Business Research

• Read the Case Study: On the relation between corporate governance compliance and operating performance. Accounting & Business Research (Wolters Kluwer UK), 39(5), 497-513. Vander Bauwhede, H. (2009).
• Write a summary analysis and what is your opinion of the discussion? What is the high point that convinces you that Corporate governance compliance does make a difference in the operating performance?

Writing Requirements

• 3–4 pages in length  (excluding cover page, abstract, and reference list)
• APA format, Use the APA template located in the Student Resource Center to complete the assignment.
• Aecounting and Business Research. Vol. 39. No, 5, pp. 497-513, 2009 497
  On the relatíon between corporate
  governance compliance and operating
  performance
  Heidi Vander Bauwhede
  Abstract — Better corporate perfonnance has been cited as one of the main benefits of adopting good corporate govemance
  structures within organisations. However, in contrast to theory, a prior European study (Bauer et al., 2004) reports evidence of
  a negative relationship between corporate govemance and corporate performance. This study re-examines this relationship,
  and reports evidence of a positive relationship between the extent of compliance with intemational best practices concerning
  board structure and functioning and operating perfonnance when operating perfonnance is measured by the retum on assets
  (ROA). This resuh is robust to controlling for the firms’ compliance with best practices in other govemance areas, and holds
  for some other govemance dimensions, namely disclosure of corporate govemance and the range of takeover defences.
  Further tests indicate that greater compliance with intemational best practices conceming board stmcture and functioning is
  significantly associated with reporting less income from asset disposals and that studying a performance measure that
  includes this item obscures the inherently positive relationship between operating perfonnance and the extent of compliance
  with intemational best practices regarding board stmcture and functioning. The results provide some support for an oftencited motivation for the adoption of good govemance practices, and provide explicit evidence that the measure of operating
  perfonnance is cmcial in examining firm-level operating performance.
  Keywords: corporate govemance; operating performance
  1. Introduction
  This paper examines the relationship between
  corporate govemance compliance and operating
  performance for a set of large listed European
  companies. My focus is on compliance with
  intemational best practice in corporate govemance.
  Following Jensen (1993) and prior govemance
  research, I hypothesise that greater compliance with
  intemational corporate govemance best practices
  and, more specifically, best practices conceming the
  structure and functioning of the board, is associated
  with better operating performance, ceteris paribus.
  I investigate the relationship between corporate
  govemance compliance and operating performance
  for a sample of European companies in 2000-2001,
  because, during that period, there remained considerable variation in corporate govemance practices
  (see Wójcik, 2006; Bauer et al, 2008), notwithstanding that there were pressures from, for
  example, institutional investors or cross-listings to
  comply with intemational corporate govemance
  best practices and that in some countries local codes
  were, de facto, mandatory.”‘^
  The study focuses on operating performance, and
  not stock market performance, in order to investigate fiirther the result of a prior European study
  (Bauer et al., 2004) on the relation between
  compliance with best practices conceming corporate govemance and operating performance which
  seems to conflict with both theory as well as prior
  American results. More specifically, Bauer et al.
  (2004) report evidence of a negative relationship
  between ratings on the extent of compliance with
  intemational best practices and firm operating
  The author is at Maastricht University and at Ghent
  University. She also has an affiliation to Katholieke
  Universiteit Leuven. She gratefiilly acknowledges Ping-Sheng
  Koh, Kevin McMeeking, Piet Sercu, Konstantinos
  Stathopoulos, participants at the 2006 European Accounting
  Association Annual Conference (Dublin, Ireland), the editor
  and two anonymous reviewers for usefijl comments. She also
  thanks Deminor for providing the govemance data. The usual
  disclaimer applies.
  Correspondence should be addressed to Dr Heidi Vander
  Bauwhede, Maastricht University, Department of Accounting &
  Information Management, P.O. Box 616, Maastricht, 6200 MD,
  Netherlands.
  E-mail: H.VanderBauwhede@maastrichtuniversity.nl.
  This paper was accepted for publication in July 2009.
  ‘ I refer to a study commissioned by the European commission (Weil et al., 2002) and to the website of the European
  Corporate Govemance Institute (http://www.ecgi.org/codes/
  all codes.php) for an overview of the corporate govemance
  codes in the European Union. Intemational govemance codes
  are, for example, those established by the Intemational
  Corporate Govemance Network (ICGN), and the Organisation
  for Economic Co-operation and Development (OECD).
  ^Some countries (such as the UK and Italy) required
  companies to disclose whether they complied with a (national)
  corporate govemance code under a ‘comply or explain’
  approach. This approach requires firms to disclose whether
  (and to what extent) they comply with a particular corporate
  govemance code and, if they do not (fully) comply, to explain
  why they do not comply.
  498 ACCOUNTING AND BUSINESS RESEARCH
  performance, whereas theory (Jensen, 1993), predicts a positive relationship^ and a prior American
  study (Larcker et al., 2005) finds some (albeit weak)
  evidence of a positive relationship. I primarily focus
  on board structure and functioning, and not on other
  dimensions of corporate governance (such as, for
  example, rights and duties of shareholders and
  range of takeover defences), because it is especially
  the structure and functioning of the board that can
  directly affect the operating efficiency and operating performance of a company. However, for
  completeness, I also perform and report the results
  of some additional analyses on the relation between
  other dimensions of corporate governance and firm
  operating performance.
  I use a sample of European listed companies for
  which a private rating agency issues a firm-level
  rating of the extent of compliance with international best practices conceming board structure
  and functioning. Results of univariate and multivariate tests indicate that the one-year ahead retum
  on assets (ROA) increases in the extent of
  compliance with intemational best practices conceming board structure and functioning. Tests
  show that the results are not affected by the
  potential endogeneity of the extent of govemance
  compliance. In addition, the results are robust to
  controlling for the firms’ compliance with best
  practices in other govemance areas, such as rights
  and duties of shareholders and-range of takeover
  defences, and to controlling for country-level
  performance. Moreover, I also find a positive
  relation between the extent of compliance with
  recommendations in some other govemance
  dimensions, more specifically disclosure on corporate govemance and range of takeover defences,
  and firm operating performance.
  Further, additional analyses indicate that greater
  compliance with intemational best practices conceming board stmcture and fiinctioning is significantly associated with reporting less income from
  asset disposals and that studying a performance
  measure that includes the income fi^om asset
  disposals, such as the retum on equity (ROE) or
  net profit margin (NPM) used by Bauer et al.
  (2004), instead of a performance measure which is
  not impacted by the income fi^om asset disposals,
  such as the retum on assets (ROA), obscures the
  inherently positive relationship between operating
  performance and the extent of compliance with
  ^ Bauer et al. (2004) find indications of a positive relationship
  between govemance ratings, and stock retums and firm value,
  respectively.
  intemational best practices regarding board structure and functioning.
  This study contributes to the literature on the
  relation between corporate govemance and corporate performance. A first contribution is that the
  study reports a positive relation between the extent
  of compliance with intemational best practices on
  various govemance dimensions (board stmcture
  and functioning, disclosure on corporate govemance) and the operating performance of European
  companies. A second contribution is that this study
  reports evidence which indicates that the unexpected negative relationship between corporate
  govemance compliance and operating performance
  as reported by Bauer et al. (2004)^* is due to poorlygovemed companies using the available discretion
  over the timing of asset sales to cover up their
  inherently lower operating performance. The key
  difference between this study and that of Bauer et al.
  (2004) is that the retum on assets is introduced as
  the preferred measure of operating performance
  because the income measure used in computing the
  retum on assets, i.e. operating income, is less
  influenced by discretionary items than the income
  measure used to compute the retum on equity or net
  profit margin, i.e. income before extraordinary
  items. The retum on equity and net profit margin
  are the performance measures used by Bauer et al.
  (2004).
  The remainder of the paper is organised as
  follows. The next section develops the main
  research hypothesis. Section 3 describes the sample
  and data. Section 4 presents the empirical model.
  Section 5 presents the empirical results. Section 6
  concludes.
  2. Hypothesis development
  The various corporate govemance codes that have
  been issued since the late 1990s oflen refer to better
  performance as one of the key benefits of adopting
  their corporate govemance recommendations. This
  performance can be understood as better market
  performance (i.e. higher stock retums or firm
  Examples of other studies that have examined the relation
  between govemance and perfomiance using samples from other
  countries (for example, the US, Australia, and various Asian and
  some (individual) European countries), and using and focusing
  on a variety of govemance attributes and performance measures,
  are: Larcker et al. (2006), Black et al. (2006), Brown and Caylor
  (2006a), Brown and Caylor (2006b), Dumev and Kim (2005),
  Larcker et al. (2005), Alves and Mendes (2004), Bebchuk et al.
  (2004), Klapper and Love (2004), Drobetz et al. (2004), Kiel
  and Nicholson (2003), Bhagat and Black (2002), Yermack
  (1996), and Klein (1998).
