[cg-frd] hasan et al - 2010 - corporate governance and financial reporting disclosures - bangladesh perspective

Board of directors, corporate management and external auditor may have an influence on financial reporting disclosures.. This would be the first known study to examine the association be

Corporate Governance and Financial Reporting Disclosures:

Bangladesh Perspective

Dr Md Shamimul Hasan

Assistant Professor, Department of Business Administration World University of Bangladesh, Dhaka, Bangladesh,

Dr Syed Zabid Hossain

Professor, Department of Accounting and Information Systems, University of Rajshahi,

Former Pro-vice Chancellor, University of Khulna, Bangladesh

Dr Robert J Swieringa

Professor of Accounting, Anne and Elmer Lindseth Dean Emeritus, John Graduate School of Management,

Cornell University, Ithaca, New York, Former Board Member of FASB

ABSTRACT

Financial reporting disclosures are very essential to the shareholders of a company because they frequently use these disclosures for their economic decisions about the business enterprise Board of directors, corporate management and external auditor may have an influence on financial reporting disclosures From this perspective, the study investigates the influence of corporate governance on financial reporting disclosures The results show that corporate governance is significantly associated with the extent of financial reporting disclosures External auditor, multilisting and profitability are significantly (5 percent level) associated with overall financial reporting disclosures index

Keywords: Bangladesh, financial reporting disclosure, corporate governance

1 Introduction

This research investigates the influence of corporate governance on corporate financial reporting disclosures The scandals of high profile companies such as Enron, WorldCom, Tyco and some other firms in the U.S, have realized the question of the effectiveness of monitoring mechanisms in organizations (Raphaelson and Wahlen, 2004) Corporate governance refers to the structures and processes for the direction and control of companies

Good governance contributes to sustainable economic development by enhancing the performance of companies and increasing their access to outside capital Corporate governance reduces emerging market vulnerability to financial crises, reinforces property rights, reduces transaction costs and the cost of capital, and leads to capital market development Weak corporate governance frameworks reduce investors’ confidence, and can discourage outside investment Also, as pension funds continue to invest more in equity markets, corporate governance is crucial for preserving retirement savings (World Bank:

2009) Corporate governance is affected by the relationships among participants in governance system Controlling shareholders, which may be individuals, family holdings, bloc alliances, or other corporations acting through a holding company or cross holdings, can significantly influence corporate behavior As owners of equity, institutional investors are increasingly demanding a voice in corporate governance in some markets Individual shareholders usually do not seek to exercise governance rights but may be highly concerned about obtaining fair treatment from controlling shareholders and management Creditors play

an important role in a number of governance systems and can serve as external monitors over corporate performance Employees and other stakeholders play an important role in contributing to the long-term success and performance of the corporation, while governments establish the overall institutional and legal framework for corporate governance (OECD:

2004)

In Bangladesh, January 10, 2011 is called Black Monday because the stock market collapsed

on that date and has not yet recovered Though a lot of measures have been taken by the Securities and Exchange Commission (SEC), Dhaka Stock Exchange (DSE), Chittagong Stock Exchange (CSE), Bangladesh Bank (BB), and Ministry of Finance (MoF), there is no result of these efforts Almost every day of the year 2011, small investors were engaged in many activities, including procession, press-conference, hunger-strike, block the roads, and close the stock market trade as a part of their expression of frustration They solicited intervention of the Prime Minister for stabilizing the market Even they expressed their anguish and frustration by opening their chest and inviting government officials to shoot them The probe report opined that there are many issues that are responsible for collapse of the market Governance of SEC and other institutions could not satisfy the probe committee (PC) One of the main recommendations of the committee was the removal of chairman, executive director and directors of SEC (SMIR, 2011) This recommendation clearly indicates

a red flag for corporate governance Whereas, SEC is the only regulating authority of the listed companies that regulates annual financial reporting disclosures of the companies, it is expected that the financial reporting disclosures of the companies are not regularly monitored Under these crucial circumstances, investors believe that the capital market in Bangladesh is volatile up till now

