting or

proportional representation of minorities in the board

of directors is allowed; (4) an oppressed minorities

mechanism is in place; (5) the minimum percentage of

share capital that entitles a shareholder to call for an

extraordinary shareholders’ meeting is less than or

equal to 10% (the sample median); or (6) shareholders

have pre-emptive rights that can be waived only by a

shareholders’ vote.

Table 2. Global Banking Indices for 80 Countries

Country DSC IVP

Country DSC IVP

Australia 73 6.1

Bahrain 84 5.1

Botswana 62 4.7

Bolivia 55 3.3

Canada 75 5.9

Bosnia 47 3.1

Cyprus 68 4.5

Bulgaria 63 2.9

Ghana 56 5.6

Chad 15 3.7

Hong Kong 91 4.9

Costa Rica 53 4.2

India 74 4.4

Croatia 56 3.2

Ireland 70 5.3

Czech Rep 65 4.1

Israel 79 5.9

El Salvador 58 4

Kenya 52 4.4

Estonia 68 4.6

Malaysia 72 5.4

Guatemala 46 3.4

Malta 72 4.9

Honduras 59 3.3

Mauritius 52 4.2

Hungary 73 4.6

New Zealand 79 6.1

Iceland 77 5.7

Nigeria 42 4.1

Latvia 70 3.9

Pakistan 59 5

Lithuania 73 3.8

Singapore 71 5.5

Macedonia 53 3.5

South Africa 78 5.5

Nicaragua 61 3.1

Sri Lanka 73 4.4

Panama 56 4.2

Thailand 75 4.7

Poland 71 3.7

Trinidad and Tobago 62 4.1

Romania 62 3.7

UK 71 6.3

Russia 62 2.8

USA 76 6.1

Slovakia 79 3.7

Zimbabwe 47 4.9

Slovenia 77 4.3

English-origin average 67.88 5.12 Civil other-origin average 61.79 3.83


331

DSC=disclosure, IVP=investor protection

Table 2. Global Banking Indices for 80 Countries (cont’d)

Country DSC IVP

Country DSC IVP

Austria 78 5.1

Algeria 53 4.7

Germany 74 6.1

Argentina 66 3.7

Japan 80 5

Belgium 70 5.6

Korea Rep 68 4.1

Brazil 74 4.5

Switzerland 82 4.9

Chile 62 5.2

Taiwan 72 4.8

Colombia 63 4.1

German-origin average 75.67 5.00

Egypt 55 4.8

France 66 5

Denmark 79 6.3

Greece 67 5.1

Finland 85 6.4

Italy 89 3.5

Norway 84 6.2

Jordan 74 4.9

Sweden 90 5.9

Luxemburg 61 4

Scandinavian-origin average 84.50 6.20

Mali 46 4.6

Mexico 75 4.5

Morocco 62 4.5

Netherlands 86 5.2

Peru 57 4.2

Philippines 70 4.3

Portugal 73 5.1

Spain 81 4.5

Uruguay 41 4.1

Venezuela 56 3.6

French-origin average 65.77 4.53

DSC=disclosure, IVP=investor protection

It is clear from Table 3 that legal origins matter

for the strength of investor protection in which

Scandinavian countries is ranked first followed by

English, German, French and Civil other but

collectively, common law countries have stronger

investor protection compared to civil law countries.

Despite the fact that this paper uses a different

perspective of investor protection, most of the results

are consistent with La Porta et al. (1998) except for

English compared to German origin which was found

to be insignificant. However, we have made a

significant contribution by including a new dimension

for other Civil countries not considered in La Porta et

al. (1998). Moreover, we found more statistically

significant results for the following comparisons i.e.

English versus Scandinavian origin, French versus

Scandinavian origin and German versus Scandinavian

origin.

Table 4 presents the descriptive statistics for

disclosure model 2 which is the complete model. On

average, the banking disclosure level across all

countries was moderate of 67%. From Table 5, the

correlation coefficients show very little to moderate

multicollinearity across the explanatory variables.

With a correlation of 0.37 (significant at 1%),

suggests that common law countries have relatively

moderate investor protection compared to civil law

countries. This result is consistent with the findings in

La Porta et al. (1998).


