An analysis of the nature and effectiveness of corporate governance in smaller listed australian companies

Abstract The objective of this thesis is to investigate the corporate governance attributes of smaller listed Australian firms.. While there is an extensive body of literature examining

An analysis of the nature and effectiveness of corporate governance in smaller listed

February 2011

Abstract

The objective of this thesis is to investigate the corporate governance attributes of smaller listed Australian firms This study is motivated by evidence that these firms are associated with more regulatory concerns, the introduction of ASX Corporate Governance Recommendations in 2004, and

a paucity of research to guide regulators and stakeholders of smaller firms While there is an extensive body of literature examining the effectiveness of corporate governance, the literature principally focuses on larger companies, resulting in a deficiency in the understanding of the nature and effectiveness of corporate governance in smaller firms

Based on a review of agency theory literature, a theoretical model is developed that posits that agency costs are mitigated by internal governance mechanisms and transparency The model includes external governance factors but in many smaller firms these factors are potentially absent, increasing the reliance on the internal governance mechanisms of the firm Based on the model, the observed greater regulatory intervention in smaller companies may be due to sub-optimal internal governance practices Accordingly, this study addresses four broad research questions (RQs) First, what is the extent and nature of the ASX Recommendations that have been adopted by smaller firms (RQ1)? Second, what firm characteristics explain differences in the recommendations adopted by smaller listed firms (RQ2), and third, what firm characteristics explain changes in the governance of smaller firms over time (RQ3)? Fourth, how effective are the corporate governance attributes of smaller firms (RQ4)?

Six hypotheses are developed to address the RQs The first two hypotheses explore the extent and nature of corporate governance, while the remaining hypotheses evaluate its effectiveness A time-series, cross-sectional approach is used to evaluate the effectiveness of governance Three models, based on individual governance attributes, an index of six items derived from the literature, and an index based on the full list of ASX Recommendations, are developed and tested using a sample of 298 smaller firms with annual observations over a five-year period (2002-2006) before and after the introduction of the ASX Recommendations in 2004

With respect to (RQ1) the results reveal that the overall adoption of the recommendations increased from 66 per cent in 2004 to 74 per cent in 2006 Interestingly, the adoption rate for recommendations regarding the structure of the board and formation of committees is significantly lower than the rates for other categories of recommendations With respect to (RQ2) the results reveal that variations in rates of adoption are explained by key firm differences including, firm size, profitability, board size, audit quality, and ownership dispersion, while the results for (RQ3) were inconclusive With respect to (RQ4), the results provide support for the association between better governance and superior accounting-based performance In particular, the results highlight the importance of the independence of both the board and audit committee chairs, and of greater accounting-based expertise on the audit committee In contrast, while there is little evidence that a majority independent board is associated with superior outcomes, there is evidence linking board independence with adverse audit opinion outcomes These results suggest that board and chair independence are substitutes; in the presence of an independent chair a majority independent board may be an unnecessary and costly investment for smaller firms

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Table of Contents

Abstract i

Table of Contents iii

List of Tables ix

List of Figures xi

Statement of Original Authorship xii

List of Abbreviations xiii

Acknowledgements xvi

Chapter One: Introduction 1.1 Introduction 1

1.2 Motivation 2

1.3 Corporate governance in smaller firms 3

1.3.1 The external governance environment 4

1.3.2 The internal governance environment 7

1.4 Research objectives and research questions 7

1.5 Theoretical framework 8

1.6 Research design 9

1.7 Summary of major findings 10

1.8 Contribution of the study 11

1.9 Organisation of the thesis 12

Chapter Two: Institutional setting 2.1 Introduction 15

2.2 Development of corporate governance principles and disclosure in Australia 15

2.2.1 Voluntary period (1991-1996) 16

2.2.2 Introduction of Listing Rule 3C(3)(j) (1996-2004) 17

2.2.3 Principles of Good Corporate Governance and Best Practice Recommendations 18

2.2.4 Changes subsequent to the introduction of the ASX recommendations (post 2003) 20

2.2.5 ASX recommendations in the context of theories of regulation 21

2.3 Overview of governance codes internationally 22

2.3.1 United States 23

2.3.2 United Kingdom 24

2.3.3 European Union 26

2.3.4 New Zealand 27

2.3.5 Hong Kong 27

2.3.6 Singapore 28

2.3.7 Summary 30

2.4 Corporate governance codes and smaller companies 34

2.5 Conclusion 40

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Chapter Three: Literature review

3.1 Introduction 43

3.2 Agency theory 43

3.3 Regulation of corporate disclosure 46

3.4 The relevance of corporate governance 49

3.5 The effectiveness of corporate governance 51

3.5.1 Governance and performance and valuation studies 51

3.5.2 Governance and disclosure research 53

3.5.3 Governance and ASX queries 53

3.5.4 Governance and modified audit opinions 54

3.6 Internal governance factors 55

3.6.1 Board characteristics 56

3.6.2 Board committees 61

3.6.3 Internal control systems 64

3.7 External governance influences 65

3.7.1 Debt 65

3.7.2 External Audit 65

3.8 The relevance of corporate governance in smaller companies 66

3.9 Conclusion 68

Chapter Four: Theoretical framework and hypothesis development 4.1 Introduction 71

