The Effect of Firm Characteristics on Corporate Governance: An Empirical Study in the United States

TLDR: In this article, the authors used a multivariate logistic regression (logit) model to compare the performance of 85 United States companies and found that return on assets, firm size, debt ratios, and auditor opinion are useful in discriminating the best governed firms from the worst governed firms.

Abstract: Recent financial scandals in United States companies have exposed "corporate governance" weaknesses. The measure of corporate governance used in this study is based on a Business Week survey. The governance rankings of this survey are derived from the opinions of experts who rated each company on four aspects of governance: shareholder accountability, quality of directors, independence of the board, and corporate performance. We use a multivariate logistic regression (logit) model in this study and the sample size is 85 United States companies. Our results suggest that return on assets, firm size, debt ratios, and auditor opinion are useful in discriminating "best" governed firms from "worst" governed firms 1. Introduction The practical importance of good corporate governance has been acknowledged for a long time (Shleifer and Vishny, 1997), but has taken the limelight in recent years in the wake of numerous high profile corporate scandals all over the world. Globally, there is increased awareness about the results of poor corporate governance: fraud, runaway CEO pay, excessive diversification, questionable acquisitions and decisions that result in an overall destruction of the inherent value of an organization. Shareholders are filing suits, regulators are enacting laws to ensure good governance, and increasingly, firms are attempting to better govern themselves. This interest in governance has resulted in an explosion of research and commentaries in the popular press and academic journals. Despite the importance of and interest in the topic, empirical research has not converged to provide guidance for best practices that might be followed to improve governance. Some empirical studies have shown positive relationships between well governed corporations and firm performance (Gill, 2001; Gompers, Ishii and Metrick, 2003), while others have not (Dalton, Daily, Ellstrand and Johnson, 1998). The complexity of the issue calls for additional research that might shed light on some of the controversies currently raging in this area. There are numerous mechanisms by which a firm may be effectively governed such as, board and leadership structure, ownership structure and large block shareholders, CEO compensation, takeovers, and overall transparency in reporting. Research indicates that firms perceived as well governed command a premium in the market that could be as high as 10-12% (Newell and Wilson, 2002). Critical among various governance mechanisms is the structure of the board (Daily, Dalton and Cannella, 2003). Are there characteristics of a board that make it effective as a tool of governance? What is the impact of a "good" board on performance of a firm? These questions are not new and have been asked many times in prior research but have been mired in controversy and not fully answered. In this paper we review prior research exploring the relationship between board characteristics and firm performance. We then present empirical results of our study on accounting and financial characteristics of US firms that have the "best" and the "worst" corporate governance according to a Business Week survey. Explanatory variables used in this study include: return on assets, debt ratio, market value of equity, profit margin, cost of goods sold ratio, dividend payout ratio and audit opinion. Some of the accounting variables used above are historical and have an inward looking focus. They measure the past successes of various decisions taken by the board of directors. On the other hand, market based measures mentioned above are forward looking in the sense that they emphasize future expected earnings of the firm. These measures reflect current plans and strategies of the management team. Section 2 provides a brief literature review. The data and methodology are discussed in sections 3 and 4. Section 5 describes the empirical results and we conclude the paper in section 6. 2. Literature Review Agency theory holds that managers are the agents of shareholders, the principals. …