siagian et al - 2013 - corporate governance, reporting quality, and firm value - evidence from indonesia

Siregar and Yan Rahadian Accounting Department, University of Indonesia, Jawa Barat, Indonesia Abstract Purpose – The purpose of this paper is to investigate whether corporate governance

Corporate governance, reporting quality, and firm value:

evidence from Indonesia

Ferdinand Siagian College of Business, Minnesota State University,

Mankato, Minnesota, USA, and Sylvia V Siregar and Yan Rahadian

Accounting Department, University of Indonesia, Jawa Barat, Indonesia

Abstract

Purpose – The purpose of this paper is to investigate whether corporate governance practices and the quality of reporting are associated with firm value for public firms in Indonesia.

Design/methodology/approach – The authors hypothesize that there are positive associations between firm value and corporate governance practices and reporting quality For the authors’ proxies for corporate governance and reporting quality they develop two new indices First, they develop

a corporate governance index (the CGI) to measure corporate governance practices by Indonesian firms Second, they develop a reporting quality index (the RQI) to measure the firms’ quality of reporting and disclosures To examine the associations the authors run multivariate regressions

of their proxies for firm value on the two indices.

Findings – Consistent with the first hypothesis, the paper finds positive associations between corporate governance and different proxies of firm value These findings suggest that firms that implement better corporate governance have higher values Contrary to the second hypothesis, the paper finds negative associations between reporting quality and the proxies for firm value These findings indicate that lower value firms tend to disclose more information that is consistent with the P3LKE than higher value firms.

Research limitations/implications – The results suggest that corporate governance practice by Indonesian public firms is value relevant and therefore, should provide incentives to the firms to improve their governance This shows that the Indonesian government’s efforts to promote corporate governance provide benefits to publicly traded firms The results also indicate that firms with low values are more likely to disclose information that is consistent with the P3LKE This warrants further research because this finding is inconsistent with the contention that more disclosures should result in higher value.

Practical implications – The authority needs to put more efforts in promoting good corporate governance implementations and making sure that public firms improve their disclosures and reporting quality in order to provide benefits to the users of financial information.

Originality/value – Corporate governance index for public firms is not readily available in Indonesia Therefore, the authors develop an index to measure corporate governance implementations

by Indonesian public firms To the authors’ knowledge, this is the first paper that develops an index

to measure adherence to the P3LKE, which is a comprehensive measure of the quality of reporting Keywords Corporate governance, Disclosure, Reporting, Firm value, Quality, Performance, Performance management, Indonesia

Paper type Research paper

1 Introduction This paper investigates whether corporate governance and the quality of reporting are associated with firm value Specifically, we test the association between firms corporate governance index (CGI) scores and their values that we measure using

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price-to-book value (PBV), Tobin’s Q, and return on assets (ROA) We also investigate

the association between firms reporting quality index (RQI) scores and their values

After the financial crisis in 1997 and 1998, the Indonesian Government initiated

several efforts to improve corporate governance and reporting quality For example,

the government through the capital market authority (BAPEPAM) promotes corporate

governance by requiring independent board members and an audit committee that is

chaired by an independent director (Siagian and Tresnaningsih, 2011) In 2002, the

BAPEPAM issued the P3LKE that provides guidance about what to report and

disclose in the financial statements for firms that are publicly traded in the JSX

(BAPEPAM, 2002) The objectives are to improve firm performance and the quality of

financial statements reported to the public

Separation of ownership and control creates agency problems within the firms

( Jensen and Meckling, 1976; Fama and Jensen, 1983) As a result, managers may take

actions that are not for the best interest of the shareholders Because the shareholders

are usually dispersed and do not have the capabilities to directly monitor and control

managers’ actions, performance of the firm may be harmed Moreover, the managers

have better information about the firm than the shareholders This asymmetry of

information costs the shareholders because they cannot make informed decisions

A set of governance mechanisms can be implemented to mitigate the agency

problems The purpose of the corporate governance is to make sure that managers will

act for the best interests of the shareholders In addition, it can force the managers to

disclose important information so that the information asymmetry between the

managers and shareholders can be minimized We hypothesize that firms that

implement good corporate governance and have more disclosures will have less agency

problems and will have higher values

To test our hypothesis we develop two indices in this study The first index is the