4.2 A framework for corporate governance 72

4.3 Introduction of the ASX Best Practice Recommendations 77

4.3.1 Adoption of recommendations (RQ1) 77

4.3.2 Factors influencing the adoption of corporate governance recommendations (RQ2) 80

4.3.3 Factors associated with changes in corporate governance (RQ3) 84

4.4 Corporate governance and firm outcomes (RQ4) 85

4.4.1 Performance 86

4.4.2 Disclosure 87

4.4.3 ASX price movement queries 88

4.4.4 Modified audit opinions 89

4.5 Summary 90

Chapter Five: Research method 5.1 Introduction 91

5.2 Study period 91

5.3 Sample selection 92

5.4 Data sources 94

5.5 Research method 94

5.5.1 Internal corporate governance environment 94

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5.5.2 Development of governance index 95

5.5.3 Research method H1, H2A and H2B 97

5.5.4 Change in levels of governance 99

5.5.5 Outcome-related research models (H3 H6) 99

5.5.6 The relationship between ASX recommendations and outcome variables 100

5.5.7 Internal governance variables 101

5.6 Outcome (dependent) variables 101

5.6.1 Performance 101

5.6.2 Disclosure 102

5.6.3 ASX price movement queries 104

5.6.4 Modified audit opinions 104

5.7 Definition of independent variables 105

5.7.1 Board size (BRDSZE) 105

5.7.2 Board independence (BDIND) 105

5.7.3 Independence of board chair (CHIND) 105

5.7.4 Board expertise (BDEXP) 106

5.7.5 Board meetings 106

5.7.6 Audit committee (AC) 106

5.7.7 Remuneration committee and nomination committee (RC and NC) 106

5.8 Control variables 107

5.8.1 Firm size (SIZE) 107

5.8.2 Industry (IND) 107

5.8.3 Audit firm (AUDIT) 108

5.8.4 Leverage (LEV) 108

5.8.5 Growth (GROWTH) 108

5.8.6 Ownership dispersion (SHLDRS) 109

5.8.7 Age (AGE) 109

5.8.8 Commitment test entities (CTE) 109

5.8.9 Pre-post (PREPOST) 110

5.9 Regression models 110

5.9.1 Regression models for the effectiveness of corporate governance 2002-2006 111

5.9.2 Regression model for indices based on ASX recommendations 113

5.10 Summary 113

5.11 Conclusion 115

Chapter Six: Results of the extent and nature of corporate governance 6.1 Introduction 117

6.2 Observation and analysis of corporate governance reporting 117

6.3 Commencement of the Best Practice Recommendations 119

6.4 Change in ASX governance recommendations 2004-2006 122

6.5 Categories of governance recommendations 126

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6.6 Factors influencing adoption of recommendations 130

6.6.1 Descriptive statistics 131

6.6.2 Correlations 134

6.7 Regression analysis of factors associated with conformance with ASX recommendations (H2A) 137

6.7.1 Factors associated with overall governance score (GOVSC) 137

6.7.2 Behavioural index 138

6.7.3 Structural index 139

6.7.4 Disclosure index 140

6.7.5 Summary of regression analysis 141

6.8 Robustness testing 142

6.9 Change in governance 142

6.10 The relationship between committee formation and board size 144

6.11 Conclusion 147

Chapter Seven: Results of tests on the effectiveness of corporate governance 7.1 Introduction 149

7.2 Descriptive statistics for variables in the outcomes models 149

7.2.1 Data transformations 151

7.3 Correlations 153

7.4 Results for performance variables 2002- 2006 158

7.4.1 Return on assets (H3A) 158

7.4.2 Market performance (H3A) 161

G - H A 162

7.4.4 Governance and market-sensitive disclosure (H4A) 165

7.4.5 Governance and ASX queries (H5A) 166

7.4.6 Governance and modified audit opinions (H6A) 168

7.4.7 Summary of results 170

7.5 Additional analysis 172

7.5.1 Non-contemporaneous association between governance and return on assets (ROA) (2002-2006) 172

7.5.2 Board independence 174

7.5.3 Audit committee characteristics 176

7.5.4 Audit committee characteristics and performance outcomes (H3A) 178

7.5.5 Audit committee characteristics and disclosure (H4A) 179

7.5.6 Audit committee characteristics and ASX queries (H5A) 181

7.5.7 Audit committee characteristics and modified audit opinions (H6A) 181

7.5.8 Summary of associations between audit committee characteristics and dependent variables 182

7.5.9 Robustness testing 183

7.5.10 Summary of additional analysis 184

7.6 Governance indices created from the ASX recommendations 2004-2006 184

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7.6.1 Governance indices and ROA 185

