Proceedings of World Business and Economics Research Conference
24 - 25 February, 2014, Rendezvous Hotel, Auckland, New Zealand, ISBN: 978-1-922069-45-0
Disclosure of Corporate Governance Structure and
Financial Vulnerability
Roshayani Arshad*, Wan Ainul Asyiqin W M Razali** and
Noorbijan Abu Bakar***
The purpose of this study is to examine whether the monitoring effectiveness
of corporate governance structure has increased with positive impact on firm
performance. Corporate governance structures examined are independent
non-executive directors, audit committee and internal audit. Firm
performance is based on an integration of Beneish M-score and Z-score
model. These models allow an examination on the ability of the company to
meet its profit maximisation objective as well as safeguarding the integrity of
its financial reporting. Based on annual reports of 227 public listed
companies for the financial periods 2010 and 2011, this study finds that
independent non-executive directors and audit committee are effective
monitors with positive impact on performance. However, there is no
significant relationship between internal audit function and performance.
Nevertheless, these findings provide useful insights to regulatory authorities
and other stakeholders that the corporate governance practices in Malaysia
are more align with international best practices.
JEL Codes: M 40 Accounting
1. Introduction
Following high-profile financial scandals around the world, various initiatives have been
undertaken by regulatory authorities to improve corporate governance practices. In
enhancing the effectiveness of these initiatives, companies in many jurisdictions around
the world are also required to disclose their corporate governance structures in their
annual reports (Chang and Sun, 2010). Recent study by Arping and Sautner (2010) find
that companies become more transparent with regards to their corporate governance
disclosure after the implementation to improve corporate governance practices. Lim et al.
(2007) also provide evidence that boards composed of largely independent non-executive
directors are associated with higher extent of voluntary disclosure following corporate
governance initiative in the US to enhance board independence. These evidences imply
that there is a link between effective corporate governance structure and corporate
disclosure. Past studies (e.g. Htay, 2012; Mohamad and Sulong, 2010; Rouf, 2010) find
mixed results in the relation between corporate governance structure and the extent of
corporate disclosures in annual reports. Chang and Sun (2010) argue that the mixed
findings can be attributed to non-mandatory disclosure requirements of corporate
governance structures. In support of this argument, they provide evidence that mandated
*Associate Professor Dr. Roshayani Arshad, Accounting Research Institute, Universiti Teknologi Mara,
Malaysia. Email : roshayani@salam.uitm.edu.my
**Wan Ainul Asyiqin bt Wan Mohd Razali, Accounting Research Institute, Universiti Teknologi Mara,
Malaysia. Email : wan_asyiqin@yahoo.com
***Associate Professor Noorbijan Abu Bakar, Faculty of Accountancy, Universiti Teknologi Mara, Malaysia.
Email : noorbi374@salam.uitm.edu.my
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Proceedings of World Business and Economics Research Conference
24 - 25 February, 2014, Rendezvous Hotel, Auckland, New Zealand, ISBN: 978-1-922069-45-0
disclosure of corporate governance mechanisms improves the credibility of accounting
earnings.
The increasing calls for more transparent corporate governance structures by regulatory
authorities around the world in their efforts to restore investors‟ confidence are expected to
improve the quality of corporate reporting. The strengthened link between financial
reporting and corporate governance mechanisms highlighted the potential usefulness of
the information reported as a useful screening mechanism that can facilitate monitoring
effectiveness by board members as well as oversight roles of the auditors. While
improved disclosure is expected to benefits the investors and other stakeholders,
companies operating in disclosure environment where there are higher resistance by
management for more disclosure, management may have incentives to disclose less
accurate information (Hermalin and Weisbach, 2010). This can reduce the quality of
information reported. On the other hand, Qu et al. (2013) argue that even for companies
operating in less regulated disclosure environment may have incentives to disclose more
comprehensive disclosure in order to meet the demands of their various stakeholders.
