Description
The purpose of this paper is to investigate the relationship between board composition
and firm performance variance in the context of recent corporate governance reforms, based on the
agency and organisational literatures.
Accounting Research Journal
Board composition and firm performance variance: Australian evidence
Yi Wang, and J udith Oliver
Article information:
To cite this document:
Yi Wang, and J udith Oliver, (2009),"Board composition and firm performance variance: Australian
evidence", Accounting Research J ournal, Vol. 22 Iss 2 pp. 196 - 212
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Michael L. McIntyre, Steven A. Murphy, Paul Mitchell, (2007),"The top team: examining board composition
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pp. 547-561 http://dx.doi.org/10.1108/14720700710827149
Salim Darmadi, (2013),"Board members' education and firm performance: evidence from a developing
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dx.doi.org/10.1108/10569211311324911
R. Rathish Bhatt, Sujoy Bhattacharya, (2015),"Board structure and firm performance in Indian IT firms",
J ournal of Advances in Management Research, Vol. 12 Iss 3 pp. 232-248 http://dx.doi.org/10.1108/
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Board composition and ?rm
performance variance: Australian
evidence
Yi Wang
School of Accounting and Corporate Governance, University of Tasmania,
Launceston, Australia, and
Judith Oliver
Faculty of Business and Enterprise, Swinburne University of Technology,
Hawthorn, Australia
Abstract
Purpose – The purpose of this paper is to investigate the relationship between board composition
and ?rm performance variance in the context of recent corporate governance reforms, based on the
agency and organisational literatures.
Design/methodology/approach – This paper uses 384 of the top 500 Australian companies as its
dataset. Board composition measures include the percentages of af?liated, executive and independent
members on the board. Firm risk is represented by the standard deviation of shareholder return.
Several control variables are introduced in the regression analysis.
Findings – The results show a negative impact of executive directors on subsequent risk. Af?liated
and independent directors, however, have no signi?cant effect on the level of performance variance.
Blockholders give a positive in?uence on ?rm risk. Moreover, companies with poor dividend payout or
low managerial shareholdings tend to be riskier.
Research limitations/implications – This paper does not examine the actual risk preference of
individual directors, which could involve an attitudinal survey of board members. Future research
may also examine the speci?c attributes towards risk for each type of af?liated directors.
Practical implications – The ?ndings cast doubts on the hope that promoting board independence
would reduce agency con?icts relating to managerial risk aversion, and support the proposition that,
although ?rms may comply with the demands for more independent directors, they could employ a
number of tactics to neutralize the power of outsiders.
Originality/value – The empirical work surrounding this topic has been scant. This study may
present the ?rst Australian empirical evidence on the relationship between board composition and
?rm performance variance.
Keywords Boards of Directors, Corporate governance, Organizational performance, Australia
Paper type Research paper
1. Introduction
In 2002, in response to corporate collapses resulting from accounting irregularities and
failures of ethics and controls, the New York Stock Exchange and NASDAQ Stock
Market started corporate governance reforms to help win back the trust and con?dence
of investors. One year later, the Securities and Exchange Commission approved their
corporate governance listing standards. Also in 2003, the London Stock Exchange
(1998) revised its Combined Code, and the Australian Securities Exchange (ASX)
endorsed Principles of Good Corporate Governance and Best Practice Recommendations
The current issue and full text archive of this journal is available at
www.emeraldinsight.com/1030-9616.htm
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Accounting Research Journal
Vol. 22 No. 2, 2009
pp. 196-212
qEmerald Group Publishing Limited
1030-9616
DOI 10.1108/10309610910987510
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(Guidelines) which re?ect “best international practice” by highlighting the importance
of independent directors.
The New York Stock Exchange, NASDAQ, London Stock Exchange and ASX
require that a majority of each listed company’s directors qualify as independent
directors. The de?nitions of “independence” proposed by the stock exchanges vary.
It appears that they are sourced fromthe statement in the Cadbury Report (Department
for Trade and Industry, 1992, Code 2.2) – an independent director:
[. . .] should be independent of management and free from any business or other relationship
which could materially interfere with the exercise of their independent judgement, apart from
their fees and shareholding.
Although it is for the board to decide in particular cases whether the de?nition of
independence is met, there are lists of the categories of persons who should not be
considered independent.