7.6.2 Governance indices and market returns 188

7.6.3 Governance indices and voluntary disclosure 189

7.6.4 Governance indices and market-sensitive disclosures 191

7.6.5 Governance indices and ASX queries 193

7.6.6 Governance indices and modified audit opinions 193

7.6.7 Summary of results for ASX recommendations-based indices 195

7.7 Principal components analysis of the ASX recommendations 196

7.7.1 Description of the components 199

7.7.2 Association between governance components and performance variables 2004-2006 202

7.7.3 Association between governance components and disclosure variables 2004-2006 203

7.7.4 Association between governance components and ASX queries 2004-2006 205

7.7.5 Association between governance components and modified audit opinions 2004-2006 205

7.7.6 Summary of PCA analysis of ASX recommendations 205

7.8 Review of results 207

7.8.1 Accounting-based performance 207

7.8.2 Disclosure 208

7.8.3 Modified audit opinions 209

7.9 Conclusions 209

Chapter Eight: Conclusions 8.1 Introduction 211

8.2 Summary of thesis 211

8.2.1 Motivation for the research 211

8.2.2 Theoretical framework and hypotheses 212

8.2.3 Research method 213

8.3 Summary of findings 213

8.3.1 The nature of corporate governance in smaller firms 213

8.3.2 The effectiveness of corporate governance 214

8.4 Discussion of key findings 216

8.5 Limitations and opportunities for further research 217

8.6 Contribution 219

References 223

Appendix A:Members of the ASX Corporate Governance Council and Members of the Working G C P C 233

Appendix B: The ASX Best Practice Recommendations 235

Appendix C: Australian Stock Exchange Listing Rules Appendix 4A 237

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List of Tables

Table 1.1 Differences in the information environment for listed Australian firms 5

Table 2.1 Review of international corporate governance codes 31

Table 2.2 Comparison of different approaches to governance in smaller listed companies 40

Table 5.1 Summary of sample selection process 93

Table 5.2 Sample distribution and size comparison 94

Table 5.3 Components of governance index based on ASX Recommendations 97

Table 5.4 Summary of regression techniques 111

Table 5.5 Summary of predicted relationships between independent and control variables and dependent variables 114

Table 5.6 Summary description of independent variables 115

Table 6.1 Changes in governance practices 2002-2006 120

Table 6.2 Significance of changes in governance practices 2002-2006 122

Table 6.3 Conformance with ASX recommendations 2004-2006 123

Table 6.4 Adoption of ASX recommendations by category 126

Table 6.5 Tests of changes in adoption of governance recommendations 130

Table 6.6 Descriptive statistics raw data 132

Table 6.7 Descriptive statistics transformed data 133

Table 6.8 Frequencies of dichotomous variables 134

Table 6.9 Pearson and Spearman correlation coefficients 135

Table 6.10 Results of regression analysis on governance score (GOVSC) 138

Table 6.11 Results of regression analysis on behavioural governance score (GOV_B) 139

Table 6.12 Results of regression analysis on structural governance score (GOV_S) 140

Table 6.13 Results of regression analysis on disclosure governance score (GOV_D) 141

Table 6.14 Summary of relationships between governance indices and independent variables in 2004 142 Table 6.15 Results of regression analysis on change of structural governance 144

Table 6.16 Cross Tabulations of board size and committees 146

Table 7.1 Descriptive statistics of panel data 2002-2006 152

Table 7.2 Pearson and Spearman correlation coefficients 156

Table 7.3 Results of OLS regression of governance measures on return on assets (ROA) 2002-2006 160

Table 7.4 Results of OLS regression of governance measures on market adjusted returns (CAR) 2002-2006 162

Table 7.5 Results of ZINB regression of governance measures on non-routine disclosure (ASX code '14") 2002-2006 164

Table 7.6 Results of ZTNB regression of governance measures on market-sensitive disclosure 166

2002-2006 166

Table 7.7 Results of logistic regression of governance measures on ASX queries 2002-2006 168

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Table 7.8 Results of logit regression of governance measures on modified audit opinion (MAO) 170

2002-2006 170 Table 7.9 Summary of results 171 Table 7.10 Results of OLS regression of governance measures on one- and two-year lags of return on

assets (ROA) 2002-2006 173 Table 7.11 Descriptive statistics for audit committee characteristics 177 Table 7.12 Results of regression analysis of audit committee characteristics on performance

2002-2006 179 Table 7.13 Results of regression of governance measures on disclosure variables 180 Table 7.14 Results of regression of audit committee characteristics on modified audit opinions

(MAO) 2002-2006 182 Table 7.15 Summary of significant associations between audit committee characteristics and

dependent variables 183 Table 7.16 Results of test of OLS regression of governance indices on return on assets (ROA)

2004-2006 (RM 5) 186 Table 7.17 Results of OLS regression of governance indices on one-year lagged return on assets

(ROA) 2004-2006 (RM 5) 187 Table 7.18 Results of OLS regression of governance indices on two-year lagged return on assets

(ROA) 2004-2006 (RM 5) 188 Table 7.19 Results of OLS regression of governance indices on CAR 2004-2006 (RM 5) 189 Table 7.20 Results of ZINB regression on voluntary disclosure 190 Table 7.21 Results of ZTNB regression of governance indices on market-sensitive disclosure

2004-2006 (RM5) 192 Table 7.22 Results of logistic regression on receipt of modified audit opinion 194 Table 7.23 Summary of results for governance indices based on ASX recommendations 195 Table 7.24 Comparison of component and randomly generated eigenvalues, and reliability

coefficients for components derived from ASX recommendations 198 Table 7.25 Identification of components and the relevant variables 200 Table 7.26 Summary of predicted relationships between governance components and

dependent variables 2004-2006 201 Table 7.27 Results of OLS regression of governance components on temporal measures of

return on assets (ROA) 2004-2006 203 Table 7.28 Results of regression of governance components on disclosure variables 204 Table 7.29 Results of logistic regression of governance components on modified audit opinions