  Vol. 39, No. 5. 2009 499
  value)^ or as better operating performance. The
  expected relationship between compliance with
  corporate govemance recommendations and operating performance is based on the argument that
  firms with a better govemance structure operate
  more efficiently which increases their operating
  performance (see, for example, Jensen, 1993).
  However, results of previous studies on the relation
  between govemance and operating performance are
  mixed. Larckeret al. (2005), for example, find some
  evidence of a positive relationship between an
  overall govemance metric (The Corporate Library
  Board Effectiveness Rating) and the one-year ahead
  ROA for a set of large listed American companies.
  By contrast, Bauer et al. (2004) find a negative
  relationship between an overall govemance score
  and operating performance for large European
  companies.
  As with any govemance study, a crucial element
  in examining the relationship between govemance
  and performance is how one defines and measures
  ‘better govemance’. In this study, I use a rating,
  issued by a private rating agency (Deminor rating),^
  that assesses the extent to which large listed
  European firms comply with intemational best
  practices conceming corporate govemance and,
  more specifically, the extent to which firms comply
  with intemational best practices conceming board
  structure and functioning.^ Higher compliance is
  implicitly assumed to be better govemance.
  However, this is not necessarily true. A first reason
  is that European companies may have adopted
  govemance mechanisms and practices that differ
  from the intemationally accepted best practices, but
  are better tailored to the specific context in which
  they operate. However, it is probably also true that
  ^ Examples of studies that have examined aspects of corporate govemance and market performance in an American setting
  are Yemack (1996), Bhagat and Black (2002), Gompers et al.
  (2003) and Bebchuk et al. (2004). Beiner et al. (2006), Alves
  and Mendes (2004), Drobetz et al. (2004) and Kiel and
  Nicholson (2003) are examples of govemance-market performance studies using samples of Swiss, Portuguese, German and
  Australian companies, respectively.
  * In Section 3,1 provide more detail on the rating.
  ‘Most govemance studies use either a single indicator of
  govemance, or an ‘arbitrary’ index. Larcker et al. (2006) argue
  that measurement error in these govemance metrics may be
  partly responsible for the mixed results on the association
  between tiie typical measures of corporate govemance and
  accounting and economic outcomes. Nevertheless, I prefer to
  use the ratings issued by an independent rating agency as
  measures of govemance compliance since these are publicly
  available and easily accessible for market participants. The aim
  of the study is to see whether these publicly available measures
  of the extent of compliance with intemational best practices are
  related to fiiture operating performance and can as such signal
  future operating performance to market participants, who can, in
  tum, use this infonnation for decision making.
  there is less need for govemanee practices tailored
  to local contexts for the largest companies in
  Europe, which operate globally instead of locally.
  Whether large listed European companies benefit
  fi-om compliance with intemational best practices,
  and then specifically in terms of higher operating
  performance, is ultimately an empirical question.
  Another reason why higher compliance is not
  necessarily better govemance is that the best
  practices identified by Deminor are not always
  unequivocally related to better govemance. For
  example, evidence on whether CEO duality is bad
  govemance and board diversity is good govemance,
  is mixed (see, for example, Sonnenfeld, 2004;
  Massa and Simonov, 2007).* In order to refine the
  analysis I focus on the dimension of corporate
  govemance which is particularly likely to directly
  infiuence operating efficiency and operating performance, i.e. the structure and functioning of the
  board of directors.^ As Jensen (1993: 862-863) puts
  it, ‘The board, as the apex of the intemal control
  system, has the final responsibility for the functioning of the firm. Most importantly, it sets the rules of
  the game for the CEO. The job of the board is to
  hire, fire, and compensate the CEO, and to provide
  high-level counsel’ and ‘.. . the very purpose of the
  intemal control mechanism is to provide an early
  waming system to put the organisation back on
  track before difficulties reach a crisis stage.’ Jensen
  (1993) then also attributes the weak corporate
  performance from the early 1990s to problems with
  the intemal control activity (Jensen, 1993: 352) in
  the 1980s, which, in tum, stemmed from problems
  with the board of directors (Jensen, 1993: 862).
  The major threat to a well-functioning board, and
  strong operating performance, is that the board is
  dominated by managers (especially in Anglo-Saxon
  countries) or majority shareholders (especially in
  continental European countries) who act in their
  ovra interest (instead of in the interest of all
  stakeholders), and cover up any underperformance
  by eamings management or manipulation to
  appease (minority) shareholders. Jensen (1993:
  869) then also recognises that characteristics such
  as, for example, high-equity ownership by managers and board members, a small board, not many
  insiders on the board, and a CEO which is not the
  chairman of the board, are key elements of a wellfunctioning govemance system, which limits selfinterested behaviour by managers, uncovers bad
  performance in time and takes the necessary actions
  * I thank one of the anonymous reviewers for this observation.
  ‘ For completeness, I later expand the analyses to govemance
  dimensions other than board structure and fiinctioning. The
  results are reported in Section 5.4.
  500 ACCOUNTING AND BUSINESS RESEARCH
  to ‘put the organisation back on track’ (Jensen,
  1993: 863). These key elements of a well-functioning board mentioned by Jensen (1993) are all
  covered by the intemational best practices conceming board structure and functioning. Therefore, I
  expect that higher compliance with intemational
  best practices conceming board structure and
  functioning is related to better operating performance.
  Although greater compliance with intemational
  best practices conceming rights and duties of
  shareholders and range of takeover defences may
  increase the pressure by investors and the market for
  corporate control on companies to perform well, it is
  less straightforward that this greater compliance
  with intemational best practices conceming rights
  and duties of shareholders and range of takeover
  defences is per se related to better underlying
  operating performance, for in the absence of a wellfunctioning board, managers and majority shareholders could still act in their own self-interest,
  underperform, and cover up weak performance by
  eamings management or manipulation.'””’ This
  leads to the following hypothesis:
  HI: A company’s operating performance increases
  in the extent of compliance with intemational
  best practices conceming board stmcture and
  functioning, ceteris paribus.
  3. Sample and data
  This study uses ratings of compliance with international best practices regarding board stmcture and
  functioning which are supplied by a private rating
  agency, Deminor Rating. Deminor Rating (a subsidiary of Deminor Intemational) releases, since
  March 2001, corporate govemance ratings on the
  companies of the FTSE Eurotop 300 index.’^”^ The
  ratings are based on over 300 corporate govemance
  indicators, which were identified after consulting
  ‘”De Angelo (1988), for example, reports that, during an
  election campaign, managers exercise accounting discretion to
  portray a favourable eamings picture to voters.
  As concems disclosure on corporate govemance, it is
  straightforward that mere disclosure per se cannot improve the
  operating performance of a company. However, the level of
  disclosure is highly positively correlated with the quality of the
  structure and the fiinctioning of the board: companies with wellstructured and -functioning boards have no problem in disclosing this information, while companies with badly-structured and
  -functioning boards are less transparent about this. A positive
  association between high disclosure and good operating
  performance is then probably also due to a well-structured and
  well-functioning board than to the level of disclosure per se.
  ‘^On 25 May 2005, Deminor announced that it had sold its
  corporate govemance unit Deminor Rating to Institutional
  Shareholder Services (ISS).
  ‘^ Some other studies that have used Deminor data are Bauer
  et al. (2008), Bauer et al. (2006), Wójcik (2006), Wójcik et al.
  (2005), and Bauer et al. (2004).
  institutional investors. The indicators can be divided into four categories: rights and duties of
  shareholders, range of takeover defences, disclosure
  on corporate govemance and board stmcture and
  functioning. Deminor Rating issues a rating of each
  one of the four categories. This study focuses on the
  rating regarding board stmcture and functioning.
  This rating covers indicators on the election of
  members of the company’s bodies, composition of
  the board, functioning of the board, remuneration of
  the company’s bodies and committees of the board.
  Ratings are assigned by senior analysts from the
  different European offices of Deminor after all the
  most recent publicly available information on a
  particular company (i.e. not only financial reports,
  but also articles of association, agendas, resolutions
  and minutes of ordinary and extra-ordinary general
  meetings, investor’s handbooks and newsletters,
  intemet-sites and all other publicly available information) has been benchmarked against the best
  practice found in intemationally accepted standards. Those intemationally accepted standards are
  established by, for example, the Intemational
  Corporate Govemance Network (ICGN) and the
  Organisation for Economic Co-operation and
  Development (OECD). A rating is measured on a
  scale of 5 to 1, with 5 representing the best practice
  (Deminor Rating, 2001: 9-10).
  The sample studied in this paper consists of all
  companies from the FTSE Eurotop 300 for which
  there is a Deminor rating of board structure and
  functioning for the year 2000 and/ or 2001, as well
  as complete infonnation on the other variables in
  the model.'”* I exclude financial companies (FTSE
  industry sector code 80) because their financial
  stmcture is distinct from other companies and they
  are often subject to special mies and recommendations. I delete observations with extreme observations (i.e. values outside the 5* and 95* percentile)
  for the ratios in the model, namely leverage and the
  three measures of operating performance (i.e. ROA,
  ROE and NPM), for ratios easily take on extreme
  values. The final sample exists of 201 firm-year
  observations (from 118 different companies).