CGI that we use to measure corporate governance implementations in a public firm

This index is divided into five parts: rights of shareholders, equal treatment of

shareholders, role of stakeholders, disclosure and transparency, and board

responsibilities The second index is a reporting and disclosure index (the RQI)

that we develop to measure firm’s adherence to the Financial Reporting and

Disclosure Guidance (the P3LKE) issued by the Indonesian Capital Market

Regulatory Body (the BAPEPAM) We consider firms that adhere to the P3LKE as

firms with high-quality report

Using a sample of 125 firms that were traded in the JSX we find that corporate

governance is positively associated with firm value suggesting that firms with higher

CGI score have higher value The results are consistent for all three proxies of firm

value that we use in our tests In our sensitivity test, we use weighted CGI by putting

different weights on corporate governance practices according to their importance

We find that the results are consistent with our main test using the non-weighted scores

We find that RQI score is negatively associated with all proxies for firm value

These findings do not support our hypothesis that predicts positive association

between reporting quality and firm value One possible explanation is that firms

with low values disclose more information that is consistent with the P3LKE because

they try to improve their values by emitting more information to the market This

inconsistent finding warrants further research to examine why high-value firms

disclose less information that is consistent with the P3LKE

We make two contributions to the literature First, we contribute to the literature by

showing that corporate governance is positively associated with firm value for public

5 Corporate governance

firms in Indonesia The use of CGI in Indonesia is still rare because such index for public firms is not readily available By developing a CGI for public firms we are able to measure corporate governance implementations by Indonesian firms Second, to our knowledge, compliance to the P3LKE has not been studied before and we are the first

to develop a checklist to measure firm adherence to the guidance This index allows us to comprehensively evaluate the quality of reporting for our sample firms Other studies use other proxies for reporting quality such as earnings management or discretionary accruals (Xie et al., 2003), conservatism (Mayangsari, 2003), and restatement of financial reports (Agrawal and Chadha, 2004) Different from those studies, we use a comprehensive reporting index issued by the capital market authority We provide new evidence that the guidance is more likely to be followed by firms with low value that

is shown by a negative association between the RQI score and firm value

The remainder of the paper is organized as follows We draw the theories about the subjects and develop the hypotheses in Section 2 Section 3 describes the research method, sample selection procedure, and descriptive statistics We present the results

of the tests in Section 4 and conclude the study in Section 5

2 Literature review and hypotheses development Separation of ownership and control in firms creates agency problems ( Jensen and Meckling, 1976; Fama and Jensen, 1983) Managers who are involved in firm’s daily operations have superior information than the shareholders who are usually dispersed Because of the dispersion the shareholders do not have the ability to directly observe the managers This asymmetry of information creates problems if the managers’ objectives are not aligned with the objectives of the shareholders There is a potential moral hazard problem that the managers will pursue their own interests at the expense

of the shareholders Because of information asymmetry the shareholders cannot accurately evaluate the actual performance of the managers

Corporate governance represents a set of mechanisms that are intended to reduce agency risk that result from information asymmetry (Asbaugh et al., 2004) They state that corporate governance allows for better monitoring and control so that the managers are more likely to make decisions that are for the best interest of the shareholders such as investing in positive NPV projects It also improves protection to the shareholders by minimizing opportunistic behavior of the managers that decreases firm value Therefore, firms that implement corporate governance are more likely to have a higher firm value