2002-2006 206 Table 7.30 Summary of associations between components and dependent variables 206

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List of Figures

Figure 1.1 Financial and information flows in a capital markets economy 6

Figure 1.2 Financial and information flows for smaller firms 6

Figure 2.1 Flowchart of changes in corporate governance reporting in Australia 16

F I 74

Figure 4.2 Corporate governance framework 75

Figure 6.1 Changes in selected governance mechanisms 2002-2006 121

Figure 6.2 Change in total conformance by level and by category 2004-2006 127

Figure 7.1 Scree plot of eigenvalues of components based on ASX Recommendations 198

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List of Abbreviations

AIM Alternative Investment Market

AMEX American Stock Exchange

ASIC Australian Securities and Investments Commission

ASX Australian Securities Exchange (formerly Australian Stock Exchange) ASXCGC ASX Corporate Governance Council

ASXMS ASX Markets Supervision

CCDG Council of Corporate Disclosure and Governance

CGC Corporate Governance Committee

CISCO City Group for Smaller Companies (now Quoted Companies Alliance) CLERP Corporate Law Economic Reform Program

CTE Commitments Test Entity

ECGF European Corporate Governance Forum

FRC Financial Reporting Council

GEM Growth Enterprise Market

HKEx Stock Exchange of Hong Kong

ICAA Institute of Chartered Accountants in Australia

IFRS International Financial Reporting Standards

LSE London Stock Exchange

MAS Monetary Authority of Singapore

NASDAQ National Association of Securities Dealers Automatic Quotation NYSE New York Stock Exchange

NZSC New Zealand Securities Commission

NZX New Zealand Exchange

OECD Organisation for Economic Co-operation and Development

PCA Principal Components Analysis

PCAOB Public Accounting Oversight Board

SEC Securities and Exchange Commission

SGX Singapore Exchange

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I would also like to thank Kim for her patience during the long journey and everyone else who has been neglected.

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1

Chapter One Introduction

1.1 Introduction

There has been considerable public, investor and regulatory interest in corporate governance issues over the past 20 years This interest has been created by a number of stimuli, including increased fluidity of global capital, corporate failures, the need to improve investor confidence, and recent poor public perception of corporate accountability In response to these stimuli, market regulators across the globe have undertaken reforms of corporate governance requirements, usually taking the form of development of codes of conduct or best practice guidelines

A spate of corporate failures in 2001, both in Australia and overseas, led the Australian Stock Exchange1 (ASX) to form the ASX Corporate Governance Council (ASXCGC) develop and deliver an industry-wide, supportable and supported framework for corporate

A“XCGC Foreword)2

Good Corporate Governance and Best Practice Recomme

which became effective for listed companies from reporting dates after 1 January 2004

The ASX first required companies to disclose their corporate governance practices when Listing Rule 3C(3)(j) became effective for reporting periods ending on or after 30 June 1996 This rule required listed companies to disclose their main corporate governance practices in place during the reporting period The ASX opted for a non-prescriptive approach with the subsequent introduction of recommendations owing to concerns that smaller companies might be overwhelmed by the burden of compliance (Ramsay and Hoad, 1997) Concerns about the cost of compliance with corporate governance codes for smaller companies have been a feature of debates in other jurisdictions In the context of the UK market, Peter (2005,

2

While the major principles of good corporate governance are of relevance to all companies, it would be a mistake to believe that every aspect of the detail of what is promulgated for large listed companies is relevant across the spectrum In order to achieve acceptance and eventually enthusiasm for corporate governance the principle must be relevant to the size, structure and nature of the business entity

number of smaller companies (Ramsay and Hoad, 1997), and the debate regarding how corporate governance requirements should apply to these companies has been robust The objective of this thesis is to investigate the nature and effectiveness of corporate governance

in smaller listed Australian companies

1.2 Motivation

This thesis is motivated by several factors First, despite the debate over how corporate governance codes should apply to smaller companies, there is comparatively little empirical evidence related to the corporate governance environment of smaller companies, and the efficacy of governance mechanisms in these firms Reasons for the lack of empirical evidence include the economic significance of the largest companies and the availability of data for these firms This thesis addresses this gap by examining the governance structures of smaller Australian firms

Second, despite the lack of research focus on smaller companies, there is evidence that smaller companies create more regulatory concerns Smaller listed Australian companies receive a disproportionately high number of ASX queries regarding large, unexplained share price movements (Neagle and Tsykin, 2001) Smaller companies in the US are also associated with a higher number of regulatory interventions for breaches of accounting standards (Dechow, Sloan and Sweeney, 1996) This evidence of adverse outcomes for smaller firms provides the second motivation for exploring the governance environment of smaller firms

Third, the introduction of the ASX Recommendations in 2004 provides an opportunity to examine how smaller companies have approached the commencement of a new governance code and to determine if the new code has caused smaller firms to review and amend their corporate governance policies and mechanisms More specifically, this thesis investigates the extent of adoption of individual recommendations and examines the principal factors associated with the governance choices of smaller firms Where changes in corporate