  Table 1, Panels A and B give a breakdown of the
  observations by industry sector and by country,
  respectively.
  I obtain financial statement data from
  Worldscope.
  ”’The item that is most frequently missing is the Deminor
  govemance rating. This rating is missing because not all FTSE
  Eurotop 300 firms are followed by Deminor.
  Vol. 39, No. 5. 2009 501
  Table 1
  Sample description
  Panel A: Breakdown of sample by industry*
  Industry code
  4
  7
  11
  13
  15
  21
  24
  25
  26
  31
  34
  41
  43
  44
  47
  48
  49
  52
  53
  54
  58
  59
  63
  67
  72
  73
  78
  93
  97
  Industry description
  Mining
  Oil & Gas
  Chemicals
  Construction & Building Materials
  Forestry & Paper
  Aerospace
  Diversified Industrials
  Electronic & Equipment
  Engineering and Machinery
  Automobiles
  Household Goods & Textiles
  Beverages
  Food Producers & Processors
  Health
  Number of firms % Number of firm-years
  Personal Care & Household Products
  Pharmaceuticals
  Tobacco
  General Retailers
  Leisure, Entertainment & Hotels
  Media & Photography
  Support Services
  Transport
  Food & Dñig Retailers
  Telecommunication Services
  Electricity
  Gas Distribution
  Water
  Information Technology Hardware
  Software & Computer Services
  Total
  * Following the FTSE Global Classification System.
  Panel B: Breakdown of sample by country”*
  Country
  Belgium
  France
  Italy
  2
  6
  9
  6
  1
  3
  3
  7
  7
  8
  4
  2
  4
  1
  2
  4
  2
  7
  2
  9
  3
  1
  4
  6
  8
  2
  1
  2
  2
  118
  Number of firms % Number of firm-years
  3 2.54
  25 21.19
  6 5.08
  The Netherlands 8 6.78
  Portugal
  Spain
  Switzerland
  Germany
  Denmark
  Norway
  Sweden
  Finland
  Ireland
  UK
  Total
  1 0.85
  7 5.93
  7 5.93
  12 10.17
  2 1.69
  1 0.85
  8 6.78
  1 0.85
  1 0.85
  36 30.51
  tl8 100
  ** All but two countries in the sample (Switzerland
  other countries
  and Monetary
  , but the UK, Denmark and Sweden
  Union).
  6
  49
  10
  13
  1
  13
  13
  21
  3
  2
  12
  2
  2
  54
  201
  and Norway)
  are part of the
  1.69
  5.08
  7.63
  5.08
  0.85
  2.54
  2.54
  5.93
  5.93
  6.78
  3.39
  1.69
  3.39
  0.85
  1.69
  3.39
  1.69
  5.93
  1.69
  7.63
  2.54
  0.85
  3.39
  5.08
  6.78
  1.69
  0.85
  1.69
  1.69
  100
  %
  2.99
  24.38
  4.98
  6.47
  0.50
  6.47
  6.47
  10.45
  1.49
  1.00
  5.97
  1.00
  1.00
  26.87
  100
  are member of the
  Eurozone or EMU
  3
  10
  15
  11
  2
  5
  4
  12
  12
  16
  8
  4
  7
  1
  3
  8
  4
  11
  3
  15
  5
  1
  8
  8
  14
  4
  1
  3
  3
  201
  %
  1.49
  4.98
  7.46
  5.47
  1.00
  2.49
  1.99
  5.97
  5.97
  7.96
  3.98
  1.99
  3.48
  0.50
  1.49
  3.98
  1.99
  5.48
  1.49
  7.46
  2.49
  0.50
  3.98
  3.98
  6.97
  1.99
  0.50
  1.49
  1.49
  100
  European Union. All
  (i.e. Europe’s European
  502 ACCOUNTING AND BUSINESS RESEARCH
  4. Research design and model specification
  I test the relationship between the extent of
  compliance with intemational best practices conceming corporate govemance, and more specifically board structure and functioning, and the
  operating performance of large listed European
  companies by estimating the following operating
  performance model:
  Performancei, = ßo + iS|CG.COMPi,
  where:
  i, +
  (1)
  Performanceit = ROA, where: ROA is one-year
  ahead retum on assets for firm i in
  year t;
  CGCOMPLit = a rating proxying for the extent of
  compliance with intemational
  best practices regarding board
  structure and functioning for
  firm i in year t;
  = leverage, as measured by the sum
  of short-term and long-term debt
  divided by total assets, for firm i in
  year t;
  = the natural logarithm of total
  assets for firm i in year t;’^”^
  Y2001it = indicator variable which takes one
  if the observation is from 2001,
  and zero if the observation is from
  2000;
  Xjt = a vector of industry dummies, i.e.
  indicator variables for the (twodigit) industry codes of the FTSE
  Global Classification system.
  I measure the dependent variable in the operating
  performance model, i.e. one-year ahead firm-level
  operating performance, by the one-year ahead
  ROA. I use the one-year ahead, instead of the
  contemporaneous, ROA to make sure that the
  govemance systems described by the ratings are
  in place and operational at the moment that I start
  measuring operating perfonnance. Consistent with
  prior studies (e.g. Larcker et al., 2006), ROA is
  measured as operating income divided by average
  total assets.’^ For comparison, I also perform
  ‘^ Total assets are measured in thousands of Euros. Values
  initially stated in a local currency are converted to Euros by
  using the exchange rate at the balance sheet date.
  I use the natural logarithm because I do not expect a linear
  relationship between operating performance and firm size.
  “Th e average is computed as the sum of the value at the
  beginning of the accounting period and the value at the end of
  the accounting period, divided by two.
  analyses in which I replace the one-year ahead
  ROA with the one-year ahead ROE and the one-year
  ahead NPM, because the ROE and the NPM were
  used as performance measures in the study by Bauer
  et al. (2004). The ROE is measured as eamings
  before extraordinary items dividend by the average
  book value of stockholders’ equity, and net profit
  margin is the ratio of eamings before extraordinary
  items divided by sales (see, for example, Gompers
  et al., 2003). As argued by Core et al. (2006) and
  Barber and Lyon (1996), the ROA is clearly the
  preferred measure of operating performance
  because it is less affected by discretionary items
  than the ROE and the NPM. This implies that I
  expect a stronger relationship between the extent of
  compliance with intemational best practices conceming board stmcture and functioning and the
  one-year ahead ROA, than between the extent of
  compliance and the one-year ahead ROE or the oneyear ahead NPM. I will further refer to the three
  models as the ROA model, the ROE model and the
  NPM model.
  The test variable is a measure of the level of
  compliance with intemational best practices conceming corporate govemance, and more specifically best practices conceming board stmcture and
  fiinctioning (CG COMPL). CG COMPL is proxied by Deminor’s rating of board stmcture and
  functioning. The rating takes a value from 1 to 5
  with 5 indicating the highest compliance with
  intemational best practice. A positive sign on
  CG_COMPL indicates that greater compliance
  with best practices conceming board structure and
  fimctioning is related to better operating performance, and is consistent with the hypothesis. I further
  include in the regression leverage (LEV), computed
  as the sum of short-term and long-term debt over
  total assets, to control for the well-known impact of
  leverage on ROE, the natural logarithm of total
  assets (LNTA) as a measure of firm size, a year
  dummy (Y2001) to control for the impact of the
  general macro-economic context on individual firm
  performance, and a vector of industry dummies.
  5. Descriptive statistics and results
  5.1. Descriptive statistics
  Table 2, Panel A, presents descriptive statistics for
  the dependent and independent variables of the
  operating performance model. Table 2, Panel A,
  shows that the mean one-year ahead ROA is about
  6.6% (median 6.4%). The mean one-year ahead
  ROE is higher, and about 7.3% (median 10.2%).
  The mean one-year ahead NPM amounts to 2.9%
  (median 3.7%). Mean and median leverage is about
  28%.
  Vol. 39, No. 5. 2009 503
  Table 2
  Descriptive statistics and correlations^
  Panel A: Descriptive statistics
  Variable
  ROA
  ROE
  NPM
  LEV
  LNTA
  Panel B:
  201
  201
  201
  201
  201
  Mean
  0.0658
  0.0729
  0.0289
  0.2773
  16.5757
  StdDev
  0.0482
  0.1507
  0.0769
  0.1135
  1.0492
  Min.
  -0.0352
  -0.5838
  -0.4580
  0.0470
  13.7591
  Pearson correlation coefficients
  ROA
  ROE
  NPM
  CG COMPL
  LEV
  LNTA
  ROA
  1.0000
  0.5095
  0.5224
  0.1823
  -0.1993
  -0.4028
  ROE
  0.8328
  0.0271
  -0.1724
  -0.1337
  NPM
  0.0190
  -0.1640
  -0.2297
  0.0314
  0.0433
  0.0110
  0.1868
  15.8908
  Median Q3
  0.0635 0.0946
  0.1019 0.1588
  0.0365 0.0684
  0.2794 0.3642
  16.3970 17.2708
  CG COMPL LEV LNTA
  Max.