Failure to do so can result in withdrawal of support by various stakeholders and in turn
reduces the companies‟ survivability. This raises the issue with regards to the positive
impact on the quality of reporting as a result of corporate governance reform for
companies operating in different institutional environment. Hence, this study aims to
examine whether the quality of reporting has improved following corporate governance
reform in Malaysia. Companies in Malaysia are characterised by concentrated ownership
structure and have lower tendency to disclose more comprehensive information in their
annual reports (e.g. Rouf and Abdullah-Al Harun, 2011; Barros, Boubaker and Hamrouni,
2013). The positive impact of the corporate governance reform is examined based on the
monitoring effectiveness as measured by the relationship between disclosure of corporate
governance structure and the extent of financial vulnerability for public listed companies in
Malaysia. This study proposes that the information role of accounting information to
increase and concurrently provide useful information on firm performance to board
members and auditors in monitoring managerial actions. Findings from this study are
expected to provide some insight into the impact of corporate governance reform on
transparency and the extent of corporate governance convergence in Malaysia with
international best practices.
This paper will proceed with the review of past literature from which hypotheses will be
developed. The paper will then proceed to the empirical stage of variable measurement,
sampling, data analysis and discussion of results. The final part of this paper presents
conclusion, limitations and suggestions for future research.
2. Literature Review and Hypotheses Generation
2.1 Agency theory, Corporate Governance Structure and Firm Performance
A large body of agency literature has examined various corporate governance structures
as a tool to align the interests of the shareholders and the managers (e.g Maher and
Andersson, 1999; Dahya and McConnell, 2005, Shivdasani and Zenner, 1997). In relation
to the relationship between firm performance and various corporate governance
structures, the literature provides mixed evidence (e.g. Yermack, 1996; Dalton, Daily,
Johnson and Ellstrand, 1999). The inconsistent impact of corporate governance on
performance has been argued to be associated with institutional context (O‟Connell and
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Proceedings of World Business and Economics Research Conference
24 - 25 February, 2014, Rendezvous Hotel, Auckland, New Zealand, ISBN: 978-1-922069-45-0
Cramer, 2010). Hence, this study aims to provide valuable incremental insights into this
relationship by examining the relationship based on samples of companies operating in
Malaysia. Corporate governance structures examined in this study are independent nonexecutive directors, audit committee and internal audit.
2.1.2 Independent non-executive directors and firm performance
The agency theory perspective is among the most recognised in research on the
contribution of boards (Zahra and Pearce, 1989). Under the agency theory perspective,
separation of ownership and decision control in corporations gives rise to conflicts of
interests between managers and outside investors (Fama, 1980; Fama and Jensen,
1983). Given the potential self-serving incentives of top management, Fama and Jensen
(1983) argue that the highest internal control mechanism responsible for monitoring the
actions of top management in a company is board of directors. Further, they argue that in
increasing the board monitoring effectiveness, an optimal board should include a mix of
inside and outside directors. In line with this argument, corporate governance reforms
around the world have focused on the optimal ratio of independent non-executive directors
on board.
Consistent with the agency theory perspective, prior literature provides substantial
empirical evidence that independent non-executive directors play important monitoring
role (Bhagat and Black, 1999; Brickley, Coles and Terry, 1994; Cotter, Shivdasani and
Zenner, 1997; Dahya and McConnell, 2005; Hermalin and Weisbach, 1998). In contrast to
these supportive evidence on the monitoring role of independent non-executive directors,
several studies on firm value fails to confirm positive association between independent
non-executive directors and companies‟ performance (Agrawal and Knoeber, 1996;
Bhagat and Black, 1999; Erickson, Park, Reising and Shin, 2004; Hermalin and
Weisbach, 1991; Klein, Shapiro and Young, 2005; Vafeas and Theodorou, 1998). These
studies offer various explanations that potentially contribute to the ineffective monitoring
by independent non-executive directors. For example, Hermalin and Weisbach (1991)
argue that while independent non-executive directors provide monitoring roles of
management, inside directors‟ knowledge of the company provide valuable assistance to
the CEO in maximizing the value of the company. As such, when companies are equally
weighted between insiders and outsiders, they suggest that it is difficult to find a crosssectional relation between board composition and performance. Vafeas and Theodorou
(1998) also highlighted that the lower impact of independent non-executive directors in the
U.K are possibly associated with lower proportion of these board members on the board.