1.3 Corporate governance in smaller firms

Effective corporate governance measures act to reduce the agency costs that arise from the information asymmetries caused by the separation of ownership and management The agency conflict is central to Shleifer and Vishny (1997) description of corporate governance

C governance is a broad term given to the disparate forces and mechanisms that direct and influence the operations and management of a company A commonly cited definition is

originating in the Cadbury Committee report (1992: para 2.5) Yet, these definitions and others seemingly overlook the complexity of corporate governance and its influences and mechanisms The Organisation for Economic Co-operation and Development (OECD) takes a more holistic approach and describes corporate governance as a set of relationships between

I structure through which the objectives of the company are set, and the means of attaining

OECD T OECD definition takes a broader view of governance, in contrast to the narrower definitions focused

on control or suppliers of finance

The ASXCGC (2003, p 3) also uses a broad approach that incorporates the notion of accountability by defining corporate governance as:

objectives of the company are set and achieved, how risk is monitored and assessed, and how performance is optimised Good corporate governance structures encourage

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commensurate with the risks involved

From these definitions corporate governance is viewed not merely as the internal policies and procedures of organisations, but as a broader concept including the legal and social

that incorporates relationships with stakeholders who may or may not interact directly with the business entity Expanding on this point, it is evident that governance mechanisms and influences separate into two broad categories: those imposed from the external environment

in which the firm operates, and those that are established within the firm to provide guidance

on how the board and managers conduct the business of the firm

1.3.1 The external governance environment

All companies are subject to the scrutiny and influence of a range of stakeholders These include regulatory bodies such as the Australian Securities and Investments Commission (ASIC) and the Australian Securities Exchange (ASX), and information intermediaries such as analysts,

substantially more scrutiny by information intermediaries than their smaller counterparts Analysts mainly focus their resources on larger companies as the stocks of these companies comprise the majority of market indices Institutional investors also focus their resources on stocks in the major market indices While debtholders can influence the behaviour of companies and their boards through contracting arrangements, many smaller companies are unable to obtain debt finance Although the media plays an important role in disseminating information and reducing information asymmetries (Bushee, Core, Guay and Wee, 2006), smaller firms receive much less coverage Smaller companies are also less likely to retain the services of a Big 4 audit firm, a common proxy for audit quality Table 1 summarises key factors influencing the external governance of firms, considers their impact, and illustrates how the influence of external stakeholders varies with company size

Association

Active monitoring Lower level of monitoring Analysts Active monitoring Low coverage

Debtholders Active monitoring Debt financing frequently

unavailable for smaller entities

External Audit Higher quality (Big 4) Lower quality (non-Big 4)

Institutional Investors Higher ownership and

related to measures of its size In addition, analysts and media can effectively act as de facto

sources of regulation for larger companies by directing the attention of regulators to individual companies3 In contrast, regulation of smaller listed companies in Australia is generally limited

to the formal scrutiny of the ASX and ASIC In the absence of many of these external governance influences, the flow of information to shareholders of smaller companies will be restricted, as demonstrated in Figure 1.2 The absence of these formal and informal external factors may also lead to weaker internal governance if substitute mechanisms are not available The differences in the information and governance environments for smaller companies and their impact on performance, though evident in the literature, are rarely explicitly examined

3 For example, on 6 June 2006 The Australian published an article regarding the potential liability faced

by a subsidiary of Lend Leas A allegedly caused by toxic fumes and dust released during its clean-up of Ground Zero after the September 2001 terror (West, 2006) The company subsequently made a market disclosure, to avoid possible action for breach of continuous disclosure For small companies, not subject to media scrutiny, such publicity is less likely

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(Adapted from Healy and Palepu, 2001)

Figure 1.1 Financial and information flows in a capital markets economy

(Adapted from Healy and Palepu, 2001)

Figure 1.2 Financial and information flows for smaller firms

Investors

Financial

intermediaries

Information intermediaries

Auditors and accounting regulators

Flow of information

Regulators of capital

markets

Large business firms

Regulators of capital

markets

Smaller business firms Flow of

capital

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1.3.2 The internal governance environment

The internal governance of firms consists of the mechanisms, processes and procedures established to oversee and influence the a T

governance is to ensure compliance with corporate law and stock exchange listing rules relating to disclosure and financial reporting, and to safeguard against behaviour such as earnings management or excessive consumption of perquisites (Davidson, Goodwin-Stewart and Kent, 2005; Dechow, Sloan and Sweeney, 1996) An effective internal governance structure will ensure that markets are informed through the timely disclosure of firm specific information, and will also minimise agency costs, potentially leading to better performance

The weaker information environment for smaller firms, together with the potential absence of external governance actors, raises concerns about the overall governance environment of these firms Where the internal governance structures and attributes do not adequately substitute for the deficiency in external monitoring, then there may be adverse consequences for these smaller firms

1.4 Research objectives and research questions

There is a vast body of research literature exploring corporate governance and its associations with a range of firm outcomes However, much of the literature centres on larger companies, with relatively little attention paid to smaller firms The broad objective of this study is to extend the governance literature to smaller firms, and more specifically, to smaller listed Australian firms Owing to differences between firms of different size, the findings of earlier corporate governance studies may not be generalisable to smaller firms

