Causal Relationship between Corporate Governance and Return on Assets
of Nigerian Firms
1Iroegbu, Ferdinand N., 2Nwankwo, Caroline N., 3Onyeka, Virginia Nnenna,
1, 2, 3 Department of Accountancy
Faculty of Management Sciences
Enugu State University of Science and Technology
1. INTRODUCTION:
The issue of corporate governance and firm performance has dominated much of intellectual discussions in the last two decades. The discussions were not unconnected with the various corporate scandals that rocked giant corporations in the US and other parts of the world which have called to question the efficacy of the existing corporate governance structures in protecting shareholders’ interests (Hitt, Ireland and Hoskisson, 2009). As much as this issue is of much concern to the developed countries where most of the interests were generated, it is of utmost importance to developing countries as well. For instance, a good number of developing countries have turned in their economies to the influences of the market system, leading to the massive privatization and commercialization of state-owned enterprises while restrictions to foreign trade are been abolished or minimized. In this dispensation, corporate governance is viewed as crucial to the successes of these reforms; however, adequate attention has not been paid by researchers from developing countries at understanding the dynamics of corporate governance system in these developing countries’ economies.
For instance, Black, Jang, Kim, and Park (2010) analyzed the channels of the effect of corporate governance on firm value. They argue that good corporate governance contributes to increase firm value by mitigating the deterioration of shareholder value from related-party transactions, by increasing the investment sensitivity to growth opportunity and by increasing the payout sensitivity to profitability. Similarly, Dahya, John, and McConnell (2007) report that firms with a higher proportion of independent directors have a higher Tobin’s q, and are less likely to engaged in related party transactions. Liu and Lu (2007) show that good corporate governance is associated with lower earnings management, and lower levels of tunneling.
Therefore, these results have provided another guidance and broad view for researchers who want to investigate corporate governance effect on shareholder value. The reason for which focus is on corporate payout policy and investment decision-making these days is because firm value and corporate performance are highly affected by these two managerial decisions. These two behaviors, along with the raising of capital, are the main financial decisions that bring reward for shareholders and decide a firm’s sustainability. Under information asymmetry, managers try to mitigate the conflict of interests between corporate insiders and shareholders (Easterbrook, 1984), and signal the firm’s value to external investors by paying dividends in order to decrease the cost of capital (Miller and Rock, 1985). Paying dividends decrease free cash flow that is considered as the main source of the private benefit of control of managers (Jensen, 1986). Proper investment decision-making improves firm value and corporate performance by increasing profitability and contributing to the firm’s growth in the long term (McConnell and Muscarella, 1985; Chan, Martin, and Kensinger, 1990; Chung Wright, and Kedia, 2003).
However, if managers over invest in negative NPV project to pursue the private benefit of control which is proportional to firm size, then this overinvestment could severely exacerbates the shareholders’ value (Jensen and Meckling, 1976). In summary, these two corporate decision-making is very important in shareholder point of view. Thus, corporate payout policy and investment decision-making may operate as the main channels by which the effect of corporate governance as internal control mechanism on firm value is enacted. Given the much attention that corporate governance and firm performance has received, an area of discussion that has received limited attention relates to the role of the interactive effect of competition and corporate governance on productivity growth of firms especially in developing countries (Byuan, Lee and Park, 2011).
Abstract: Our study used the causality test to determine the causal relationship between corporate governance and return on assets of Nigerian firms. The result showed that there is no bi-directional causal relationship between other corporate governance indicators and return on assets of Nigerian firms. This result supports a vast body of literature devoted to evaluating the relationship between corporate governance and performance, measured by valuation, operating performance or stock returns This study thus concludes that emerging evidence shows that corporate governance is likely to emerge endogenously and thus be dependent on specific characteristics of the firm and its environment.
Previous literatures have documented that corporate governance mechanisms serves to reduce the extent of asymmetric information between corporate owners and managers; and also induces the managers to make efficient and rational decisions that maximizes shareholders wealth (Jensen and Meckling, 1976 Jensen, 1986; Weisback, 1988, Denis et al., 1997; Lemon and Lin, 2003).