  0.1966
  0.3015
  0.1626
  0.4955
  19.1507
  1
  -0.0092 1.0000
  -0.0273 0.2066 1.0000
  * Variable definitions:
  ROA = one-year ahead return on assets for firm i in year t, and is measured as operating
  income divided by average total assets,
  ROE = one-year ahead retum on equity for firm i in year t, and is measured as eamings
  before extraordinary items divided by the average book value of stockholders’
  equity,
  NPM = one-year ahead net profit margin for firm i in year t, and is measured as eamings
  before extraordinary items divided by sales revenues
  LEV = ratio of short-term debt plus long-term debt over total assets for firm i in year t
  LNTA = natural logarithm of total assets for firm i in year t
  CG_COMPL = score fi^om 1 to 5 with higher scores indicating greater compliance of firm i in year t
  with intemational best practice conceming board stmcture and fiinctioning
  Table 2, Panel B, presents the Pearson correlation
  coefficients between the dependent and independent variables of the operating performance model.
  The dependent variables, one-year ahead ROA,
  one-year ahead ROE and one-year ahead NPM are
  all positively correlated with CG_CO]V[PL.
  However, only the correlation of ROA and
  CGCOMPL is significant. The highest absolute
  value of the correlations among the independent
  variables is 0.21, which indicates that the regression
  results are not affected by multicollinearity.
  5.2. Regression results
  I estimate the performance model using ordinary
  least squares (OLS). A concem in testing the
  relation between the extent of compliance with
  intemational best practices conceming corporate
  govemance, and more specifically board stmcture
  and fiinctioning, and the operating performance of
  large listed European companies is that firms with
  good prospects may self-select into the group with
  stronger govemance stmctures, while firms with
  poor prospects may self-select into the group with
  weaker govemance stmctures. If this is indeed tme,
  the OLS parameter estimates are inconsistent.
  However, the results of a Hausman-like test for
  endogeneity as described in Gujarati (2003: 713)
  show that CG_COMPL is not endogenous with
  respect to any of the dependent variables (p on the
  fitted value of CG_COMPL > 0.10, two-sided).
  For the endogeneity test, I used the following first
  stage model (govemance compliance model),
  which is based on prior empirical disclosure and
  govemance studies (see, for example, Pincus et al.,
  1989 and Willekens et al, 2004):
  CG_COMPLi, = 70 + y,FFLOATi, +
  (2)
  504 ACCOUNTING AND BUSINESS RESEARCH
  where: FFLOATit= the free float of firm i in year t;
  ROA_Cit = the contemporaneous retum on assets
  for firm i in year t; Yit = a vector of country
  dummies, i.e. indicator variables for the country of
  domicile of the firms in the sample; Z^ = a vector of
  other exogenous variables from the operating
  performance model (i.e. second stage regression).
  The other variables are as defined in Equation (1).
  Re-performing the endogeneity tests (1) deleting
  the contemporaneous retum on assets in the first
  stage regression, or (2) replacing the contemporaneous retum on assets with the past retum on assets in
  the first stage regression confirm that CG_COMPL
  is not endogenous with respect to any of the
  dependent variables. This contrasts with results in
  Renders and Gaeremynck (2006), and is most likely
  due to differences in research design. More specifically, to be sure that the corporate govemance
  systems are in place and operational at the moment
  that I start measuring operating performance, I use
  one-year ahead operating perfomiance measures
  (instead of contemporaneous operating performance measures).
  As there are two years of data, there are repeated
  observations on some companies. Although observations are still independent across firms, they are
  no longer independent within firms. Therefore, the
  t-values are adjusted to control for within-company
  dependence by using clustered robust standard
  errors.’*
  Table 3 reports the results of the OLS regression
  analyses. Columns 3, 5, and 7 show the results of
  models that use the one-year ahead ROA, the oneyear ahead ROE and the one-year ahead NPM as the
  dependent variable, respectively. Table 3 shows that
  the performance models have explanatory power
  (adjusted R^ of 49.30%, 23.41% and 22.11%,
  respectively). The coefficient on CG_COMPL is
  positive and significant at the 1% level (one-sided)
  in the ROA model. The magnitude of the
  CG_COMPL coefficient (0.0054) suggests a difference of 2.16% in the realised one-year ahead
  ROA between firms with the lowest and the highest
  rating of CGCOMPL (i.e. 4*0.54%). This result
  supports the hypothesis that operating performance
  is higher for firms that comply to a greater extent
  with intemational best practices conceming board
  stmcture and functioning. Consistent with the
  argument that the one-year ahead ROA is the
  preferred measure of operating performance, the
  coefficient on CG_COMPL is not significant for the
  ROE and NPM models.
  ‘^ The results are qualitatively similar when not adjusting for
  within company dependence.
  Table 3 fiirther shows that the one-year ahead
  ROA and one-year ahead NPM decrease in size
  (LNTA). In addition, the industry dummies (not
  reported) are significant predictors of all three
  performance measures.’^
  5.3. Additional analyses
  Other measures of operating performance
  To confirm the evidence from the ROA model on
  the positive and significant relation between the
  extent of compliance with intemational best practices conceming board stmcture and fiinctioning
  and operating performance, I replace the one-year
  ahead ROA in the operating performance model
  with two altemative measures of operating performance, i.e. the one-year ahead retum on cashadjusted assets and the one-year ahead retum on
  sales (ROS) (see Barber and Lyon, 1996). The
  retum on cash-adjusted assets is measured by
  dividing operating income by the average cashadjusted assets, i.e. total assets minus cash and cash
  equivalents. The ROS is operating income divided
  by sales. Table 4 reports the results of the operating
  performance regressions when using these altemative operating performance measures. Table 4 also
  reports the results of the regression when using the
  one-year ahead ROA as the dependent variable for
  comparison. Table 4 shows that the results on the
  test variable (CG COMPL) when using the alternative operating performance measures are qualitatively similar to the result when using the one-year
  ahead ROA.
  Examining the difference in results between
  performance measures
  The results in Tables 3 and 4 report a significantly
  positive relationship between the extent of compliance with intemational best practices conceming
  board stmcture and fiinctioning (CG_COMPL) and
  performance for some performance measures
  (i.e. the one-year ahead ROA, the one-year ahead
  retum on cash-adjusted assets and the one-year
  ahead ROS, all measures which use operating
  income in the numerator), but not for other
  performance measures (i.e. the one-year ahead
  ROE) and one-year ahead NPM, two measures
  which use income before exfraordinary items in the
  numerator). Especially the difference in results
  when using the ROS and the NPM is striking, since
  the only difference between these two measures is
  the numerator. (The ROS uses operating income
  ” Deleting the industry dummies from industries with only
  one observation (i.e. health, transport, and water) or all industry
  dummies does not change the results on the test variable.
  Vol. 39, No. 5. 2009 505
  Table 3
  Regression
  Variable
  results
  Pred. sign
  ROA
  Coef. estimate
  (t-statistic)
  Pred. sign
  ROE
  Coef. estimate
  (t-statistic)
  Pred. sign
  NPM
  Coef. estimate
  (t-statistic)
  Intercept
  CG COMPL
  LEV
  LNTA
  Y2001
  Industry dummies
  Adj. R-squared
  N
  Evidence of endogeneity
  +
  9
  0.4252***
  (7.14)
  0.0054***
  (2.38)
  -0.0291
  (-0.90)
  -0.0197***
  (-5.33)
  -0.0060*
  (-1.82)
  Included
  49.30%
  201
  No
  0.4511*
  (1.70)
  -0.0034
  (-0.39)
  -0.1930
  (-1.32)
  -0.0144
  (-0.88)
  -0.0258
  (-1.59)
  Included
  23.41%
  201
  No
  regression model:
  [TAj,-1-/Î4 72001 ¡,
  ?
  +
  9
  9
  ?
  ?
  + ß5
  0.4142***
  (2.87)
  -0.0023
  (-0.61)
  -0.0702
  (-1.2)
  -0.0179**
  (-2.04)
  -0.0106
  (-1.10)
  Included
  22.11%
  201
  No
  ¡^it + Si,
  ” This table reports the results of the OLS estimation of the following regression model:
  Perfotroanceu = ßo+ ^iCG_COMPL¡, -I- ftLEVj, +
  Where: PerfonTiance;, = ROA, ROE or NPM. ROA = one-year ahead retum on assets for firm i in year t,
  and is measured as operating income divided by average total assets; ROE = one-year ahead retum on
  equity for firm i in year t, and is measured as eamings before extraordinary items divided by the average
  book value of stockholders’ equity; NPM = one-year ahead net profit margin for firm i in year t, and is
  measured as eamings before extraordinary items divided by sales revenues; CG_COMPL¡, = score fi-om 1 to
  5 with higher scores indicating greater compliance of firm i in year t with intemational best practice
  conceming board stmcture and fiinctioning; LEV¡, = ratio of short-term debt plus long-term debt over total
  assets for firm i in year t; LNTAj, = natural logarithm of total assets for firm i in year t; Y2001 ¡t = year
  dummy, =1 when an observation is fi’om 2001, zero otherwise; X¡t = a vector of industry dummies based on
  the FTSE Global Classification System two-digit code for the industry sector.