Studies find results that support the contention that corporate governance improves firm value Durnev and Kim (2005) find firms with higher governance and transparency rankings are valued higher in stock markets Asbaugh et al (2004) find that firms with better governance have lower cost of equity capital resulting in higher firm value Gompers et al (2003) analyze the empirical relationship of a governance index with corporate performance and find that corporate governance is strongly correlated with stock returns during the 1990s They find that firms with stronger shareholder rights have higher firm value, higher profits, and higher sales growth Mitton (2002) finds that corporate governance positively affects firm performance during Asian crisis in five East Asian countries Klapper and Love (2002) use corporate governance rank data of firms in 14 developing countries and find evidence that corporate governance is positively related to operating performance and market value Consistent with the above studies Alves and Mendes (2004) also find positive impact of corporate governance on stock returns

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Beiner et al (2006) find that corporate governance positively affect firm value but

they also find reverse causality; higher value firms adopt better corporate

governance practices They construct a broad CGI based on the Swiss Code of Best

Practice and find result that supports the hypothesis of a positive relationship

between firm-specific corporate governance and Tobin’s Q They find a one standard

deviation increase in the CGI causes an increase of the market capitalization by at

least 12 percent of a company’s book asset value Black et al (2006) also develop a

CGI for all public firms in Korea for year 2001 and find evidence that higher CGI is

associated with higher Tobin’s Q

The above studies show that corporate governance provides benefits to the

shareholders It improves the quality and independence of the board of directors

and the committees and puts more monitoring and controls on the managers As

a result, the managers are more likely to take actions that increase firm value

We hypothesize the following (in alternative format):

H1 Firms with better corporate governance will have a higher value

Asymmetry of information creates agency problems and increases the risks faced by the

shareholders To minimize the asymmetry of information, firms provide information and

disclosure through financial reports that includes financial statements, notes to financial

statements, and management discussion and analysis In addition, firms release

information through voluntary disclosures and the shareholders can obtain information

about firms through news and information intermediaries such as financial analysts

Nagar et al (2003) argue that managers avoid disclosing private information because

such disclosure reduces their private control benefits This is consistent with the

opportunistic behavior of the managers due to various motives They further argue that

disclosure problem is an important concern for investors and has a key role in capital

market allocation and corporate governance decisions Healy and Palepu (2000) state

that corporate disclosure is very important for the functioning of the capital market

Managers have better information than the shareholders and information differences

give rise to “lemons” problem that can harm the functioning of capital market

One possible solution to this problem is information intermediaries that provide

information to minimize the asymmetry of information Another solution is regulation

such as accounting standards Regulators are concerned about the investors and issue

regulations that allow firms to provide sufficient information to the shareholders

In 2002, the BAPEPAM issued the P3LKE that provides a list of items that need to

be reported and disclosed by firms that are publicly traded in the JSX The purpose is

to improve reporting quality that will result in better information for the users of the

financial statements Agency theory states that managers do not always act in

the best interest of the shareholders More transparency may mitigate some of the

agency problems faced by the firms Shareholders will be more informed and

information gap between the shareholders and the managers can be reduced

Investors will perceive lower investment risk that would lead to a higher firm value

Better disclosures will also help the board of directors to perform its oversight

function and various board committees can work more effectively All these benefits

will result in a higher firm value

Several studies have examined the benefits of disclosures Botosan (1997) finds that

greater disclosure is associated with a lower cost of equity capital for firms that attract

low analyst following This suggests that disclosure quality positively affects firm value

7 Corporate governance

Lambert et al (2007) show theoretically that information quality directly influences firms’ cost of capital and that improvements in information quality unambiguously reduce non-diversifiable risk Sengupta (1998) finds lower cost of debt in firms with better disclosures Healy et al (1999) investigate whether firms receive benefit from higher voluntary disclosure by examining changes in capital market factors associated with increases

in analyst disclosure ratings They find that the expanded voluntary disclosure is accompanied by improved stock performance, increased institutional ownership, analyst following, and stock liquidity even after controlling for contemporaneous changes in firm characteristics including earnings performance, size, and risk Gelb and Zarowin (2000) find evidence that disclosure quality provides information benefit to the stock market and affects stock price positively They find that enhanced disclosure results in stock prices that are more informative about future earnings