Effective monitoring through higher proportion of independent non-executive directors is
also provided by empirical evidence in the context of financial statement fraud. Prior
literature (Beasley, 1996; Beasley et al., 2000; Sharma, 2004; Dechow et al., 1996; Klein,
2002; Xie, Davidson and DaDalt, 2003). Dechow et al. (1996) argue that higher
representation of independent non-executive directors on board is expected to increase
monitoring of management financial reporting process and reduces the likelihood of
financial statement fraud. In addition to optimal ratio of independent non-executive
directors on board, effective monitoring by independent non-executive directors is
expected because they have incentives to maintain or enhance their reputations as
experts in decision control (Fama and Jensen, 1983). Consistent with this argument,
several studies provide evidence that independent non-executive directors‟ appointment
on board is associated with stock market reaction, indicating that investors value the
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Proceedings of World Business and Economics Research Conference
24 - 25 February, 2014, Rendezvous Hotel, Auckland, New Zealand, ISBN: 978-1-922069-45-0
potential benefits of independent non-executive directors‟ appointments (Lee, Rosenstein,
and Wyatt, 1999; Lin, Pope and Young, 2003; Rosenstein and Wyatt, 1990). Similar
evidence on market response to board expertise is also provided by Lee et al. (1999).
They examine the relation between the appointment of independent non-executive
directors with financial expertise and share price reactions. Their results also show that
the appointment of independent non-executive directors with financial expertise is
associated with positive abnormal stock returns. Taken together, the overall empirical
evidence in relation to market response to announcement of independent non-executive
directors‟ appointment suggests that shareholders value the appointment of independent
non-executive directors on boards. Based on this argument, effective monitoring by
independent non-executive directors can be enhanced through optimal representation on
board as well as their expertise. Hence, the following hypothesis is formulated:
H1: Effective independent non-executive directors are significantly positively related to
performance.
2.1.3 Audit committee and firm performance
An audit committee has been established as having a very important role in enhancing
monitoring effectiveness within the corporate governance structure (e.g. Alves, 2011;
Beasley et al., 2009; Carcello and Neal, 2000). In strengthening the monitoring
effectiveness of audit committee, past literatures provide evidence that such committee
are represented with higher proportion of independent non-executive directors (e.g. Dyck,
Morse and Zingales, 2007; Law, 2011; Mohiuddin and Karbhari, 2010; Xie et al., 2003).
Alves (2011) finds no relationship between the existence of audit committee and earnings
management based on sample of companies in Portugal, suggesting that mere existence
of audit committee does not improve their monitoring role. In line with this, past empirical
studies provide evidence that audit committee with higher representation of independent
non-executive directors on board are associated with more credible financial information,
preventing unauthorized earning management in the firm and enhancing firms‟
performance.
In the context of financial information, an audit committee monitors the quality of the
information by ensuring that it is analysed by independent, competent and qualified
external auditors. In other words, audit committee act as a liaison between the external
auditor and the board in ensuring the quality and integrity of financial information. As such,
audit committee members should possess related experience and expertise in financial
reporting. Past studies (e.g. Hashim and Abdul Rahman, 2011; Mohiuddin and Karbhari,
2010; Beasley et al., 2009; Fisher, Banks, Campbell, Delahunty, Hobss, Robinson,
Wallace and Wright, 2010) find significant positive relationships between audit committee
expertise and monitoring of financial reporting. In addition to audit committee
independence and expertise, past literature also highlighted the importance of diligence in
enhancing audit committee monitoring effectiveness (Huang and Thiruvadi, 2010).
However, these literatures provide inconclusive results. It is possible that the difficulty in
measuring diligence contribute to the low impact of audit committee diligence on
monitoring effectiveness. Nevertheless, this should be taken into consideration in
enhancing audit committee effectiveness. Following this reasoning, it is expected that
audit committee effectiveness is associated with monitoring the quality and integrity of
financial information. This in turn is expected to enhance firm performance. Based on this
argument, the following hypothesis is formulated:
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Proceedings of World Business and Economics Research Conference
24 - 25 February, 2014, Rendezvous Hotel, Auckland, New Zealand, ISBN: 978-1-922069-45-0
H2: Effective audit committee is significantly positively related to performance.
2.1.4 Internal audit effectiveness and firm performance
Demand for heightened accountability following various corporate governance reforms in
response to financial scandals around the world has increased the role of internal auditors
within the corporate governance structure in ensuring the quality of financial reporting
(Soh and Martinov-Bennie, 2011). The monitoring effectiveness of board members and
audit committee are to a certain extent facilitated by the validation of the effectiveness of
control processes and the reliability of financial reporting by the internal auditors.