When the ASX Recommendations were introduced, the ASXCGC noted that the range in size and diversity of companies is significant and that companies should determine if each recommendation is appropriate to its particular circumstances (2003, p 5) In addition, they noted that smaller companies may not derive efficiencies from the formation of board committees (2003, pp 22, 30, 43, 54) Given the diversity of listed companies, the non-prescriptive nature of the recommendations, and the guidance on committee formation, it is expected that variations in the rate of adoption of the recommendations will be observed Hence, the first research question asks:

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RQ1 What is the extent and nature of the ASX recommendations that have been adopted

by smaller listed firms?

There is an expectation in the first research question that considerable differences will be found in the rates of adoption of the various ASX recommendations An extension of this question is to consider the factors that may explain the governance choices of these firms As discussed above, guidance from the ASXCGC suggests that board committees may be less common in smaller firms However, firm size may only be one factor associated with differences in the adoption of the recommendations Therefore, the second research question asks:

RQ2 What firm characteristics explain differences in the ASX Recommendations adopted by

smaller listed firms?

While the second research question considers the level of ASX Recommendations that are adopted in each year, it will be informative to identify factors associated with changes in governance over time Hence the third research question asks:

RQ3 What firm characteristics explain changes in the governance environment of smaller

firms over time?

As discussed in section 1.2, while there is a considerable body of literature on corporate governance, there is comparatively little empirical evidence related to the efficacy of corporate governance in smaller firms To addresses the deficiency in the literature, the fourth research question asks:

RQ4 How effective are the corporate governance attributes of smaller listed firms?

1.5 Theoretical framework

In addressing the research questions, this study draws on agency theory and prior literature to develop a research framework The separation of ownership and control gives rise to the agency problem In the framework, agency costs are mitigated through three principal means: external monitoring, transparency in disclosure, and an effective internal corporate environment As a formal part of the framework, an effective internal governance

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environment is expected to contribute to the reduction of agency costs This is consistent with the rationale for the introduction of the recommendations, as the ASXCGC describes the recommendations as providing a reference point for structures to minimise problems and optimise performance and accountability (2003, p 3)

Within this framework, six testable research hypotheses are developed to address the research questions The first two hypotheses explore the extent and nature of corporate governance in smaller listed Australian firms, and investigate the factors associated with differences in adoption rates of the recommendations The four remaining hypotheses address the effectiveness of corporate governance by assessing its associations with four measurable outcomes drawn from the literature The four outcomes are firm performance (Cremers and Nair, 2005), disclosure (Beekes and Brown, 2006), receipt of an ASX query (Neagle and Tsykin, 2001) and the probability of receiving a modified audit opinion (Farinha and Viana, 2009)

1.6 Research design

This thesis examines the corporate governance practices and outcomes of a sample of 298 smaller firms for the years 2002 to 2006 A five-year period is chosen for several reasons First, the ASX Recommendations became effective for financial years ending in 2004 and a three-year period following the commencement of the recommendations is selected to allow changes in governance structures to be observed This is consistent with the guidance from the ASXCGC, who counselled against rapid and wholesale changes (2003, p 5) Second, to facilitate analysis of the changes engendered by the introduction of the recommendations, data is also collected for the two years prior to the commencement of the new code While a full comparison of the pre- and post-introduction periods is not possible, a limited comparison can be made using a number of governance items that can be assessed in both phases, aiding the analysis of changes induced by the introduction of the recommendations Assessing the nature and extent of corporate governance in smaller firms requires extensive manual collection of data from company annual reports, which has also constrained the analysis to a five-year period

The principal aim of this thesis is to explore the corporate governance environment of smaller listed Australian firms Achieving this aim requires the largest companies to be omitted and accordingly, firms in the top 300 by market capitalisation are excluded In addition, Australia

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has a large number of very small listed companies, and these firms are also excluded to avoid

dissimilar to smaller or mid-tier firms4 Accordingly, this thesis defines smaller firms as mid-tier firms outside of the top 300 and with a 2006 year-end market capitalisation greater than

$30M

The research methods used to examine the nature and extent of governance in smaller companies include both univariate and multivariate procedures Governance indices are constructed to assess the factors associated with differences in the rates of adoption of the ASX Recommendations The effectiveness of corporate governance is investigated by utilising three research models based on individual internal corporate governance mechanisms derived from the literature, an index derived from selected individual internal corporate governance mechanisms, and an index constructed from conformance with the ASX recommendations The model using the index derived from the ASX recommendations uses a subset of the data for the years 2004 to 2006 Regression analysis methods are used to assess the effectiveness

of governance through its association with four measurable outcomes drawn from the literature

1.7 Summary of major findings

The analysis of the nature and extent of the adoption of the ASX recommendations reveals that the overall mean level of adoption of the ASX recommendations rose from 66 per cent in