Mitton (2002) find that during the Asian Crisis in 1997-1998 firms with high quality

of disclosures show better performance than firms with lower quality He finds that firms with higher disclosure quality have significantly better stock price performance Baek et al (2004) also find that during Korean crisis in 1997 firms with high disclosure quality experienced the lowest stock price decline These studies support the contention that disclosure is positively associated with firm value

Because disclosures help in mitigating various agency problems, reducing investment risk, and reducing cost of capital, we predict that firms with better disclosures will have higher value We hypothesize the following (in alternative format):

H2 Firms with more disclosures will have a higher value

3 Research design 3.1 Sample selection Our sample consists of 125 firms that are traded in the JSX in 2003 and 2004 that submitted a P3LKE report to the BAPEPAM and had available CGI data We obtain the financial data from financial reports in the JSX database We present the sample selection process in Table I

From the JSX database we were able to collect 411 firm-year of RQI data and 267 firm-year of CGI data For the RQI, we collect the data from firms’ financial reports and evaluate individually the quality of disclosure according to the P3LKE We also collect corporate governance data that are only available for some of the listed firms The intersection of the two groups of firms results in 248 firm-year Our data are not balance panel because not all firms have data for both years We exclude observations with negative book value of equity (25 observations), extreme outliers

Total Firm-year

Total firms or observations with RQI data 411 Total firms or observations with CGI data 267 Total firms or observation with both data 248 Total observations with negative book value (25) Total observations with incomplete financial data (20) Total observation that are considered outliers (15) Total firm-year in the final sample 188

Table I.

Sample selection

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(15 observations), and observations with incomplete financial data (20 observations).

Our final sample includes 188 firm-year of data

3.2 Empirical test

Our first hypothesis predicts that corporate governance is positively associated with

firm value Our second hypothesis predicts positive association between reporting

quality and firm value In our main test, we measure firm value using market to book

value ratio (PBV)[1] We regress PBV on CGI score and RQI score while controlling for

variables that may affect firm value

Miller (2005) argues that PBV ratio is an appropriate measure of company value

Higher PBV ratio is perceived by the market as an indicator of an ability to give higher

economic profit We calculate PBV by dividing price per share by book value per share

The CGI score is calculated based on a CGI that we develop using the corporate

governance checklists from IICD, Num and Lam (2006), Standard & Poor’s and

National University of Singapore (2004) checklist, and the OECD principles[2]

This checklist is completed using secondary data from the financial statements

The questions are divided into five groups according to the OECD principles: rights of

shareholders, equal treatment of shareholders, role of stakeholders, disclosure and

transparency, and board responsibilities (OECD, 2004) For the main test we do not put

any weight on the group[3]

For the RQI, we follow the guidance issued by the BAPEPAM The BAPEPAM

issued 13 different guidance based on industry, so we develop 13 different checklists

with approximately 650 items in each checklist depending on the industry, which

makes it a comprehensive proxy to measure quality of reporting[4] For each item, we

read the notes to financial statements to determine whether an item on the checklist is

reported and disclosed There are three possible answers to the questions in the

checklist: disclosed, not disclosed, or not applicable (N/A) The score is calculated as

the ratio of the total number of applicable items that are disclosed and the total number

of items that are applicable to that firm (total number of items – N/A) as follows:

ð items  N =AÞ

For example, if a firm has 500 items and discloses all items and does not have ten items

out of a total of 650 items on the list, it will score 500/(65010) ¼ 0.78 It means the

firms does not disclose a total of 140 items and loses 0.22 disclosure points

In calculating the RQI score we realize the possibility of bias because of the difficulty in

identifying whether an item that is not disclosed or is not applicable For example,

P3LKE requires disclosure for prepaid expense We will not observe any disclosure

about prepaid expense in the financial report of firms that do not have a prepaid

expense account and of firms that do not want to disclose their prepaid expenses In the

first case, the score would not be negatively affected by not disclosing prepaid expense

because the firm does not have the account In the second case, the firm should get a

lower score because of the lower numerator

We include several control variables that may affect firm value in our regressions