  *,** and *** denote statistical significance at the 10%, 5% and 1% level respectively and is based on a onetailed test if the sign of the coefficient is in the predicted direction, and is based on a two-tailed test
  otherwise. T-values are adjusted for within-company dependence by using clustered robust standard errors.
  Results on the two-digit industry dummies are not reported for parsimony.
  whereas the NPM uses eamings before extraordinary items in the numerator. Both measures have
  sales revenues in the denominator.) This suggests
  that something that causes the difference between
  operating income and eamings before extraordinary
  items can explain why there is a significant
  relationship between performance and the extent
  of compliance with intemational best practices
  conceming board structure and functioning when
  using some performance measures, but not when
  using other performance measures. Some of the
  difference between operating income and eamings
  before extraordinary items is in interest payment
  and taxes. Moreover, given the Worldscope data
  definitions of operating income and eamings before
  extraordinary items, some of the difference between
  the two income measures stems fi’om allocations to
  and/or fi-om reserves, irom minority interests, from
  equity in eamings,^*^ and from other non-operating
  income and expenses. These other non-operating
  income and expenses include items such as: nonoperating interest income, non-operating dividend
  income, and the gain/ loss on disposal of assets, i.e.
  the income from asset disposals.
  To further explore what causes the difference in
  the relationship between corporate govemance
  ^^ This represents the ‘pretax portion of the eamings or losses
  of a subsidiary whose financial accounts are not consolidated
  with the controlling company’s accounts’ (see Thomson
  Financial, 2003).
  506 ACCOUNTING AND BUSINESS RESEARCH
  Table 4
  Regression results using alternative operating performance measures”
  ROA
  Retum on
  cash-adj. assets Return on sales
  Variable Pred. sign Coef. estimate Pred. sign Coef. estimate Pred. sign Coef. estimate
  (t-statistic) (t-statistic) (t-statistic)
  Intercept
  CG_COMPL
  LEV
  LNTA
  Y2001
  Industry dummies
  Adj. R-squared
  N
  +
  9
  0.4252***
  (7.14)
  0.0054***
  (2.38)
  -0.0291
  (-0.90)
  -0.0197***
  (-5.33)
  -0.0060*
  (-1.82)
  Included
  49.30%
  201
  +
  9
  0.4722***
  (7.11)
  0.0050**
  (2.02)
  -0.0399
  (-1.15)
  0.0220***
  (-5.42)
  -0.0056
  (-1.57)
  Included
  50.05%
  201
  0.4829***
  (4.55)
  0.0062**
  (2.09)
  0.0901*
  (1.93)
  -0.0212***
  (-3.57)
  -0.0048
  (-1.09)
  Included
  47.90%
  201
  This table reports the results of the OLS estimation of the following regression model:
  Performancei, = i^o + ;9iCG_C0MPLi, + + +
  Where: Performance;, = ROA, Retum on cash-adjusted assets or Retum on sales. ROA = one-year ahead
  retum on assets for firm i in year t, and is measured as operating income divided by average total assets;
  Retum on cash-adjusted assets = one-year ahead retum on cash-adjusted assets for firm i in year t, and is
  measured as operating income divided by average (total assets minus cash and cash equivalents); Retum on
  sales = one-year ahead retum on sales for firm i in year t, and is measured as operating income divided by
  sales revenues; CGCOMPLit = score from 1 to 5 with higher scores indicating greater compliance of firm i
  in year t with intemational best practice conceming board structure and functioning; LEVi, = ratio of shortterm debt plus long-term debt over total assets for firm i in year t; LNTAj, = natural logarithm of total assets
  for firm i in year t; Y2001i, = year dummy, =1 when an observation is fi-om 2001, zero otherwise; X;, = a
  vector of industry dummies based on the FTSE Global Classification System two-digit code for the industry
  sector.
  *,** and *** denote statistical significance at the 10%, 5% and 1% level respectively and is based on a onetailed test if the sign of the coefficient is in the predicted direction, and is based on a two-tailed test
  otherwise. T-values are adjusted for within-company dependence by using clustered robust standard errors.
  Results on the two-digit industry dummies are not reported for parsimony.
  compliance (CG_COMPL) and performance when
  using the NPM instead of the ROS as the measure of
  performance, I compute the pairwise correlations
  between each one of the identified items which
  make up the difference between operating income
  and eamings before extraordinary income (scaled
  by sales) and the measure of corporate govemance
  compliance (CGCOMPL).^’ I fiirther adjust operating income for each one of the items at a time and
  regress each one of the new income measures
  ^’ As the performance measures used in the primary analyses,
  these items and the newly computed perfonnance measures are
  on a one-year ahead basis.
  (scaled by sales) on the measure of corporate
  govemance compliance (CGCOMPL) and the
  control variables, i.e. I replace the dependent
  variable in the performance model with a new
  performance meastire.
  The results of these detailed analyses show that
  income fi-om asset disposals^^ (scaled by sales) is
  significantly negatively related to the extent of
  corporate govemance compliance (CGCOMPL)
  (correlation coefficient = -0.1869, p-value < 0.01),
  •^•^ The sample companies report a gain on disposal of assets in
  64% of the firm-years, a loss on disposal of assets in 22% of the
  firm-years, and neither a gain nor a loss on disposal of assets in
  14% of the firm-years.
  Vol. 39, No. 5. 2009 507
  and that, once operating income is adjusted for the
  income from asset disposals and this measure scaled
  by sales is used as the measure of performance
  (i.e. the ‘new ROS’), the significant relationship
  between performance and corporate govemance
  compliance (CG_COMPL), established when using
  the original ROS as the measure of performance,
  disappears. The coefficient is 0.0025, p-value >
  0.10, one-sided, when using the new ROS, compared to a coefficient = 0.0062, p-value < 0.05, onesided, when using the original ROS (see Table 4).
  Moreover, although some other items which
  make up the difference between operating income
  and eamings before extraordinary items are also
  negatively related to corporate govemance compliance, none of the adjustments to operating
  income for these items makes the relationship
  between performance and the corporate govemance compliance insignificant like the adjustment
  for the income from asset disposals does. Taken
  together, the results of the additional analyses
  suggest that the income from asset disposals plays
  a major role in the disappearance of the significant
  relationship between performance and corporate
  govemance compliance, once the NPM is used
  instead of the ROS as the measure of performance.
  Management has some discretion over the timing
  of asset sales and previous studies (Herrmann et al.,
  2003; Bartov, 1993) have shown that the timing of
  assets sales is used as an instrument to manage
  eamings. More specifically Bartov (1993) finds that
  companies use the timing of asset sales to smooth
  income, i.e. report a higher (lower) income from
  asset sales in years in which (pre-managed) income
  is lower (higher) compared to the previous year.
  Further analyses^^ indicate that this study’s sample
  companies present similar behaviour. Moreover, the
  extent of corporate govemance compliance
  (CG_COMPL) is significantly negatively correlated
  with the occurrence of a lower (pre-managed)
  income compared to the previous year (correlation coefficient = -0.2076, p-value <0.01). That
  is, poorly governed companies underperform
  more often than well-governed companies.
  Consequently, one expects that poorly govemed
  companies record a higher income from asset
  disposals than well-govemed companies. The significantly negative correlation between the income
  from asset disposals (scaled by sales) and the
  ^^ Consistent with the results of Bartov et al. (1993), the OLS
  estimation results of a regression of the income from asset
  disposals (scaled by sales) on: (1) the difference between the
  ROS and the prior period NPM; and (2) firm leverage show a
  significantly negative coefficient on the perfonnance difference.
  extent of corporate govemance compliance
  (CGCOMPL) is consistent with this expectation.
  In sum, the results indicate that companies which
  comply less with intemational best practices conceming board structure and fiinctioning try to make
  up their inherently lower performance by reporting
  a higher income from asset disposals (scaled by
  sales). The net result of this eamings management
  behaviour is that, once the income from asset
  disposals is included in the numerator of the
  performance measure, one no longer observes a
  significant relationship between operating performance and the extent to which firms comply with
  intemational best practices conceming corporate
  govemance.
  To further examine whether the income from
  asset disposals can help explain that there is a
  significant relationship between performance and
  the extent of compliance with intemational best
  practices conceming board stmcture and fiinctioning when using some performance measures but not
  others, I replace in the performance model the
  original ROA, which uses operating income in the
  numerator, by a new ROA measure which uses
  operating income adjusted for the income from
  asset disposals in the numerator. The result of
  replacing the original ROA with this new ROA
  measure is that the coefficient on CG_COMPL
  becomes insignificant. The coefficient is 0.0027, pvalue > 0.15, one-sided, when using the new ROA,
  compared to a coefficient = 0.0054, p-value <0.01,
  one-sided, when using the original ROA (see
  Table 3). This confirms the idea that the income
  from asset disposals plays a major role in explaining
  the differences in the significance ofthe relationship
  between operating performance and the extent of
  compliance with intemational best practices conceming board stmcture and fianctioning when using
  other performance measures.