Good corporate governance is an important prerequisite for attracting the patient capital needed for sustained long-term economic growth, and can lead to better relations with workers, creditors, and other stakeholders Corporate ownership is concentrated and companies are often controlled by a small number of related shareholders A few companies have dispersed ownership Most securities in Bangladesh are held by individuals- the controlling family or members of the public – rather than institutions or other companies: 43 percent of market is held by sponsors who are from the founders’ families, and 38 percent is held by the public at large Sponsors often have management and or board positions in companies Institutional investors hold only 10 percent of the market but are sometimes represented on company boards Foreigners hold 1 percent of the market (World Bank: 2009) There is no single model of corporate governance (OECD: 2004) The SEC issued Guidelines

on Corporate Governance in 2006 Listed companies are required to “comply or explain” The Guidelines cover some key topics, including the functioning of the board, and internal and external controls The Guidelines do not deal with other aspects of corporate governance, including shareholder rights Compliance is at its early stage – in 2007, about 33 percent of companies declared full compliance with the Guidelines and 60 percent declared partial compliance (World Bank: 2009) There are no provisions for punitive measures for non-compliance of any one of the conditions mentioned in the notification Only “comply or explain” basis is not enough in Bangladesh for ensuring good governance

Although financial information disclosed by the Bangladeshi companies is increasing day by day, the reliability of this reporting is decreasing day by day due to lack of practices of corporate governance Adherence to corporate governance practices will help improve the confidence of investors, reduce the cost of capital, underpin the good functioning of financial markets, and ultimately induce more stable sources of financing (OECD: 2004) Good governance in the corporate sector is a burning issue in Bangladesh

In this paper we argue that there is obviously an influence of corporate governance on corporate financial reporting disclosures index The researchers commence their analysis by measuring overall disclosure index by twenty non-financial companies included in DSE The researchers use a comprehensive measure of disclosure that captures the nature and extent of information and are able to glean insights about the disclosures index This would be the first known study to examine the association between corporate governance and overall financial reporting disclosures index The weak form of corporate governance in Bangladesh allows the researchers to (1) overview corporate financial reporting practices by non-financial companies listed in DSE, (2) identify different aspects of corporate governance , and (3) to examine the association between corporate governance and corporate financial reporting disclosures index

Next, the researchers test hypotheses about the relationship between corporate governance and corporate reporting disclosures index The researchers capture the impact of corporate governance using three measures, such as dependent variable (corporate financial reporting disclosures index), independent variables, and linkage between dependent and independent variables

Present examination of the relationship between corporate governance and corporate financial reporting disclosures index extends the literature on the determinants of corporate reporting disclosures index Previous researches have investigated a range of factors potentially associated with disclosures including board independence, dominant personality, board size, institutional ownership, external auditors, general public ownership, leverage, asset size, profitability, multilisting, and number of shareholders However, the influence of corporate governance on corporate financial reporting disclosures index has not been examined previously Present finding of significant relationship between external auditor and corporate reporting disclosures index supports the tenets of principal-agent theory and demonstrate the potential for this powerful and legitimate stakeholder group to influence corporate financial reporting disclosures index in Bangladesh Several other factors found to be associated with corporate financial reporting disclosures in prior researches have been controlled A final contribution of this research relates to the growing body of literature on corporate governance (external auditor engagement) and corporate financial reporting disclosures Present study extends this area of research by investigating and finding support for the role of external auditor in relation to corporate financial reporting disclosures The research provides robust

empirical evidence in support of claims in the literature that external auditor’s demand can drive corporate action

The remainder of the paper is organized as follows The next section reviews the prior literature and develops the hypotheses for the study Section 3 outlines the data and method, section 4 presents the results of the analysis and Section 5 concludes

2 Literature Review and Hypotheses Development

2.1 Prior Literature

One function of financial reporting is to restrain management to act against the shareholders’ interest (Watts and Zimmerman, 1978) Due to increasing complexity of business today, there is a demand for disclosure of more comprehensive information in the annual report as both potential and existing investors make their economic decision by using this information In the global investor opinion survey of McKinsey & Company (2002) on corporate governance issues, a majority of the investors agree that corporate governance remains a great concern with strengthening the quality of accounting disclosures as a top priority Majority of institutional investors is willing to pay a high premium for companies having good governance The survey also provides evidence that

a majority of respondents (71 percent) states that accounting disclosures are the most important factor that influences their investment decisions and 52 percent of respondents identify that improving financial reporting quality is a governance priority for policymakers

Good governance goes hand-in-hand with reduced risk of financial reporting problems and other bad accounting outcomes (Hermanson, 2003) Information disclosed by the companies in their annual report can be used as important input in various corporate governance mechanisms (Bushman and Smith, 2001)

Good governance by board of directors can influence financial reporting disclosures, which in turn has an important impact on shareholders confidence (Levitt, 1998 and

2000) There has been a considerable debate in recent times about the need for strong corporate governance (McConomy and Bujaki, 2000), with the countries around the world drawing up guidelines and codes of practice to strengthen governance (Cadbury, 1992;