It is very crucial to understand how corporate governance plays out in Nigeria because of the role ascribed to productivity growth by development agencies in the long run sustainable growth and development which is necessary for poverty reduction in this region. In the studies reviewed, the role of vertical integration in the model was conspicuously missing. Therefore, vertical integration is a crucial factor in the study of productivity growth of firms. Economic theory suggests that firms may embark on vertical integration when two or more of their production stages are technologically interdependent, this may result in significant cost-savings arising from technological economies of scale. More so, Arrow (1975) suggested that information asymmetry between upstream and downstream firms may necessitate vertical integration to improve resource allocation and reduce uncertainties from input supplies between two stages of successive production processes.
Our study therefore contributes to the debate on the role of the interactive effect of corporate governance on productivity of firms with particular emphasis on the causal relationship between corporate governance and return on assets of selected Nigerian firms by taking into account the role of vertical integration from a developing country perspective. It is expected that this study will provide information on policy formulation and implementation as regards the role of corporate governance for the efficient performance of firms towards a private sector growth and poverty reduction in Nigeria.
2. EMPIRICAL REVIEW:
Core et al (2006) re-examine the results Gompers et al. (2003) and argued that if the casual relationship goes from governance to performance, the market must be surprised by weak operating performance of weakly governed firms. However, they do not find empirical support for this claim and thus they question the casual interpretation assigned by Gompers et al. (2003). If governance is causally related to performance, this would mean that firms are not in equilibrium and that changing governance would lead to improved performance in the future. Chidambaran, Palia and Zheng (2006) examine this proposition. They construct three samples that "stack the deck" in favor of the hypothesis that good governance changes "cause" better performance. They find no significant differences in stock returns. Thus, Chidambaran, Palia and Zheng (2006) argue that firms are endogenously optimizing their governance structure in response to observable and unobservable firm characteristics and that on average firms are in equilibrium - in other words firms have an optimally chosen governance structure. These results are consistent with Coase (1960) in a sense that firms choose their governance structures to adapt to their legal environment.
Kole and Lehn (1999) also argue that firms change their governance structure in response to a change in the underlying firm environment. If all firms choose the best form of governance no empirical relationship will be observed between firm value and governance (Demsetz and Lehn, 1985). Shabbir (2008) finds that governance responds to previous performance, but in an opposite way – i.e. firms in the UK become more compliant with the UK governance code when the going gets tough (i.e. when prior period returns decline), and less so when previous period operating performance improves. Gillan, Hartzell, and Starks (2006) also argue that governance mechanisms emerge endogenously and are a function of state-level, industry-level and firm-level factors.
Arcot and Bruno (2007) suggest that because corporate governance is not a one-size-fits-all approach, companies that have a valid reason to deviate from best-practices code are no worse governed than companies that blindly comply. In fact they find that, in the UK, which has a “comply or explain” approach to governance regulation, an index constructed as a “tick-box” approach (i.e. when each company is given points for whether or not it complies with each provision of the code) fails to show a significant relationship between governance and performance, while an index that takes into account whether the company has a valid reason for non-compliance produces significant results. Furthermore, companies that report valid reasons for non-compliance perform better than those that merely comply. This fact may explain why research that uses a “tick-box” approach has produced controversial results
To summarize, there is growing evidence that governance is endogenously determined and the issue of causality has to be given serious consideration in governance performance research. However, there does not seem to be an emerging consensus on the nature of causality of the relationship between governance and performance. While some argue that governance causes performance, others argue that the relationship is just the opposite. Thus, this question is still open and calls for further research. This assertion can be observed in the findings of this study that there is no casual relationship between corporate governance and return on equity of Nigerian firms.
3. METHODOLOGY:
Securities and Exchange Commission (SEC), the Nigerian Stock Exchange (NSE), the Company’s Corporate Headquarters located at different parts of the country, libraries of tertiary institutions etc. Obtaining data from published annual reports and statement of accounts of quoted companies on the Nigeria Stock Exchange, it is believed, constitutes the most authoritative and accessible documents for assessing the performance of the affected firms.