  Bauer et al. (2004) suggest that lacking managerial discretion to manipulate eamings is responsible for their observation that well-govemed
  companies report lower performance (ROE and
  NPM) than poorly govemed companies, but do not
  provide evidence to support this suggestion. The
  results ofthe above analyses confirm that managerial discretion is an important factor to consider
  when examining the relationship between corporate
  govemance compliance and operating performance.
  More specifically, the results of the analyses are
  evidence: (1) that, in contrast to the finding of Bauer
  et al. (2004), well-govemed companies perform
  better than poorly govemed companies, once
  examining performance measures which are less
  prone to managerial discretion (ROA or ROS); and
  508 ACCOUNTING AND BUSINESS RESEARCH
  (2) that poorly governed companies exploit their
  discretion to manage bottom line eamings upwards
  to a level which is (relatively) similar to that of wellgoverned companies.
  Code law versus common-law countries
  Various elements of the institutional infrastructure,
  such as investor protection, differ between common-law and code-law countries. These differences were, in tum, found to be related to
  differences in, for example, the size of the capital
  markets (both equity and debt markets) (La Porta
  et al., 1997), ownership concentration (La Porta et
  al., 1998, and La Porta et al., 1999), information
  provision (see, for example. La Porta et al., 1998,
  Bail et al., 2000, Francis et al., 2003, Leuz et al.,
  2003), and the demand for auditing (Francis et al.,
  2003). I test whether the observed relation between
  the extent of compliance with intemational best
  practices regarding board structure and functioning
  and operating performance is present in both types
  of countries by estimating the operating performance model on the subsamples of the code-law and
  common-law countries separately. The commonlaw countries in the sample are the UK and
  Ireland. The code-law countries are all other
  countries in the sample. The results for the codelaw subsample (145 firm-year observations, 81
  different companies) and common-law subsample
  (56 firm-year observations, 37 different companies) (not reported) are qualitatively similar to
  the results reported in Table 3, i.e. I find a positive,
  albeit somewhat less significant, relation between
  the extent of compliance with intemational best
  practices conceming board stmcture and functioning and the one-year ahead ROA.
  5.4. Robustness checks
  The robustness of the results is tested to model
  specification. I first replace the 28 two-digit industry
  dummies, which consume a lot of degrees of
  freedom given the size of the sample, with dummies
  for broader industry classes with at least 10 firms
  per class. I formed the broader classes by using the
  one-digit classification and by redistributing the
  observations from one-digit classes with less than
  10 firms, i.e. mining, oil & gas (one-digit 0) and
  information technology (one-digit 9) to the other
  one-digit classes. The results of estimating these
  new operating performance models (not reported)
  are quahtatively similar to the results reported in
  Table 3.
  As an additional check, I replace the dependent
  variables, i.e. the performance variables, with the
  industry median adjusted values, and deleted the
  two-digit industry dummies from the operating
  performance model. The medians were computed
  per broader industry class. Results (not reported) are
  qualitatively similar to the results reported in
  Table 3.
  Next, I test whether the results are robust to
  controlling for country-level performance differences by including country dummies in the original
  operating performance model. I also estimate an
  operating performance model with inclusion of
  country dummies and replacement of the two-digit
  industry dummies by dummies for broader industry
  classes, and an operating performance model with
  inclusion of country dummies, exclusion of twodigit industry dummies and replacement of the
  dependent variables with their industry median
  adjusted values. The estimation results of all these
  altemative operating performance models show that
  the results on the test variable CGCOMPL (not
  reported) are qualitatively similar to the results
  reported in Table 3 for all three performance
  measures.
  In the primary analyses, I use one-year ahead
  instead of contemporaneous performance measures in order to make sure that the govemance
  systems described by the ratings are in place and
  operational at the moment that I start measuring
  performance. To test whether the results depend
  on this specification, I reran the operating
  performance model using contemporaneous performance measures. The results on the test
  variable are similar to the results reported in
  Table 3.
  To test whether the results are dependent on the
  measure of firm size, I replace the natural logarithm
  of total assets (LNTA) by the natural logarithm of
  market capitalisation. I explore the impact of firm
  history on the corporate govemance-operating
  performance relation by including in the regression
  model firm age or book-to-market. The results on
  the test variable are qualitatively similar to the
  results reported in Table 3.
  I further test whether the results for the operating
  performance model are not biased by correlated
  omitted corporate govemance variables. If a variable which is related to both performance and the
  extent of compliance with intemational best practices conceming board stmcture and functioning is
  omitted from the analyses, then this variable may
  actually cause the observed relation between performance and the extent of compliance with international best practices conceming board stmcture
  and functioning, and we may wrongly conclude that
  the extent of compliance with intemational best
  practice regarding board stmcture and fiinctioning
  Vol. 39, No. 5. 2009 509
  per se is related to firm performance. A correlation
  matrix (not reported) shows that the extent of
  compliance with best practices in various other
  govemance areas, such as rights and duties of
  shareholders,’^” range of takeover defences,^^ and
  disclosure on corporate govemance^^ are significantly and positively related to the firms’ compliance with best practices conceming board stmcture
  and fijnctioning. Moreover, the results of estimating
  (using OLS) the basic regressions in which the
  variable board stmcture and fiinctioning is replaced
  sequentially by, first, the Deminor rating of rights
  and duties of shareholders, next, the rating of
  takeover defences, and finally, the rating of disclosure on corporate govemance (see Table 5, Panel A)
  show that the rating of the range of takeover
  defences and the rating of disclosure on corporate
  govemance are significantly correlated with the
  ROA. Consequently, the question arises whether the
  primary results suffer fiom correlated omitted
  variables bias, for the other dimensions of govemance are clearly linked to the test variable and the
  dependent variable ROA, but not included in the
  main analyses. To address this concem I expand the
  operating performance model with the rating of
  rights and duties of shareholders and the rating of
  takeover defences, in addition to the rating of board
  stmcture and fiinctioning (i.e. the expanded operating performance model). I do not include the
  rating of disclosure of corporate govemance
  because the correlation coefficient between the
  disclosure rating and the rating of board stmcture
  and fiinctioning is high (0.7927). This high correlation does not only suggest that both ratings contain
  very similar information, but also implies that the
  results of a regression including both ratings suffer
  fiom multicollinearity, which makes interpretation
  of the coefficient estimates difficult. Table 5, Panel
  B, reports the results of the expanded operating
  performance model. These results closely parallel
  the results fiom the primary operating performance
  •^” The rating of rights and duties of shareholders covers
  indicators conceming the respect of the one-share one-vote onedividend principle, voting right restrictions, voting issues,
  shareholder proposals and voting procedures (Deminor, 2001:
  7).,^
  The rating of range of takeover defences covers indicators
  conceming the presence and strength of anti-takeover devices
  such as poison pills, golden parachutes, core shareholdings,
  extensive cross-shareholdings and co-option systems that could
  be used to protect the company from a hostile takeover and to
  disenfranchise shareholders (Deminor, 2001: 7).
  ^* The rating of disclosure on corporate govemance covers
  indicators regarding the quantity and quality of non-financial
  infomiation, such as the diversity and independence of board
  members, board committees, director remuneration, accounting
  standards, information on major shareholders of the eompany,
  and environmental information (Deminor, 2001: 7).
  model as reported in Table 3, which suggests that
  the primary results are not biased by correlated
  omitted govemance variables. More specifically,
  the rating of board stmcture and fiinctioning
  remains positive and significant in the ROA
  model, while it remains insignificant in the ROE
  and NPM models. The results on the other two
  ratings, i.e. rights and duties of shareholder and
  range of takeover defences, parallel the results of
  the regressions in which each rating was included
  separately as reported in Table 5, Panel A.