Corporate Governance Code of Bangladesh, 2006) The rationale for this emphasis can be linked to growing concerns over the integrity of stock markets (International Federation of Accountant – IFAC, 2010; Millstein, 1999) Previous studies have shown that good corporate governance reduces adverse effects of earnings management as well as likelihood of creative financial reporting arising from fraud or errors (Beasley, 1996; Dechow, et al, 1996; McMullen, 1996) Traditionally, the external auditor has also played

an important role in improving the credibility of financial information (Mautz and Sharaf, 1961; Wallace, 1980)

The differences in corporate governance across countries emerge as a result of the variations in the ownership structure and understanding the effects of various ownership structure variables is vital to shed light on corporate governance and control process of firms under difference national types of institutional arrangements (Li, 1994) Recent empirical works on the association between traditional financial reporting disclosures and corporate governance Chen and Jaggi (2000) and Eng and Mark (2003) Chen and Jaggi (2000) find a positive association between the proportion of independent non-executive directors and the comprehensiveness of information in mandatory financial disclosure of Hong Kong companies Eng and Mark (2003) find that lower managerial ownership and significant government ownership are associated with increased disclosure and that an increase in outside directors reduces the corporate disclosure of firm listed on the Stock Exchange of Singapore

In Malaysia, one-man or family run companies (Halim, 2001) and significant government equity holdings (Abdullah, 2006) distinguish the ownership pattern of Malaysian companies that may complicate the corporate governance systems Extensive occurrence

of individual and family run companies tends to discourage professionalism, encourage non-compliance and facilitate creative accounting as well as to result in severe conflicts of interests (Halim, 2001)

2.2 The Variables and Hypotheses Development

2.2.1 Dependent Variable:

An Overall Disclosures Index (ODI) of sample companies was used as the dependent variable and several corporate governance and control variables were used as the

independent variables to test the influence or impact of the corporate governance variables over the ODI

2.2.2 Primary Independent Variables (Corporate Governance Variables):

1 Board Independence (bi)

2 Dominant Personality (dp)

3 Board Size (bs)

4 Institutional Ownership (io)

5 General Public Ownership (gp)

6 External Auditor (ea)

2.2.3 Secondary Independent Variables (Control Variables)

1 Leverage (lvg)

2 Asset Size (asstsz)

3 Profitability (profitab)

4 Multi Listing (multilis)

5 Number of Shareholders (shareholders)

Board Independence

The board, which comprises a number of independent directors, has a greater monitoring and controlling ability over management (Fama and Jensen, 1983) The state of ‘independence’ is

met when a director inter alia is neither holding significant ownership nor holding any

executive position in the company (Bursa Malaysia, 2006) In Bangladesh, SEC corporate guidelines stated that one-tenth of the total number of the company’s board of directors, subject to a minimum of one, should be independent directors But in Malaysia, if a company has only three board members, two of them are required to be independent (Bursa Malaysia,

2006) Fama and Jensen (1983), Ho and Wong (2001), Cheng and Courtenay (2004) and Norita and Shamsul-Nahar (2004) found a significant positive association On the other hand, Eng and Mark (2003), Gul and Leung (2004) and Barako et al (2006) found a negative association This variable is taken in this study as an independent variable and the hypothesis

is as follows:

Ho: There is no association between board independence and overall disclosures index

CEO Duality / Dominant Personality

The corporate governance literature has emphasized the need to separate the position of CEO (chief executive officer) and board chairman to guarantee the board independence and improve transparency (Jensen, 1993) In this respect, Dechow et al (1996) revealed that the duality CEO-chairman increases the likelihood of violating the accounting principles in

American firms Byard et al (2006) indicated that the presence of a CEO who serves also as the board chairman is associated with poor quality of financial information Similarly, Beeks

et al (2004) and Firth et al (2007) reported that the financial reporting is more relevant in the case of separating the positions of CEO and board chairman for British and Chinese firms Nevertheless, other authors did not detect a significant association between CEO duality and financial reporting (Ahmed et al., 2006; Bradbury et al., 2006; Petra 2007) CEO duality is considered as an independent variable in this study and the hypothesis is as under:

Ho: There is no association between CEO Duality and overall disclosures index

Board Size

The number of directors is an important factor in the board of directors’ effectiveness A larger board size may bring a greater number of directors with experience (Xie et al., 2001) that may represent a multitude of values (Halme and Huse, 1997) on the board On the contrary, a reduced number of directors imply a high degree of coordination and communication between them and managers (Jensen, 1993) Chaganti et al (1985) claimed that smaller boards are manageable and more often play a role as a controlling function whereas larger boards may not be able to function effectively as the board leaves the management relatively free Indeed, Vefeas (2000), Ahmed et al (2006) and Bradbury et al