Although, The Nigerian Company Law requires public companies to make their accounts available to the public, in parable, apart from the shareholders of the companies, such statements of accounts are rarely available to the general public except through agencies like the Stock Exchange, the Federal Inland Revenue, for tax purposes, and the Corporate Affairs Commission, as basis for ensuring that company comply with the provisions of the Companies and Allied Matters Act of 1990. The research therefore, relied on these three to source for the required research data.
The population of the study consists of all quoted companies in the Nigerian Stock Exchange (NSE) for the period (2000 – 2013) which marks a period of uninterrupted democratic rule in Nigeria. Our generated sample for this study is limited to firms in manufacturing sector because the firms in financial sector (banks or insurance companies) and non financial services (wholesale or retail trade), productivity are hard to be compared with productivity in manufacturing sector. Moreover, they are subjected to additional regulations and have different accounting information. Similarly, firms operating in the utility, traffic and telecommunications industries were not included in our sample because they were predominantly government owned during the period of observation.
This study employed a modified version of the econometric model of Miyajima et al (2003) as adopted by Coleman and Nicholas-Biekpe (2006). Hence stating thatthere is no causal relationship betweencorporate governance and return on assets of Nigerian firms, we represent the relevant models as:
ROA ≠ f (BOS, BCOMP, DEI)……… (i)
Where:
ROA = Return on Assets (Dependent Variable) BOS = Board Size
BCOMP = Board Composition DEI = Directors Equity Interest
f = Function
Return on Assets
This is a profitability measure that evaluates the performance of the firm by dividing the profit before interest taxes and depreciation by the total assets. According to Abor (2008) a high ROA means the investment gained compare favourably to the cost investment. As a performance measure, ROA is used to evaluate the efficiency of an investment or to compute the efficiency of number of different investment. In line with Abor (2008) study, this study adopts ROA as one of the dependent variable.
Corporate Governance
This was measured in this study by Board Size (BOS), Board Composition (BCOMP) and Directors’ equity interest (DEI). The number of persons on the board represents the Board Size; Board Composition is defined as the ratio of outside directors to total number of directors while DEI represents Directors’ Equity Interest in the total shareholding of the firms under study. This is in line with the works of Miyajima et.al (2003).
4. RESULTS:
4.1 Granger Causality results
Table 4.1 presents the granger causality results of our model
Pairwise Granger Causality Tests Sample: 1 594
Lags: 2
Null Hypothesis: Obs F-Statistic Probability
BOS does not Granger Cause ROA 592 0.50769 0.60215 ROA does not Granger Cause BOS 11.7434 0.1005
BCOMP does not Granger Cause ROA 592 0.00964 0.99040 ROA does not Granger Cause BCOMP 0.63527 0.53016
DEI does not Granger Cause ROA 592 1.11489 0.32865 ROA does not Granger Cause DEI 0.41145 0.66288
As revealed from above, there is no bi-directional causal relationship between other corporate governance indicators (BOS, BCOMP and DEI) and return on assets of Nigerian firms for the period 2000 to 2013. This result supports a vast body of literature devoted to evaluating the relationship between corporate governance and performance, measured by valuation, operating performance or stock returns. Most of the research to date suggests a positive correlation between corporate governance and various measures of performance. However, there are a number of studies that have questioned such a relationship.
5. CONCLUSION – RECOMMENDATION:
Today's manufacturing and product supply operations are complex and multifaceted. Striving to balance demand variability and operational volatility can quickly create excess inventory buffers, plant asset imbalances – leading to unsatisfied customers. These challenges can place business return on assets at risk if left unattended. Therefore, this study recommends that Nigeria firms minimize the cost of assets while exceeding customer satisfaction. This can be achieved through good corporate governance oversight function.
Good corporate governance enhances profitability of the firm. It is known that as profits are in the numerator of the return on equity ratio, increasing profits relative to equity increases a company's return on equity. Increasing profits does not necessarily have to come from selling more products. It can also come from increasing good corporate governance structure. Therefore, this study recommends proper compliance with corporate governance issues. There should be strict adherence to the existing Code of Conduct for firms, failing which the regulatory authorities would impose appropriate sanctions including removal of the erring staff. This will ensure that financial disclosures are done in line with regulatory requirements there improving the relation between corporate governance and return on assets.
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