In ensuring the integrity of financial reporting, Alleyne and Howard (2005) argue that
effective internal audit is more likely to detect fraudulent financial activities. In line with
this, Gramling and Myers (2003) provide evidence that an effective internal audit function
can provide advance notice of fraud risk and consequently helps to detect and prevent
fraudulent financial reporting while Law (2011) finds that internal audit effectiveness are
associated with no fraud occurrence. Overall, internal audit effectiveness is an integral
component of the corporate governance structures in ensuring effective monitoring by the
board, accountability and firm performance. Based on this argument, this study
hypothesised that:
H3: Effective internal audit is significantly positively related to performance.
3. Methodology
3.1 Sample and Data Collection
The sample was drawn from non-financial companies listed on the main Board of Bursa
Malaysia for the financial year 2010 and 2011. The companies are selected from eight
industries, namely construction, consumer product, industrial product, IPC, plantation,
properties, technology and also trading. The finance companies were excluded due to
different regulatory requirements and also material difference in their types of operations
(e.g. Eng and Mak, 2003; Gray et al., 1995). In addition, companies were also dropped
from the sample due to missing data related to the variables of interests in this study. The
final sample consists of 227 companies for 2010 and 2011 respectively
3.2 Measurement of Variables
3.2.1 Independent Variables
The independent variables in this study are based on self-constructed corporate
governance index. The first step in developing the index is to identify the items to be
included under effective non-executive directors, effective audit committee and effective
internal audit. These items are identified based on the current corporate governance
requirements and past literatures. In Malaysia, the Malaysian Code on Corporate
Governance (MCCG) was issued in 2001 as an integral part of the Bursa Malaysia Listing
Rules. It requires all listed companies to disclose the extent of compliance with the MCCG
(Wahab, How and Verhoeven, 2008). As at 1 October 2007, some parts in the MCCG
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Proceedings of World Business and Economics Research Conference
24 - 25 February, 2014, Rendezvous Hotel, Auckland, New Zealand, ISBN: 978-1-922069-45-0
were revised to improve effective corporate governance practices, as well as to be in line
with international best practices. The key amendments to the code were aimed at
strengthening the roles and responsibilities of board of directors and audit committees.
The extent of effectiveness is measured by comparing the contents of each annual report
to the items in the corporate governance index and coded as “1” if the item is disclosed,
“2” if the item disclosed is not in compliance with the MCCG requirements and “3” if the
item is not disclosed. For each company, the overall extent of effectiveness is calculated
as a ratio of the score awarded to the company divided by the maximum potential score
awarded to that company. In addition to the independent variables, this study includes
size of an organisation, and leverage as control variables. These variables have been
identified in prior research as determinants of firm performance in the corporate
governance literature (e.g. Pervan and Višić, 2012).
The definitions and measurements of variables used in this study are listed in Table 1.
Variable
Acronym
FV
INED_EFF
AC_EFF
IA_EFF
SIZE
LEV
Table 1: Definition and Measurement of Variables
Definition
Measurement
 Integration of Beneish M-score for detection
of fraudulent financial reporting (1999) and Zscore bankruptcy prediction model (1968).
Effective
independent  Self-constructed
corporate
governance
non-executive directors
index
Effective audit committee  Self-constructed
corporate
governance
index
Effective internal audit
 Self-constructed
corporate
governance
index
Size of an organisation
 Logarithm of the market value of equity
Leverage
 Total debt / the total assets
Financial Vulnerability
3.2.2 Firm Perfomance
In complex and uncertain business environments, companies with better risk management
are potentially more competitive and able to enhance their performance (Ghazali, 2010;
Nocco and Stulz, 2006; Rahim, Yaacob, Alias and Nor, 2010). From an agency
perspective, it can be argued that companies with effective monitoring mechanisms are
more likely to increase monitoring of management financial reporting process and improve
detection of financial vulnerability as part of good risk management. Daily, Dalton and
Cannella (2003) find that financially distressed companies with independent boards have
a lower incidence of bankruptcy filings. Liou and Yang (2008) and Spathis (2002) argued
that companies experiencing financial difficulties are more likely to be associated with
fraudulent financial reporting. In safeguarding the integrity of financial reporting and
concurrently enhance firm performance, this study measures firm performance based on
an integration of Beneish M-score for detection of fraudulent financial reporting (1999) and
Z-score bankruptcy prediction model (1968).