  By excluding the rating of disclosure on corporate govemance in the expanded operating^ performance model there is still a possibility that the results
  in Table 3 and Table 5, Panel B are biased because
  of correlated omitted variables. In order to fiirther
  address this concem, I also performed a principal
  component factor analysis^^ on the four different
  ratings disclosed by Deminor, i.e. the rating of
  board stmcture and fiinctioning, the rating of rights
  and duties of shareholders, the rating of takeover
  defences and the rating of disclosure on corporate
  govemance. The solution is rotated using an
  orthogonal VARIMAX rotation. This analysis
  shows that the four ratings can be summarised in
  two underlying factors. (All factors with an
  eigenvalue greater than unity are retained.) As
  expected, the rating of board stmcture and fiinctioning and the rating of disclosure on corporate
  govemance load on factor 1. This confirms that both
  ratings contain very similar infonnation. The rating
  of rights and duties of shareholders and the rating of
  takeover defences load on factor 2. The conesponding factors scores were computed (using the
  regression method) and the two factors scores were
  then introduced together in the basic regression
  (i.e. Regression (2)) for CG_COMPL. Table 5,
  Panel C, reports the results of these tests. As
  concems the one-year ahead ROA, the results show
  that factor 1, but not factor 2, is positively and
  significantly correlated with this performance measure (p<0.01). As concems the one-year ahead ROE
  and the one-year ahead NPM, the results show that
  neither factor 1 nor factor 2 are significantly
  correlated with these performance measures. The
  results on the factor scores confirm the results
  reported in Table 3 and Table 5, Panels A and B.
  hi order to fiirther investigate the overall impact
  of firms’ govemance stmctures, I estimate an
  operating performance regression in which I replace
  the rating of board stmcture and fiinctioning by a
  total rating (i.e. a total across the different govem-
  ^’Results are qualitatively similar when using a principal
  factor method.
  510 ACCOUNTING AND BUSINESS RESEARCH
  Tahle 5
  Additional regression results”
  Panel A: OLS coefficient estimates
  one at a time
  Board structure and functioning
  Rights and duties of shareholders
  Range of takeover defences
  Disclosure on corporate govemance
  Panel B: OLS coefficient estimates
  Board structure and functioning
  Rights and duties of shareholders
  Range of takeover defences
  Other regressors
  Adj. R-squared
  N
  Panel C: OLS coefficient estimates
  Factor 1
  Factor 2
  Other regressors
  Adj. R-squared
  N
  Panel D: OLS coefficient estimates
  Total rating
  Adj. R-squared
  N
  (and t-statistics) on the
  ROA
  0.0054***
  (2.38)
  -0.0016
  (-0.55)
  0.0054**
  (2.16)
  0.0056**
  (2.27)
  different governance
  ROE
  -0.0034
  (-0.39)
  0.0224*
  (1.67)
  0.0012
  (0.16)
  -0.0097
  (-1.18)
  (and t-statistics) on ratings included together
  ROA
  0.0046**
  (2.27)
  -0.0066**
  (-2.04)
  0.0060**
  (2.20)
  Included
  51.56%
  201
  ROE
  -0.0073
  (-0.80)
  0.0280**
  (2.00)
  -0.0052
  (-0.64)
  Included
  25.54%
  201
  (and t-statistic) for factor scores
  ROA
  0.0094***
  (2.69)
  0.0008
  (0.25)
  Included
  49.82%
  201
  ROE
  -0.0178
  (-1.42)
  0.0238
  (1.63)
  Included
  25.46%
  201
  (and t-statistic) for overall governance rating
  ROA
  0.0018**
  (2.03)
  49.12%
  201
  ROE
  -0.0002
  (-0.06)
  23.32%
  201
  ratings, included each
  NPM
  -0.0023
  (-0.61)
  0.0086
  (1.42)
  0.0007
  (0.20)
  -0.0043
  (-1.09)
  in one model
  NPM
  -0.0041
  (-0.98)
  0.0107
  (1.56)
  -0.0013
  (-0.30)
  Included
  22.96%
  201
  NPM
  -0.0082
  (-1.47)
  0.0097
  (1.58)
  Included
  23.33%
  201
  NPM
  -0.0004
  (-0.29)
  21.99%
  201
  * This table reports the results of the OLS estimation of the following regression model:
  Performancei, = ^o + ^iCG_COMPLi, + i?2LEVit -f ftLNTAu + jß4y200
  Where: Performance!, = ROA, ROE or NPM. ROA = one-yea
  and is measured as operating income divided by average total
  r ahead retum on assets
  li, + ^5A’i,+ ei,
  for firm i in year t,
  assets; ROE = one-year ahead retum on
  Vol. 39, No. 5. 2009 511
  Table 5
  Additional regression results {continued)
  equity for firm i in year t, and is measured as eamings before extraordinary items divided by the average
  book value of stockholders’ equity; NPM = one-year ahead net profit margin for firm i in year t, and is
  measured as eamings before extraordinary items divided by sales revenues; CG_COMPLi, = score JTom 1 to
  5 with higher scores indicating greater compliance of firm i in year t with intemational best practice
  conceming board structure and functioning; LEV;, = ratio of short-term debt plus long-term debt over total
  assets for firm i in year t; LNTAi, = natural logarithm of total assets for firm i in year t; Y2001i, = year
  dummy, =1 when an observation is fi-om 2001, zero otherwise; X¡, = a vector of industry dummies based on
  the FTSE Global Classification System two-digit code for the industry sector.
  Panel A reports the results on CG_COMPL in four different regressions. The four regressions differ in the
  measure used for CGCOMPL. In the first regression, CG COMPL equals the Deminor rating of board
  stmcture and fiinctioning (cf the model and the results reported in Table 3). In the second regression,
  CG_COMPL is the Deminor rating of rights and duties of shareholders. In the third regression,
  CG_COMPL is the Deminor rating of range of takeover defences. And in the fourth regression,
  CG_COMPL is the Deminor rating of disclosure on corporate govemance. Panel B reports the results on
  CG_COMPL of a regression in which CG_COMPL is measured by including three separate Deminor
  ratings (i.e. rating of board stmcture and fiinctioning, rating of rights and duties of shareholders and the
  rating of takeover defences) together in one regression. Panel C reports the results of a performance
  regression in which CG_COMPL is replaced by two factor scores. These two factors scores are obtained
  (using the regression method) fi-om a principal component factor analysis (using an orthogonal VARIMAX
  rotation) on the four sub-ratings disclosed by Deminor. The rating of board stmcture and fiinctioning and the
  rating of disclosure on corporate govemance load on factor 1. The rating of rights and duties of shareholders
  and the rating of takeover defences load on factor 2. Panel D reports the results on CG_COMPL in a
  regression in which CG_COMPL is measured by the total govemance rating as reported by Deminor. The
  total govemance rating summarises firms’ performance in the various govemance dimensions covered by
  Deminor.
  *,** and *** denote statistical significance at the 10%, 5% and 1% level respectively and is based on a onetailed test if the sign of the coefficient is in the predicted direction, and is based on a two-tailed test
  otherwise. T-values are adjusted for within-company dependence by using clustered robust standard errors.
  Results on the two-digit industry dummies are not reported for parsimony.
  anee dimensions) as disclosed by Deminor. The and the operating performance of large listed
  estimation results for that model are included in European companies. Although theory suggests
  Table 5, Panel D. These results show that the total that greater compliance with intemational best
  rating is significantly and positively related with the practices conceming board structtire and fiinctionone-year ahead ROA, but is not significantly related ing is positively related with operating performwith the one-year ahead ROE nor with the one-year anee, a prior European study (Bauer et al., 2004)
  ahead NPM. reports evidence of a negative association between
  Note that, notwithstanding that the performance corporate govemance compliance and corporate
  model was carefiilly constmcted based on theory performance. I have re-examined the relation
  and prior empirical evidence, and that the above between corporate govemance compliance and
  tests indicate that the results ofour primary analysis operating performance in a setting where there
  are robust to correlated omitted govemance vari- remained considerable diversity in the extent of
  ables, one can never exclude that there exists an compliance with intemational best practices regardunknown correlated factor which is omitted from ing corporate govemance. Consistent with expectthe analyses and actually causes the relationship ations, results of univariate and multivariate tests
  between perfonnance and the extent of compliance show that greater compliance with intemational best
  with intemational best practices conceming board practices conceming board stmcture and fiinctionstmcture and functioning. ing is significantly and positively correlated with
  the one-year ahead ROA. The results are robust to
  6. Conclusion controlling for firms’ compliance with best practices
  This paper has examined the relation between the in other govemance areas, such as rights and duties
  extent of compliance with intemational best prac- of shareholders and range of takeover defences, and
  tices conceming board stmcture and ñinctioning to controlling for country-level performance.
  512 ACCOUNTING AND BUSINESS RESEARCH
  Results of additional tests show that greater compliance with intemational best practices in other
  govemance dimensions, namely disclosure of corporate govemance and range of takeover defences,
  is significantly and positively correlated with the
  one-year ahead ROA.
  Further tests show that greater compliance with
  intemational best practices conceming board structure and functioning is significantly associated with
  reporting less income from asset disposals and that
  studying a performance measure that includes this
  item, as Bauer et al. (2004) do, obscures the
  inherently positive relationship between operating
  performance and the extent of compliance with
  intemational best practices regarding board stmcture and functioning. The measure of operating
  performance is thus crucial when examining firmlevel operating performance.