(2006) found that large board size reduces the information content of income and intensifies the earning management respectively for American, Singapore and New Zealand firms However, several authors argued that the high number of directors ensures the value relevance

of financial statements (Byard et al., 2006), while others did not confirm this link (Firth et al.,

2007) The study by Bonn (2004) found no relationship between board size and firm performance She further argued that the board size only measures the factual number of

directors without capturing their task Hence, one could argue that it is the skills and knowledge base that the board brings to the firm not the number In contrast, Dwevedi and Jain (2005), found an insignificant positive relationship They conclude that larger boards are

in a position to improve the governance of the company As such, board size is used as an independent variable in the current study and the hypothesis is as follows:

Ho: There is no association between board size and overall disclosures index

Institutional Ownership

Considering the influence of shareholder activism in governance reforms is important to obtain insight into governance practices (Daily et al., 2003) To date, institutional investors’ participation has emerged as an important force in corporate monitoring mechanism to protect minority shareholders’ interest The significant increase in the institutional shareholdings has led to the formation of a large and powerful constituency to play a significant role in corporate governance In the UK, institutional investors own between 65 to 75 percent of the

UK stock market, which suggest a prominent role that institutional shareholders can play as

an agent to the governance systems (Mallin,2003) To mitigate the problems associated with conflict between controlling owners and minority shareholders in Asian firms, the involvement of institutional investors’ equity participation may improve corporate governance practices (Claessen and Fan, 2002) Concentrated shareholdings by institution provide an incentive for diligent monitoring as they have the resources, expertise and stronger incentives to actively monitor the actions of management and prevent managers’ opportunistic behavior (Wan Hussin and Ibrahim, 2003)

Institutional shareholders are often characterized in academic research as sophisticated investors who have advantages in acquiring and processing information compared with other investors (Bartov et al., 2000; Jiambalvo et al., 2002) Consequently, institutional investors can be more effective as traders and monitors than can small, diffuse retail investors Intuitional investors could actually prefer that information not be broadly disseminated because they are concerned about either a decline in the quality of the information communicated or a loss of their information advantage (NIRI, 2000) Recent studies indicate

a negative relation between institutional ownership and voluntary disclosure (Kelton et.al

2004) While examining the determination of a firm’s decision to provide shareholders access

to conference calls, Bushee at al (2003) find that firms that provide open conference calls

have a lower institutional ownership than firms that do not provide open calls Institutional ownership is accepted in the present study as an independent variable and the hypothesis is as given below

Ho: There is no association between institutional ownership and overall disclosures index

General Public

Differences in the proportion of a firm that is owned by outsiders may account for some of the observed differences - in the comprehensiveness of mandatory disclosure, because the greater number of people who need to know about the affairs of a firm, the greater will be the details required of an item of information and the more comprehensive the disclosure of a firm will

be (Apostolou and Nanopoulos, 2009) Leftwich et al (1981) suggested that issuing financial reports could solve monitoring problems associated with increases in the proportion of the firm owned by outsiders If this is true, one would expect to find from a population of reporting firms that, as the number of shareholders or the proportion of the firm owned by outsiders’ increases, the financial information disclosed in annual reports will become more comprehensive It is expected that if a company has a large proportion of public ownership, the political cost will be bigger and the company will decide to disclose more information General Public is an independent variable and the hypothesis is-

Ho: There is no association between general public and overall disclosures index

External Auditor

The external audit can be an effective control mechanism to monitor the managers and guarantee the integrity of financial reports (Jensen and Meckling, 1976; Watts and Zimmerman, 1983) The appointment of an independent external auditor can reduce the probability of earnings manipulation by shrinking managerial opportunism (DeAngelo, 1981;

Becker et al., 1998; Chung et al., 2003) In practice, the auditor reputation or quality is associated with being part of or affiliated with a major international auditing firm (Brown et

clients in comparison with other companies (Teoh and Wong, 1993; Becker et al., 1998) In Bangladesh, there are six audit firms that have international links The following table presents the list of those audit firms:

Table-3: International Link of Audit Firms

Hoda Vasi Chowdhury and Co Delloite Haskins and Sells

External auditor is an independent variable and our hypothesis is-

Ho: There is no association between external auditor and overall disclosures index

Leverage

Business enterprises may borrow from different sources Lending institutions always want to ensure security of their supplied funds Lenders want reliable information about borrowers That is why borrowers usually furnish more information in their annual reports to meet the information needs of creditors, investors and other stakeholders So, there is an association between the amount of loan and the level of disclosure of the reporting entity Considering, these things, a few disclosure studies were conducted to examine the association, if any, between gearing ratio and corporate disclosure level Ahmed and Nicholls (1994) and Chow and Wong-Boren (1987) have found no significant association between leverage ratio and the extent of voluntary disclosure in Bangladesh and Mexico respectively Karim (1996) and