2004 to 74 per cent in 2006 However, there is substantial variance in the rates of adoption of individual recommendations: in 2004 only 26 per cent of firms disclosed the existence of a nomination committee, while 91 per cent provided disclosure of remuneration policies Structural recommendations, related to board characteristics and committee formation, have consistently lower rates of adoption than recommendations that refer to policies and procedures related to behaviour and disclosure Regression analysis indicates that larger firms, more profitable firms, firms with larger boards, firms using BIG 4 audit firms, and firms with greater ownership dispersion have internal governance environments that are more reflective of the ASX recommendations

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In 2006 there were approximately 900 companies with a market capitalisation below $30M listed on the ASX

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The results of models using governance indices to test the effectiveness of corporate governance find consistent evidence of a positive association between accounting-based performance and internal corporate governance attributes While indices of structural

associations between better governance and market performance, market-sensitive disclosure, or ASX queries Conformance with disclosure-based recommendations is associated with a lower probability of receiving a modified audit opinion

-Results on the effectiveness of individual corporate governance attributes provide a number of key insights First, the results highlight the importance of an independent board chair for smaller companies In contrast, there is little evidence that a majority independent board is associated with superior outcomes Together, these results indicate that board independence and chair independence may be substitutes; in the presence of an independent chair, a majority independent board may be an unnecessary and costly investment for smaller companies Second, analysis of specific audit committee characteristics demonstrates that the independence of the committee chair and accounting-based expertise of the committee members are the most important characteristics for smaller firm audit committees While majority independent committees are viewed as desirable, there was little evidence to support this recommendation

The overall results highlight the importance of an independent board chair, an independent audit committee chair, and the accounting-based expertise of both the board and audit committee members In contrast, there was no evidence that greater board independence or the existence of remuneration or nomination committees was associated with enhanced performance Together, these results provide support for the principles-based approach to corporate governance of the ASX Rather than being constricted by a mandatory rules-based system, the ASX approach enhances the ability of all listed firms to achieve an optimal corporate governance environment

1.8 Contribution of the study

The findings of this study contribute to the scarce corporate governance literature related to smaller listed companies, and more specifically to the literature related to the corporate governance of smaller Australian firms Despite the large number of smaller listed firms in the Australian market, previous research has not detailed the extent to which these firms have

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implemented the ASX recommendations This study provides an extensive assessment of the corporate governance practices of a sample of these firms over a five-year period The study demonstrates that, despite the increasing level of conformance with the recommendations, many smaller companies are utilising the flexibility inherent in the governance code by only adopting recommendations that are appropriate to their needs and providing an explanation for non-adoption of other recommendations

A number of findings may also have implications for future policy decisions Achieving a majority independent board is a potentially expensive exercise for many smaller companies, yet there was little evidence that a majority independent board conveyed extensive benefits

On the contrary, majority independent boards were associated with a higher probability of receipt of a modified audit opinion These findings and the positive findings regarding the independence of the board chair, suggest that in smaller companies where resources are limited, an independent board chair is more efficacious than a majority independent board, consistent with the existence of a substitution effect

The audit committee is a key corporate governance mechanism, and its importance is reflected

in the three recommendations related to committee formation, composition and charter The results of this study indicate that two committee characteristics, the independence of the chair, and greater accounting-based expertise on the committee, are associated with superior outcomes In the presence of an independent chair and relevant expertise, the independence

of the committee has little discernible effect on firm outcomes Future reviews of the corporate governance recommendations may consider providing improved guidance to smaller companies that are unable to form audit committees that are fully compliant with the recommendations Moreover, policy-makers may consider giving greater emphasis to the technical skills of the committee members, as at present this aspect merely forms part of the accompanying guidance and is not part of the recommendations

1.9 Organisation of the thesis

The remainder of this thesis is structured as follows Chapter Two explores the development

of corporate governance codes in Australia, and then reviews the codes of major international and regional markets, before comparing how the different markets cater for the needs of smaller firms Using agency theory as its basis, Chapter Three considers the relevance of corporate governance, and reviews the findings of prior literature while considering how the

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results apply to smaller companies In Chapter Four, a theoretical framework is proposed and

a series of testable research hypotheses are developed Chapter Five describes the research design, including the study period, sample selection, data collection, research models, and the definition of the variables Chapter Six presents the results of tests of Hypotheses 1 and 2 that consider the nature of the governance recommendations adopted by the sample firms, and the factors that explain the variation in the internal governance environment of smaller firms The effectiveness of corporate governance, tested by Hypotheses 3 to 6, is the focus of Chapter Seven which presents the results of tests of the association between governance attributes and firm performance and disclosure, and two adverse outcomes, receipt of an ASX query and the probability of receipt of a modified audit opinion Chapter Eight concludes the thesis with a discussion and summary of the findings, major contributions, limitations and potential implications for policy

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Chapter Two Institutional setting

2.1 Introduction

Listed companies are characterised by the divergent interests of stakeholders Good corporate governance aims to balance and protect the interests of various stakeholders by ensuring that appropriate mechanisms to align these divergent interests are in place and to ensure adequate monitoring of management The disclosure of corporate governance practices enables market participants to assess the adequacy of such practices and mechanisms and where necessary, agitate for improvement (Ramsay and Hoad, 1997) Consistent with this and in the context of the Australian market, firms are able to adopt governance practices and mechanisms that best suit their size, structure or complexity The disclosure of such practices enables investors to make their own assessment of the risks associated with each firm