The Beneish M-score model is a mathematical model that utilises financial ratios with
either eight variables or five variables version in identifying whether the company has
manipulated its earnings. The variables are constructed from the data in the company‟s
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Proceedings of World Business and Economics Research Conference
24 - 25 February, 2014, Rendezvous Hotel, Auckland, New Zealand, ISBN: 978-1-922069-45-0
financial statements and once calculated, create an M-Score to describe the degree to
which the earnings have been manipulated. An M-score of less than -2.22 suggest that
the company will not be a manipulator. An M-score score greater than -2.22 (i.e. less
negative than this) signals that the company is likely to be a manipulator. As for the Zscore formula, it was developed in 1968 by Edward I. Altman for predicting bankruptcy.
The Z-score is a combination of four or five common business ratios using a weighting
system in determining the likelihood of bankruptcy. Using these two models, a company is
coded as 1 if there is a positive relationship between business failure companies (by
measuring Z-score) engaging in fraudulent financial reporting (by measuring Beneish
Index model) and if otherwise, a company is coded 0. The collective measure used in this
study to measure performance is referred to as financial vulnerability as it reflects the
ability of the company to meet its profit maximisation objective as well as safeguarding the
integrity of its financial reporting.
4. Analysis and Results
4.1 Descriptive Statistics
Table 2 presents the descriptive statistics on the dependent variable, FV. The results of
the descriptive statistics for continuous independent variables and control variable are
presented in Table 3.
FV
Table 2: Descriptive Statistics for Financial Vulnerability
Minimum
Maximum
Mean
0
1
0.17
Results in Table 2 reported that the mean value for the extent of financial vulnerability is
0.17. This indicates that the sample of companies selected in this study has good
performance.
Table 3: Descriptive Statistics for Independent and Control Variables
Minimum
Maximum
Mean
INED_EFF
1.00
1.33
1.01
AC_EFF
1.00
1.85
1.20
IA_EFF
1.00
1.60
1.09
SIZE(RM‟000)
3.3310
7.74
5.5595
LEV (%)
0.0006
1.39
0.2337
Table 3 reported that the mean values for INED_EFF, AC_EFF and IA_EFF 1.01, 1.20
and 1.09 respectively. Overall, these results indicate that the corporate governance
structures are highly effective. Finally, in relation to the control values, Table 3 reported
that the mean value for firm size is 5.56 (RM 2,199,003,000) while the mean value for
leverage is 23.37 per cent.
4.2 Multivariate Analysis
In this study, linear multiple regression is used as the basis of analysis for testing H1 to
H3. The hypothesized relationships for H1 to H3 respectively are modeled as follows:
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Proceedings of World Business and Economics Research Conference
24 - 25 February, 2014, Rendezvous Hotel, Auckland, New Zealand, ISBN: 978-1-922069-45-0
FV = β o +
+ β1 INED_EFF + β2 AC_EFF + β3 IA_EFF + Β4 SIZE + β5 LEV + ε
Where variable definitions are given in Table 1.
In the above regression models, multicollinearity was tested using the variance inflation
factor and tolerance levels, and found to be well within the satisfactory range. The results
of the regression analysis are presented in Table 4 and are now discussed in terms of
tests of each of the hypotheses.
Table 4:
Multiple Regression Results for Factors Affecting Measure of Financial Vulnerability
Dependent
FV
Variable
R²
0.207
Adjusted R²
0.189
F
11.549
Sig
0.000
Model
Beta
t
Sig.
(constant)
0.385
INED_EFF
0.356
2.182
0.030***
AC_EFF
0.335
2.913
0.004***
IA_EFF
-0.032
-0.209
0.835
SIZE
-0.121
-1.460
0.146
LEV
0.314
5.039
0.000***
*Significant at 10% level (1-tailed test) **Significant at 5% level (1-tailed test) ***Significant
at 1% level (1-tailed test)
Results of the multiple regression analysis in Table 4 reported that the adjusted R² is 18.9
per cent, indicating that financial vulnerability of an organisation can be explained by the
model. The F value of 11.55 at a significant level of P = 0.000 provide evidence that the
model in this study is valid.