We specifically control for firm size, growth, and leverage We control for size

because it is expected to be associated with firm value (Yermack, 1996) We include

growth as an explanatory variable because firm value depends on future investment

9 Corporate governance

opportunities (Myers, 1977; Smith and Watts, 1992; Yermack, 1996) Finally, we also control for the amount of leverage because it may have significant impact on firm value (Ross, 1977) Ross suggests that the value of a firm will increase with leverage because increasing leverage increases the market’s perception about value Stulz (1990) argues that debt can have both positive and negative impact on firm value We use debt-to-equity ratio as the proxy for firm leverage

We estimate the following regression to test our hypothesis:

where FIRMVAL is the firm value that we measure using PBV, CGI, RQI, SIZE, GROWTH, LEV

Our hypotheses predict that after controlling for variables that may affect firm

Table II presents the descriptive statistics for the variables that we use in our tests Panel A shows that the average of PBV is 1.307 with a high standard deviation (1.157) This indicates that the PBV of the firms in our sample varies considerably The average

is also relatively small with an average of only 0.629 with standard deviation of 0.132 Panel B of Table II shows an improvement in the average of the CGI score from 0.666 in

2003 to 0.676 in 2004 However, the difference is not statistically significant We also find

an improvement in the score average of RQI from 0.623 in 2003 to 0.636 in 2004 However, our mean-difference test shows that the improvement is not statistically significant We believe that there is still a room for improvement for both the CGI and RQI scores Based

on industry, we find improvements in RQI scores from 2003 to 2004 in investment, toll road, hotels, restaurants, transportation, and farm industries and deteriorations in manufacturing, construction, trade, real estate, and forestry (not reported)

The average growth in the past three years is 11.3 percent with the average size of about 71.8 million The average debt-to-equity ratio is 1.752 that varies significantly with standard deviation of 2.66

4 Empirical results

In this section we report the results of our empirical tests We first report the main results then we discuss the sensitivity tests using alternative proxies Table III presents the Pearson correlation for variables in our main model First of all, all our proxies for firm value show significant positive correlations to each other This suggests that the three proxies are appropriate to represent firm value

The correlation table shows that PBV is positively correlated with the CGI score, firm size, and leverage This suggests that firms that implement corporate governance, larger firms, and firms with high debt tend to have higher market value We find that RQI and PBV are negatively correlated This indicates that firms with high RQI scores tend to be firms with low PBV and vice versa

We find significant positive correlation between corporate governance and reporting quality at 10 percent level This suggests that firms that implement corporate governance tend to have higher RQI scores RQI is positively correlated with firm size suggesting that large firms tend to adhere to the P3LKE more Corporate

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a0

a1

a2

a3

a4

a5

e it

Table II Descriptive statistics of variables in the regression

11 Corporate governance

governance is also positively correlated with firm size This finding indicates that large firms tend to implement corporate governance

To test our hypotheses we regress PBV on RQI and CGI while controlling for variables that are known to affect firm value We present the regression result in Table IV

TQ ROA CGI RQI SIZE GROWTH LEV

PBV 0.84 0.41 0.28 0.13 0.28 0.08 0.26

(0.00)*** (0.00)*** (0.00)*** (0.08)* (0.00)*** (0.25) (0.00)***

(0.00)*** (0.00)*** (0.05)* (0.00)*** (0.24) (0.89)

(0.00)*** (0.28) (0.02)** (0.00)*** (0.00)***

(0.09)* (0.00)*** (0.88) (0.76)

(0.02)** (0.36) (0.75)

(0.94) (0.28)

(0.44) Notes: n ¼ 192 FIRMVAL, firm value that we measure using PBV; PBV, price to book value ratio; RQI, reporting quality index score; CGI, unweighted corporate governance index score; SIZE, log total assets; GROWTH, average growth of sales in the last three years; LEV, debt-to-equity ratio.

