An analysis of the nature and effectiveness of corporate governance in smaller listed Australian companies Kevin Plastow B Comm (Hons) A thesis submitted in fulfilment of the requirements for the degree of Doctor of Philosophy to the School of Accountancy Queensland University of Technology 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 timeseries, 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 The findings make several important contributions First, the findings contribute to the literature by providing evidence on the extent, nature and effectiveness of governance in smaller firms The A governance code The findings regarding board and chair independence, and audit committee characteristics, suggest that policy-makers could consider providing additional guidance for smaller I ? A“X rather than a prescriptive rules-based approach ii 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 1.2 Motivation 1.3 Corporate governance in smaller firms 1.3.1 The external governance environment 1.3.2 The internal governance environment 1.4 Research objectives and research questions 1.5 Theoretical framework 1.6 Research design 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 iii 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 iv 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 v 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 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Members of the ASX Corporate Governance Council                      Association of Superannuation Funds of Australia Ltd Australasian Investor Relations Association Australian Council of Superannuation Investors Australian Institute of Company Directors Australian Institute of Superannuation Trustees A “ A Australian Stock Exchange Limited Business Council of Australia Chartered Secretaries Australia CPA Australia Group of 100 Institute of Actuaries of Australia Institute of Chartered Accountants in Australia Institute of Internal Auditors Australia International Banks and Securities Association of Australia Investment and Financial Services Association Law Council of Australia National Institute of Accountants Property Council of Australia Securities & Derivatives Industry Association Securities Institute of Australia Members of the Working Group for the       Corporate Practices and Conduct Australian Institute of Company Directors Australian Society of Certified Practising Accountants Business Council of Australia Law Council of Australia (Business Law Section) Institute of Chartered Accountants in Australia Securities Institute of Australia 233 234 Appendix B The ASX Best Practice Recommendations 1.1 Formalise and disclose the functions reserved to the board and those delegated to management 2.1 A majority of the board should be independent directors 2.2 The chairperson should be an independent director 2.3 The roles of chairperson and chief executive officer should not be exercised by the same individual 2.4 The board should establish a nomination committee 2.5 Provide the information indicated in Guide to reporting on Principle 3.1 Establish a code of conduct to guide the directors, the chief executive officer (or equivalent), the chief financial officer (or equivalent) and any other key executives as to: 3.1.2 the responsibility and accountability of individuals for reporting and investigating reports of unethical practices 3.2 Disclose the policy concerning trading in company securities by directors, officers and employees 3.3 Provide the information indicated in Guide to reporting on Principle 4.1 Require the chief executive officer (or equivalent) and the chief financial officer (or financial reports present a true and fair view, in all material respects, of the operational results and are in accordance with relevant accounting standards 4.2 The board should establish an audit committee 4.3 Structure the audit committee so that it consists of: only non-executive directors a majority of independent directors an independent chairperson, who is not chairperson of the board at least three members 4.4 The audit committee should have a formal charter 4.5 Provide the information indicated in Guide to reporting on Principle 5.1 Establish written policies and procedures designed to ensure compliance with ASX Listing Rule disclosure requirements and to ensure accountability at a senior management level for that compliance 5.2 Provide the information indicated in Guide to reporting on Principle 6.1 Design and disclose a communications strategy to promote effective communication with shareholders and encourage effective participation at general meetings 6.2 Request the external auditor to attend the annual general meeting and be available to answer shareholder questions about the conduct of the audit and the preparation and 235 7.1 The board or appropriate board committee should establish policies on risk oversight and management 7.2 The chief executive officer (or equivalent) and the chief financial officer (or equivalent) should state to the board in writing that: 7.2.1 the statement given in accordance with best practice recommendation 4.1 (the integrity of financial statements) is founded on a sound system of risk management and internal compliance and control which implements the policies adopted by the board system is operating efficiently and effectively in all material respects 7.3 Provide the information indicated in Guide to reporting on Principle 8.1 Disclose the process for performance evaluation of the board, its committees and individual directors, and key executives 9.1 P enable investors to understand (i) the costs and benefits of those policies and (ii) the link between remuneration paid to directors and key executives and corporate performance 9.2 The board should establish a remuneration committee 9.3 Clearly distinguish the structure of nonfrom that of executives 9.4 Ensure that payment of equity-based executive remuneration is made in accordance with thresholds set in plans approved by shareholders 9.5 Provide the information indicated in Guide to reporting on Principle 10.1 Establish and disclose a code of conduct to guide compliance with legal and other obligations to legitimate stakeholders 236 Appendix C Australian Stock Exchange Listing Rules Appendix 4A List of corporate governance matters The following is an indicative list of corporate governance matters that an entity may take into account when making the statement in its annual financial statements under rule 4.10.3: If the entity is a body corporate, whether individual directors, including the Chair, are executive or non-executive directors (in the case of a trust, whether individual directors of the management company, including the Chair, are executive or non-executive directors) The main procedures the entity has in place for: reviewing the membership of that body; and nominating representatives to that body If a procedure involves a nomination committee, set out, or summarise, the main responsibilities, the names of committee members and their positions in relation to the entity (eg, director of the company) The policies relating to the appointment and retirement of non-executive directors (in the case of a trust, non-executive directors of the management company) The main procedures by which the governing body or individual members of it can seek independent professional advice, at the entit duties If the entity is a body corporate, the main procedures for establishing and reviewing the compensation arrangements for: the chief executive officer (or equivalent), and other senior executives of the governing body, and non-executive members of the governing body If a procedure involves a remuneration committee, set out, or summarise, the main responsibilities and rights, and the names of committee members If a member of the committee is director If the entity is a trust, the main procedures for establishing and reviewing the compensation arrangements for the governing body If a procedure involves a remuneration committee, set out, or summarise, the main responsibilities and rights, and the names of committee members If director of the management c 237 The main procedures the entity has in place for the nomination of external auditors, and for reviewing the adequacy of existing external audit arrangements (particularly the scope and quality of the audit) If a main responsibilities and rights, and the names of committee members If a member of the company), s T putting arrangements in place to manage them T to standards 238 ... 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 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. .. ownership and monitoring In Figure 1.1, the right-hand side of the diagram demonstrates the flow of information from companies to their investors and financial intermediaries In considering the roles