  Although the results show only correlation
  between one-year ahead operating perfonnance
  and the extent of compliance with intemational
  corporate govemance best practices, and do not
  prove causation, the results suggest that firms may
  benefit from complying with intemational corporate
  govemance best practices, which may help to
  convince companies to adopt good govemance
  practices. In addition, the results ofthe investigation
  may support regulators in motivating and defending
  their corporate govemance decisions, and may
  prove useful for investors when assessing and
  evaluating company perfonnance. One has to bear
  in mind, however, that not all individual govemance
  characteristics identified by the independent rating
  agency as being best practices can unequivocally be
  classified as such. Also, as with most other
  govemance studies, tests were performed on a set
  of large listed non-financial companies. Therefore,
  the results do not necessarily hold in a sample of
  smaller companies, privately-held companies, or
  financial companies. An examination ofthe impact
  of govemance on the operating perfonnance of
  smaller companies, privately-held companies, or
  financial companies is then also an interesting
  avenue for fiiture research.
  References
  Alves, C. and Mendes, V. (2004). ‘Corporate govemance
  policy and company performance: the Portuguese case’.
  Corporate Govemance: An International Review, 12(3):
  290-301.
  Ball, R., Kothari, S. P. and Robin, A. (2000). ‘The effect of
  intemational institutional factors on properties of accounting eamings’. Joumal of Accounting and Economics,
  29(1): 1-51.
  Barber, B. M. and Lyon, J. D. (1996). ‘Detecting abnormal
  operating perfonnance: the empirical power and specification of test statistics’. Journal of Financial Economics,
  41(3): 359-399.
  Bartov, E. (1993). ‘The timing of asset sales and eamings
  manipulation.’ The Accounting Review, 68(4): 840-855.
  Bauer, R., Braun, R. and Clark, G. L. (2008). ‘The emerging
  market for European corporate govemance: the relationship between govemance and capital expenditure, 1997-
  2005’. Joumal of Economic Geography, 8(4): 441^69.
  Bauer, R., Clark, G. L. and Wójcik, D. (2006).
  ‘Geographically dispersed ownership and inter-market
  stock price arbitrage – Ahold’s crisis of corporate govemance and its implications for global standards’. Journal of
  Economic Geography, 6(3): 303-322.
  Bauer, R., Giinster, N. and Otten, R. (2004). ‘Empirical
  evidence on corporate govemance in Europe: the effect on
  stock retums, firm value and performance’. Joumal of
  Asset Management, 5(2): 91-104.
  Bebchuk, L., Cohen, A. and Ferrell, A. (2004). ‘What
  matters in corporate govemance?’ Olin Paper No. 491,
  Harvard Law School.
  Beiner, S., Drobetz, W, Schmid, M. M. and Zimmermann,
  H. (2006). ‘An integrated framework of corporate governance and firm valuation’. European Financial
  Management, 12(2): 249-283.
  Bhagat, S. and Black, B. (2002). ‘The non-correlation
  between board independence and long-term firm performance’. Journal of Corporate Law, 27(2): 231-273.
  Black, B. S., Jang, H. and Kim, W. (2006). ‘Does corporate
  govemance predict firms’ market values? Evidence fi-om
  Korea’. Journal of Law, Economics, and Organization, 22
  (2): 366-413.
  Brown, L. D. and Caylor, M. L. (2006a). ‘Corporate
  govemance and firm valuation’. Journal of Accounting
  and Public Policy, 25(4): 409-434.
  Brown, L. D. and Caylor, M. L. (2006b). ‘Corporate
  govemance and firm operating performance’. Working
  paper, Georgia State University and University of South
  Carolina.
  Core, J. E., Guay, W. R. and Rusticus, T. (2006). ‘Does weak
  govemance cause weak stock retums? An examination of
  firm operating performance and investors’ expectations’.
  Joumal of Finance, 61(2): 655-687.
  De Angelo, L.E. (1988). ‘Managerial competition, information costs and corporate govemance: the use of accounting
  performance measures in proxy contests. Joumal of
  Accounting and Economics, 10: 3-36.
  Deminor Rating (2001). Corporate Govemance Rating
  Service Europe, http://www.deminor.com (22pp.).
  Drobetz W, Schillhofer, A. and Zimmermann, H. (2004).
  ‘Corporate govemance and expected stock retums: evidence fi-om Germany’. European Financial Management,
  10(2): 267-293.
  Dumev, A. and Kim, E. H. (2005). ‘To steal or not to steal:
  firm attributes, legal environment, and valuation’. Journal
  of Finance, 60(3): 1461-1493.
  Francis, J. R., Khurana, I. K. and Pereira, R. (2003). ‘The
  role of accounting and auditing in corporate govemance
  and the development of financial markets around the
  world’. Asia-Pacific Joumal of Accounting and
  Economics, 10: 1—30.
  Gujarati, D. (2003). Basic Econometrics. Intemational
  Edition. McGraw-Hill Companies, Inc.
  Gompers, P., Ishii, J. and Metrick, A. (2003). ‘Corporate
  govemance and equity prices’. Quarterly Joumal of
  Economics, 118(1): 107-155.
  Vol. 39, No. 5. 2009
  513
  Herrmann, D., Inoue, T. and Thomas, W. B. (2003). ‘The
  sale of assets to manage eamings in Japan’. Journal of
  Accounting Research, 41(1): 89-108.
  Jensen, M. C. (1993). “The modem industrial revolution,
  exit, and failure of intemal control systems’. Journal of
  Fma/îce, 48(3): 831-880.
  Kiel, G.C. and Nicholson, G. J. (2003). ‘Board composition
  and corporate performance: how the Australian experience
  informs contrasting theories of corporate govemance’.
  Corporate Govemance: An Intemational Review, 11(3):
  189-205.
  Klapper, L. F. and Love, I. (2004). ‘Corporate govemance,
  investor protection and performance in emerging markets’.
  Joumal of Corporate Einance, 10(5): 703-728.
  Klein, A. (1998). ‘Firm perfomiance and board committee
  structure’. Joumal of Law and Economics, 41: 275-303.
  La Porta, R., Lopez-de-Silanes, F., Shleifer, A. and Vishny,
  R. (1997). ‘Legal determinants of extemal finance’.
  Joumal of Einance, 52(3): 1131-1150.
  La Porta, R., Lopez-de-Silanes, F., Shleifer, A. and Vishny,
  R. (1998). ‘Law and finance’. Journal of Political
  Economy, 106(6): 1113-1155.
  La Porta, R., Lopez-de-Silanes, F. and Shleifer, A. (1999).
  ‘Corporate ownership around the world’. Joumal of
  Einance, 54(2): 411-5\7.
  Larcker, D.F., Richardson, S. A. and Tuna, I. (2005).
  ‘Ratings add fire to the govemance debate’. Financial
  Times Mastering Corporate Governance Part Two.
  Larcker, D.F., Richardson, S. A. and Tuna, 1. (2006).
  Corporate govemance, accounting outcomes, and organizational performance. Working paper. Graduate School of
  Business Stanford University and The Wharton School,
  University of Pennsylvania.
  Leuz, C, Nanda, D. J. and Wysocki, P. D. (2003). ‘Earnings
  management and investor protection: an intemational
  comparison’. Journal of Einancial Economics, 69(3):
  505-527.
  Massa, M., and Simonov, A. (2007). Shareholder homogeneity and firm value: the disciplining role of noncontrolling shareholders. Working paper
  Pincus, K., Rusbarsky, M. and Wong, J. (1989). ‘Voluntary
  formation of corporate audit committees among NASDAQ
  ñrms’. Joumal of Accounting and Public Policy, 8(4): 239-
  265.
  Renders, A., and Gaeremynck, A. (2006). ‘Corporate
  govemance and performance: controlling for sample
  selection bias and endogeneity’. FETEW Research Report
  AFI06-06, KU.Leuven, 35pp.
  Sonnenfeld, J. (2004). Good govemance and the misleading
  myths of bad metrics. Academy of Management Executive,
  18(1): 108-113.
  Thomson Financial (2003). Worldscope Data Definitions
  Guide.
  Weil, Gotshal and Manges LLP (2002). ‘Comparative matrix
  of corporate govemance codes relevant to the european
  union and its member states’, http://ec.europa.eu.int/comm/
  internal market/company/docs/corpgov/corp-gov-codes- •
  rpt-part3_en.pdf, 379pp.
  Willekens, M., Vander Bauwhede, H. and Gaeremynck, A.
  (2004). ‘Voluntary audit committee formation and practices
  among Belgian listed firms’. Intemational Joumal of
  Auditing 8(3): 207-222.
  Wójcik, D., Clark, G. L. and Bauer, R. (2005). ‘Corporate
  govemance and cross-listing: evidence from European
  companies’. Working paper.
  Wójcik, D. (2006). ‘Convergence in corporate govemance:
  evidence from Europe and the challenge for economic
  geography. Joumal of Economic Geography, 6(5): 639-
  660.
  Yermack, D. (1996). ‘Higher market valuation of companies
  with a small board of directors’. Joumal of Einancial
  Economics, 40(2): 185-211.
  Copyright of Accounting & Business Research is the property of Croner.CCH Group Limited and its content
  may not be copied or emailed to multiple sites or posted to a listserv without the copyright holder’s express
  written permission. However, users may print, download, or email articles for individual use.