***,**,*Correlations significant at 0.01, 0.05, and 0.1 levels, respectively FIRMVAL it ¼ a 0 þ a 1 CGI it þ a 2 RQI it þ a 3 SIZE it þ a 4 GROWTH it þ a 5 LEV it þ e it

Table III.

Correlation of variables

in the model

(0.011)**

(0.003)***

(0.004)***

(0.050)**

(0.083)*

(0.000)***

Notes: FIRMVAL, firm value that we measure using PBV, PBV, price to book value ratio; CGI, unweighted corporate governance index score; RQI, reporting quality index score; SIZE, log total assets; GROWTH, average growth of sales in the last three years; LEV, debt-to-equity ratio *Test variables significant at 10, 5, and 1 percent levels, respectively

FIRMVAL it ¼ a 0 þ a 1 CGI it þ a 2 RQI it þ a 3 SIZE it þ a 4 GROWTH it þ a 5 LEV it þ e it

Table IV.

Regression results using

PBV as the dependent

variable and un-weighted

CGI as the independent

variable

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Consistent with our first hypothesis we find positive association between PBV and

suggesting that firms that implement better corporate governance are likely to have

a higher value The magnitude of the slope (3.7) is large, suggesting that an increase in

CGI score is associated with a large increase in firm value

We find negative association between RQI and firm value This finding does not

support our second hypothesis that predicts a positive association It suggests that

firms with lower values tend to disclose more information that is consistent with the

P3LKE One possible explanation is that low-value firms try to improve their values by

disclosing more information that is consistent with the P3LKE It is possible that when

the BAPEPAM issue the P3LKE, the managers of low-value firms would follow the

guidance in order to influence market perception about the company On the other

hand, high-value firms may not see this guidance as something important and

therefore, may not follow the guidance in determining what information to disclose

Consistent with prior studies, we find size, growth, and leverage affect firm value

The coefficient for SIZE is positive and significant suggesting that larger firms tend to

have higher values We also find positive and significant coefficient on GROWTH

suggesting that firms with higher growth have higher values Leverage (LEV) is also

positively associated with firm value suggesting that these firms seem to be able to

benefit from their leverage

4.1 Sensitivity analysis

4.1.1 Tobin’s Q and ROA for firm value To test whether our results are sensitive to how

we measure firm value, we also run multivariate regressions using Tobin’s Q and return

on assets as our proxy for firm value Earlier work on firm performance has used Tobin’s

Q as the measure of firm value (Demsetz and Lehn, 1985; Morck et al., 1988; Yermack,

1996; Gompers et al., 2003) We calculate Tobin’s Q by comparing the market value of a

We use book value of debt (BVDEBT) for both the numerator and denominator because

market value of debt is not available in Indonesia Table V shows the regression results

of regressing Tobin’s Q and ROA on CGI, RQI, and the control variables

The coefficients on CGI are positive and significant for both regressions using Tobin’s

Q and ROA These results are consistent with the results of using PBV and support our

first hypothesis that there is association between firm value and corporate governance

even when we use different proxies for firm value Consistent with our main test the

results show significant negative coefficients for RQI suggesting that firms with lower

values tend to disclose more information that are consistent with the P3LKE

In general, the results of our sensitivity tests support the results of the main test that

finds a negative association between firm value and RQI and positive association

between firm value and CGI Our results also show that the independent variables

in our models explain the variation in ROA better than variation in PBV or Tobin’s Q

4.1.2 Weighted CGI In our main test we use the non-weighted CGI It means that we do

not put any weight on the five groups of items in the index In this sensitivity analysis, we

follow the IICD recommendation and calculate the weighted CGI based on 20 percent

weight on rights of shareholders, 15 percent weight on equal treatment of shareholders, 15

percent weight on role of stakeholders, 25 percent weight on disclosure and transparency,

13 Corporate governance