H1 predicts that INED_EFF is significantly positively related to firm performance as
measured by FV. Results in Table 4 reveal significant relationship. Hence, H1 is accepted.
Consistent with recent studies (Chang and Sun, 2010; Qu et al., 2013), board with higher
proportion of independent non-executive directors are more effective monitors and this in
turn has a positive impact on firm performance. It also points to the success of the
corporate governance reforms in Malaysia in enhancing the corporate governance
practices. In line with Qu et al. (2013), corporate governance practices in Malaysia and
some countries in the Asia Pacific region are aligning their corporate governance practices
with the international best practices.
With regards to audit committee, H2 predicts that AC_EFF is significantly positively related
to firm performance as measured by FV. Results in Table 4 reveal significant relationship.
Hence, H2 is accepted. These results indicate that the audit committee monitoring
effectiveness has also increase following the corporate governance reform in Malaysia.
The requirements on more representation of independent non-executive directors on audit
committee as well as on the overall representation on the board seem to increase the
overall monitoring effectiveness of the board members. In addition, it also highlights that
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Proceedings of World Business and Economics Research Conference
24 - 25 February, 2014, Rendezvous Hotel, Auckland, New Zealand, ISBN: 978-1-922069-45-0
the recruitment of board members with relevant experience and expertise further enhance
board members monitoring effectiveness. Finally, results in Table 4 also indicate that audit
committee members provide an important and effective communication link between
board members and external auditors with regards to monitoring the quality and integrity
of financial reporting. This in turn can contribute significantly to the overall effective
monitoring mechanisms in enhancing firm performance.
H3 predicts IA_EFF is significantly positively related to firm performance as measured by
FV. Results in Table 4 reveal insignificant negative relationship. Hence, H3 is rejected.
These results indicate that internal auditors have not increased their roles and
responsibilities in enhancing the overall corporate governance effectiveness. It is possible
that the emphasis on the roles and responsibilities of the independent non-executive
directors and audit committee by the corporate governance reform in Malaysia during the
period of study reduces the impact of internal auditors on monitoring effectiveness by
board members. In addition, the negative relationship between internal audit effectiveness
and firm performance may be due to the existence of in-house internal audit department
within the company (Coram et al., 2006). The practice of outsourcing internal audit
function can limit the roles and responsibilities of the internal auditors beyond the scope of
duties specified by the management. Nevertheless, this is expected to change in line with
the improvement in the monitoring effectiveness of board members.
5. Conclusion and Limitations
This study examines the relationships between selected corporate governance structure
and firm performance as measured by financial vulnerability. The significant positive
relationships between independent non-executive directors, audit committee and financial
vulnerability points to the success of the corporate governance reform in Malaysia. In
particular, the results highlight that the representation of independent non-executive
directors on board as well as on audit committee are contributing to the overall
effectiveness of corporate governance structure. It is also possible that companies are
recruiting these directors with relevant experience and expertise with consequent positive
impact on their monitoring effectiveness. The positive impact on financial vulnerability
measure indicates that independent non-executive directors and audit committee are
effective in monitoring the ability of the company to meet its profit maximisation objective
as well as safeguarding the integrity of its financial reporting. In addition, it also provides
useful information that can facilitate screening, monitoring, and decision making
processes for board members and other relevant stakeholders.
Of the three corporate governance structure in this study, internal audit function is not
significantly related to financial vulnerability. While it can be associated with the roles and
responsibilities of this function not in alignment with the current demand of corporate
governance, it is expected that this will improve in line with the improvement of the overall
corporate governance practices.
There are some limitations in this study. First, this study focuses only selected corporate
governance structure. Future research may include other independent variables linked to
corporate governance structure that could also have an impact on financial vulnerability. In
addition, other measures of firm performance can also be used in future research. Despite
these limitations, this study provides useful insights in understanding the relationships
between various corporate governance structures and their monitoring effectiveness in a
developing country environment. Finally, it can facilitate relevant regulatory authorities in
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Proceedings of World Business and Economics Research Conference
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enhancing the current corporate governance practices as well as to relevant stakeholders
on the current corporate governance practices in different institutional environment.
Acknowledgment
The authors would like to express their gratitude to the Accounting Research Institute,
Ministry of Education, Malaysia and Universiti Teknologi MARA for funding and facilitating
this research project.
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