332

Table 3. Tests of Means (t-statistics) for Investor Protection

La Porta et al. 1998 Hooi and Boolaky 2015

Common vs. civil law 5.00a

3.86a

English vs. French origin 4.73a

3.14a

English vs. German origin 3.59a

0.40

English vs. Scandinavian origin 1.91c

-5.99a

English vs. Civil other origin na 6.37a

French vs. German origin 0.00 -1.62

French vs. Scandinavian origin -1.06 -10.36a

French vs. Civil other origin na 3.78a

German vs. Scandinavian origin -1.08 -4.22a

German vs. Civil other origin na 3.91a

Scandinavian vs. Civil other origin na 13.26a

a: significant at 1%, b: significant at 5%, c: significant at 10%, (2-tailed)


(n=80) Mean Std Dev

DSC 66.888 12.993

COM 0.300 0.461

IVP 4.616 0.897

INC 2.925 1.053

ACC 2.890 1.169

AUD 2.150 1.057

DSC=disclosure,

COM=common law,

IVP=investor protection,

INC=income,

ACC=accounting quality,

AUD=audit quality

Table 5. Pearson correlation of explanatory variables

COM IVP INC ACC AUD

COM 1

IVP 0.371a

1

INC -0.057 0.495a

1

ACC -0.101 0.011

0.168 1

AUD 0.114 -0.176 -0.138 0.444a

1

a: significant at 1%, b: significant at 5% (2-tailed)

Note: Collinearity Statistics (VIF)

COM IVP INC ACC AUD

VIF 1.360 1.754 1.504 1.377 1.421

COM=common law,


INC=income,


AUD=audit quality


333

4.2 Global disclosure model From Table 6, the legal determinants are found to be

significant with an adjusted R2 of 26.7% with civil

law being significant at 5%. The insignificance of

common law may suggest that for the banking

industry, civil law countries are found to be more

transparent. This is contrary to prior research in which

banking disclosures are found to be higher in common

law countries as opposed to civil law countries (Hooi

2012). Moreover, studies in accounting disclosures

were found to be similar (Jaggi and Low 2000; Hope

2003). A possible reason could be partly due to the

fact that the original sample of 104 are predominantly

civil i.e. 67.3%. Investor protection has a direct

influence on banking disclosures (significant at 1%).

Our finding extends the literature by reporting that

although the legal system could affect disclosure, the

law related to investor protection has more influence

on the disclosure of information by banks around the

globe. We identify that there are civil law countries

which have a high score of investor protection and

high disclosure index as well. Moreover, national

income has improved Model 1 with an adjusted R2 of

41% and has a direct influence on banking disclosures

(significant at 1%). However, the common law

variable is found to be insignificant in the extended

Model 1.

For further analysis, Table 7 reports the split

sample of common and civil law countries.

Interestingly, investor protection is found to be

significant (1%) only for common law countries and

national income is found to be significant (1%) only

for civil law countries with adjusted R2 of 39.8% and

44.9% respectively. This suggests that investor

protection is more important for common law

countries similar to La Porta et al. (1998) who found

that common law countries have relatively stronger

investor protection than civil law countries. The

positive correlation of 0.37 between common law and

investor protection supports this argument.

Table 6. Results for Model 1

(n=104)

Panel A

Expected Estimated

Variable Relationship Coefficient t-Stat p-value

Intercept NA 28.448 4.739 0.000

COM +ve -6.017 -2.344 0.021

IVP +ve 8.536 6.271 0.000

F-Stat: 19.745 F-value: 0.000

Adjusted R-Square: 0.267

Panel B

Expected Estimated


Intercept NA 31.297 5.781 0.000

COM +ve -1.884 -0.771 0.443

IVP +ve 4.361 2.958 0.004

INC +ve 5.547 5.053 0.000

F-Stat: 24.873 F-value: 0.000


COM=common law,


INC=income


334

Table 7. Results for legal origins

(n=34)

Panel A: Common

Expected Estimated


Intercept NA 18.139 1.507 0.142

IVP +ve 8.115 2.889 0.007

INC +ve 2.632 1.604 0.119

F-Stat: 11.917 F-value: 0.000


(n=70)

Panel B: Civil

Expected Estimated


Intercept NA 33.079 5.363 0.000

IVP +ve 2.643 1.543 0.128

INC +ve 7.606 5.265 0.000

F-Stat: 29.143 F-value: 0.000


IVP=investor protection, INC=income

To address possible issues on the robustness of

Model 1, the following two tests were performed (not

shown in tables). First, it has been argued that OECD

countries demand higher level of disclosures due to

the fact that most are early adopters of Basel banking

rules. The dummy variable OECD was tested to

determine whether it is a better proxy for economic

development. The univariate analysis confirms that

national income is actually a better proxy than OECD

with the corresponding adjusted R2 of 36.9% (F-Stat

61.3) and 26.6 % (F-Stat 38.4) respectively.