This chapter discusses the development of governance codes in Australia and reviews subsequent reforms that have led to the present model for governance and its disclosure A review of the various approaches to corporate governance across major global and regional markets is undertaken to identify similarities and differences in the operation of governance codes The chapter concludes with a comparison of how the various governance codes and recommendations apply to companies of different size

2.2 Development of corporate governance principles and disclosure in Australia

This section traces the introduction and evolution of corporate governance codes in Australia and the changes in the ASX listing rules pertaining to disclosure of governance in company annual reports There are three important dates in the evolution of corporate governance reporting in Australia: 1991, 1996, and 2004 The dates and changes are encapsulated in a flowchart in Figure 2.1

of investor and public confidence The guide set out two objectives: to provide guidance for directors, officers and professional advisors as to what

is acceptable conduct and practice; and to spread and reinforce high standards of corporate conduct (Bosch, 1991, p 1)

The recommendations set out in the guide were voluntary The extent to which they were followed is open to speculation; not only was any form of compliance voluntary but so too was the disclosure of governance practices However, the guide proposed that the annual reports

of all public companies should include a statement that the company supports and has adhered to the principles espoused in the guide, and that any departures from the principles should be noted and the reason for the departures given Despite the widespread acceptance

of the guide and the input of business groups (including Business Council of Australia and The Australian Institute of Company Directors) and two professional accounting bodies, Australian Society of Certified Practising Accountants (now CPA Australia) and the Institute of Chartered Accountants in Australia (ICAA), the recommendations for disclosure do not appear to have won common acceptance Of the 299 annual reports in the Connect 4 database for the 1994 financial year, Collett and Hrasky (2005) identified only 30 companies that made voluntary corporate governance disclosures Furthermore, their findings indicated that the disclosures may have been motivated by a desire to subsequently raise debt or equity capital

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In September 1994 the ASX released a discussion paper, canvassing options for the corporate governance requirements that would later be released as Listing Rule 3C(3)(j), requiring mandatory disclosure of governance practices from 1996 The new rule required companies to set out in their annual reports a statement of the main corporate governance practices that the company had in place during the reporting period Although the new rule was only to apply from 1996, the ASX had earlier indicated that compliance would be encouraged in the intervening period (Carson, 1996) Examining the voluntary disclosures in the 1995 reporting period, Carson reports that only two per cent of companies were fully compliant, only 11 per cent disclosed more than half of the required items, and 33 per cent did not comply with any aspect of the new rule other than that already required by existing rules Her findings also indicate that larger companies and companies with listings on overseas stock exchanges were more likely to voluntarily disclose more information The findings of Carson, and Collett and Hrasky (2005), indicate reluctance on the part of Australian listed companies to voluntarily disclose details of their corporate governance policies and procedures in the mid-199

2.2.2 Introduction of Listing Rule 3C(3)(j) (1996-2004)

The Australian Securities Exchange (ASX) introduced Listing Rule 3C(3)(j), to apply from reporting periods on or after 30 June 1996, requiring listed companies to include a statement

of their main corporate governance practices in place during the year To assist companies, the ASX published as an appendix to the rule an indicative list of nine governance matters for companies to take into account when completing the governance statement for inclusion in the annual report The rule was based on a similar rule of the London Stock Exchange that originated in the Cadbury report (Collett and Hrasky, 2005) and did not mandate any governance practices but merely required disclosure of the main practices that the company had in place during the reporting period

The effectiveness of Listing Rule 3C(3)(j) was subject to assessment soon after it took effect The ASX issued a media release in March 1997 which indicated that every one of the top 150 listed companies had complied with the new rule In contrast, the Australian Investment

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with t box-ticking , or compliance with the spirit of the law can

be achieved by providing high quality disclosures

A shortcoming of the AIMA and ASX studies is that the sample companies were from the largest companies by market capitalisation and not representative of the entire market A more comprehensive assessment of compliance with the new listing rule was undertaken by Ramsay and Hoad (1997) Using a sample of 268 annual reports drawn from large, medium and small listed companies, they found substantial shortcomings in the governance disclosures Amongst the findings were that 25 per cent of companies did not discuss the criteria for board membership, 23 per cent did not discuss management remuneration, and 65 per cent did not discuss procedures for reviewing the performance of the management or directors The extent and quality of governance disclosure was typically better for large companies than for small and medium-sized firms Given that the AIMA study found

observe shortcomings in the disclosures of medium and smaller firms

2.2.3 Principles of Good Corporate Governance and Best Practice Recommendations

Following a spate of corporate collapses in 2001, both in Australia and internationally, there were renewed calls for improved corporate governance and increased regulation In response the ASX formed the ASX Corporate Governance Council (ASXCGC) comprising members from

21 business and professional organisations6 Their unanimous goal was to:

-wide, supportable and supported framework for corporate governance which could provide a practical guide for listed companies, their investors, the wider market and the Australian community (ASX, 2003, Foreword)

Although improving the stewardship of public companies was a major motivation for requiring enhanced corporate governance, it is not the sole rationale Other motivations for demonstrating good corporate governance, both on an

6 A list of the Council members is presented in Appendix A