Belkaoui et al (1977) have observed a significant negative relationship between the mentioned variables On the contrary, Robbins and Austin (1986) had found a significant positive correlation between debt and municipal disclosures Leverage is selected as an independent variable and our hypothesis is-

Ho : There is no association between leverage and overall disclosures index

Asset Size

Many disclosure studies e.g., Chow and Wong-Boren (1987); Cooke (1991, 1992 and 1993); Ahmed and Nicholls (1994) suggest that there is a significant relationship between company asset size and the extent of voluntary disclosure Ahmed and Courtis (1999) carried out a meta-analysis of 28 disclosure studies and found that a significant association exists between corporate size and disclosure levels Marston and Shrives (1996) reviewed a number of disclosure studies and reached the same conclusion Therefore, asset size is selected as an independent variable and our hypothesis is –

Ho : There is no association between asset size and overall disclosure index

Profitability

Profitability affects the level of disclosures Adelberg (1979) found that the narrative disclosures were deliberately made complex to communicate bad news and made more lucid and easily understandable to communicate good news As profits are always good news to the investors and other stakeholders, therefore, management discloses more information about this variable in their annual reports Profitability was used by a number of researchers as an independent variable for fluctuations in disclosure level There are mixed results found about the association between profitability and disclosure Singhvi (1967), Singhvi and Desai (1971), Inchausti (1997), Raffournier (1995), Wallace and Naser (1995), Cerf (1961), Hossain (1998), Razzaque (2004), Ahmed (2009) and Hasan (2011) found a positive association between profitability and the extent of disclosure But, Belkaoui and Kahl (1978) found a negative association between them Again, McNally et al (1982), Malone et al (1993), Meek et al (1995), Suwaidan (1997), and Abd Elsalam (1999) found no association between them Profitability is used as an independent variable and our hypothesis is -

Ho : There is no association between profitability and overall disclosures index

Multiple Listing

The capital orientation of companies may also influence companies in making differential disclosure Voluntary disclosures may be associated with the objective of raising capital (Horngren, 1957; Cooke, 1991) Listing status may also be viewed as a screening scenario Firms listed in more prestigious markets may provide signals to customers, suppliers and

creditors about the strength of the company and that may also encourages brand recognition

It also provides signals about the future prospects of the company (Mittoo, 1992) That also impacts on the perceptions of other groups like government and local authorities, consistent

with Roberts et al (1998); Wallace, Naser and Mora (1994) are also in the same opinion Listing status has been tested and identified to be significant by Firth (1979), Cooke (1989), Meek and Gray (1989), Wallace et al (1994), Hossain et al (1995), Meek et al (1995) and Inchausti (1997) Multiple listing is used as an independent variable and our hypothesis is -

Ho : There is no association between multiple listing and overall disclosures index

Shareholders

Shareholders are the real owners of a company They are also treated as internal and external stakeholders They have direct interest to the company They can change the management and appoint new agents if they believe that the existing management is not managing the entity efficiently It is expected that a large number of shareholders will exert more pressure on management Number of shareholders is an important factor in determining the corporate disclosure level (Alam, 2008) and as such it is taken as independent variable in this study The hypothesis is-

Ho: There is no association between number of shareholders and overall disclosures index

3 Methodology

3.1 Selection of Sample

Stratified sampling technique was used as our populations were heterogeneous and it reduces the sampling error Each business segment was considered as a stratum and accordingly four stratums had been selected purposively and five companies were then selected from each stratum as shown in the following table

Table -1: Distribution of Population and Sample Size of the Companies

Stratum Population Size Sample Size Sample as percent

of Population

Percent of total Sample

Food & Allied 8 5 63 25

Total size of population was 40 and sample size was 20 which represent 50 percent of total population The sample size in terms of percentage of population was dissimilar and the percent of sample size of each stratum was equal i.e., 25 percent

3.2 Selection of Disclosure Items

A draft check list was prepared that provided the basis for a survey with yes / no questions that was used to select the individual items for the final checklist Finally, two-hundred items were used to measure a company disclosure score The 200 items reflect the following disclosure items of an annual report

Table -2: Summary of Draft and Final Disclosure Checklist

3.3 Scoring the Disclosure Items

Various approaches are available to develop a scoring scheme to determine the disclosure level of corporate annual reports The items were considered equally important to disclose and hence a dichotomous unweighted approach was used for scoring If a company discloses an item it will be awarded one and if not it will be awarded zero

3.4 Developing Overall Disclosure Index