Interestingly, only national income is significant (at

1%) whereas OECD and its interaction with national

income are insignificant which further confirms the

univariate analysis. We believe that the national

income is a better predictor for the global disclosure

model especially the fact that it is more representative

in terms of economic development compared to

OECD. Moreover, the split regression of 30 OECD

countries in the original sample of 104 with investor

protection and national income find that (1) model is

insignificant for OECD and (2) model is weaker for

74 non-OECD compared to the legal split with 70

civil countries (shown as panel B in table 6) have the

corresponding adjusted R2 of 27.1% (F-Stat 14.6) and

44.9 % (F-Stat 29.1) respectively.

Second, Huang (2006) argue that bank opacity is

highly correlated with government opacity and La

Porta et al. (1998) argue that law enforcement is an

important factor for disclosures. The corruption

perception index (CPI) developed by Transparency

International and La Porta et al. (1998)’s law

enforcement (LWE) variables were tested to

determine their relevance to the global disclosure

model. The correlation analysis confirms that both

CPI and LWE are highly correlated and OECD is

moderately correlated with national income with their

respective values of 0.83, 0.83 and 0.64 (significant at

1%). Moreover, LWE cannot be used for the study

with a limited dataset of 47 countries and CPI is

highly correlated (0.74 at 1%) with investor protection

which is supported by the extant literature for banking

disclosures and not CPI. Hence, the above robustness

tests suggest that OECD, CPI and LWE variables

warrants exclusion from the global disclosure model

and the conclusions from the study are subject to these

limitations.

Table 8 reports on Model 2. Common law is

found to be insignificant and consistent with Model 1.

Investor protection is marginally significant at 10%

and national income is significant at 1%. These results

may suggest that investor protection does encourage

minority investors to enter the stock market

specifically in the global banking industry. This


335

situation may lead to a greater demand for

transparency through a larger dispersion of ownership

across the domestic banks.

Table 8. Results for Model 2

(n=80)

Panel A

Expected Estimated


Intercept NA 31.887 5.415 0.000

COM +ve -0.163 -0.061 0.951

IVP +ve 3.388 2.157 0.034

INC +ve 6.636 5.329 0.000

F-Stat: 22.248 F-value: 0.000


Panel B

Expected Estimated


Intercept NA 32.500 4.841 0.000

COM +ve 1.451 0.547 0.586

IVP +ve 2.894 1.868 0.066

INC +ve 6.036 4.938 0.000

ACC +ve 2.787 2.647 0.010

AUD +ve 2.377 2.008 0.048

F-Stat: 19.951 F-value: 0.000


COM=common law,


INC=income,


AUD=audit quality

However, this finding is contrary to Hooi’s

(2012) negative association between anti-director

rights and banking disclosures which may be due to a

significantly smaller dataset of 37 firm-level banks for

17 countries. The subsample analysis found that the

accounting and audit quality variables to be

significant at 1% and 5% respectively with an

adjusted R2 of 48.5% (F-Stat 19.951). This confirms

the crucial role that accounting and audit play in

enhancing disclosures of banks. Hence, the results are

consistent to all hypotheses except with H1.

5 Conclusion

In addition to testing the influence of the legal

framework and national income, this paper has

investigated the impact of the quality of financial

governance on bank disclosure practices at a macro

level. The findings indicate that investor protection is

relevant which is consistent with Hooi’s (2012)

banking disclosure model. More importantly, this

study has extended Hooi’s (2012) results by

incorporating a significantly larger sample of

countries and suggests that national income and

quality of financial governance do influence bank

disclosure practices. Furthermore, this paper has

explored and extended La Porta et al.’s (1998)

findings on the association between national income

and the quality of a country’s accounting standards to

the banking disclosure model.

We have used a more extensive dataset of

104 countries compared to only 17 developed and

developing countries used in Hooi’s (2012) banking


336

disclosure model for the similar financial year of 2004

and 41 countries used by La Porta et al.’s (1998)

accounting quality model. It is important to note that

the conclusions of this paper are subject to this

limitation. Interestingly, investor protection is found

to be significant only for common law countries and

national income is found to be significant only for

civil law countries. This suggest that investor

protection is more important for common law

countries because La Porta et al. (1998) has argued

that common law countries have relatively stronger

investor protection than civil law countries. The

positive association between investor protection with

banking disclosures may suggest that investor

protection does encourage minority investors to enter

the stock market specifically in the global banking

industry. This situation may lead to a greater demand

for transparency through a larger dispersion of

ownership across the domestic banks. In conclusion,

investor protection, national income and quality of

financial governance are significant determinants in

the theoretical framework for the transparency of

international banking operations. Research

implications of this study can provide valuable

insights for policymakers in harmonising complex

international banking regulations for institutions and

regulators such as the BIS and FSB. Future research

could involve a longitudinal study of pre and post

analysis of the implementation of international

financial reporting standards (IFRS) and Basel

regulations to banks globally.

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