The New York Stock Exchange and NASDAQ take a mandatory approach in which
companies must comply with their standards in order to be listed on the exchanges.
The ASX (2003, p. 5) and London Stock Exchange, on the other hand, follow a
voluntary approach:
[. . .] f a company considers that a recommendation is inappropriate to its particular
circumstances, it has the ?exibility not to adopt it – a ?exibility tempered by the requirement
to explain why.
In August 2007, the ASX released the second edition of the Guidelines, which contains
no signi?cant changes to the recommendations to “structure the board to add value” as
introduced above, except that the term “best practice” has also been removed from the
title and text to eliminate any perception that the recommendations are prescriptive
and so not to discourage companies from adopting alternative practices and “if not,
why not” reporting where appropriate.
Matching the trend towards greater board independence, empirical research on the
board composition-?rm performance link has become a popular topic. Ellstrand et al.
(2002) noted that, although board composition had many dimensions, in literature the
term typically referred to the proportions of inside (individuals employed by the ?rm)
and outside directors serving on the boards. The results, as shown in Table I,
have been inconsistent. Zahra and Pearce (1989) identi?ed some sources of these
con?icting ?ndings, including differences in time-frames, samples, performance
measures, and the operational de?nitions employed with regard to the outsiders’
variable.
Several academics attempted to investigate the potential in?uence of directors on
?rm risk. Schellenger et al. (1989) believed that the con?icting empirical evidence with
respect to the existence or non-existence of a board composition effect on ?nancial
performance might be due to failure to control risk. After testing a sample of 526 US
?rms with complete data for the year 1986, they located a negative association between
the percentage of outside directors and standard deviation of shareholder return. The
proportion of outside directors and beta, however, were positively correlated. According
to Schellenger et al. (1989, p. 463), “[w]hat this suggests is that ?rms with a greater
percentage of outsiders on the board have greater systematic risk, but less total risk”.
In another US study, Kim and Buchanan (2008) observed that the literature had
paid little attention to exploring the implications of chief executive of?cer (CEO)
Board
composition and
?rm performance
197
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duality on strategic management such as ?rm risk-taking behaviour; little is known on
whether the presence of duality contributes to agent opportunism or promotes
stewardship pro-organisational behaviour in ?rm strategic management practices.
Thus, using a sample of 290 large US corporations, they examined the empirical
relationship between CEO duality and ?rm risk-taking propensity. Their results show
that, consistent with the agency theory perspective, CEO duality reduces income
stream risk as measured by the standard deviation of return on assets. It is also found
that institutional ownership moderates the negative correlation between duality
structure and ?rm risk.
This study intends to extend the works of Schellenger et al. (1989) and Kim and
Buchanan (2008) by examining the impact of other board members on the level of
performance risk, in the recently altered regulatory environment with respect to the
requirement for a majority of independent directors. It may present the ?rst empirical
evidence on the relationship between board composition and ?rm performance
variance in the Australian context.
Authors Country Results
Pfeffer (1972) USA Contingent
Baysinger and Butler (1985) USA Positive
Fosberg (1989) USA Insigni?cant
Schellenger et al. (1989) USA Positive
Hermalin and Weisbach (1991) USA Insigni?cant
Pearce and Zahra (1992) USA Positive
Daily and Dalton (1992) USA Positive
Yermack (1996) USA Insigni?cant
Agrawal and Knoeber (1996) USA Negative
Muth and Donaldson (1998) Australia Negative
Vafeas and Theodorou (1998) UK Insigni?cant
Dalton et al. (1998) USA Insigni?cant
Lawrence and Stapledon (1999) Australia Negative
Bhagat and Black (2000) USA Insigni?cant
Coles et al. (2001) USA Insigni?cant
Dehaene et al. (2001) Belgium Positive
Hossain et al. (2001) New Zealand Positive
Panasian et al. (2003) Canada Contingent
Kiel and Nicholson (2003) Australia Negative
Cotter and Silverster (2003) Australia Insigni?cant
Singh and Davidson (2003) USA Insigni?cant
Balatbat et al. (2004) Australia Insigni?cant
Peng (2004) China Insigni?cant
Chang and Leng (2004) Malaysia Insigni?cant
Chin et al. (2004) New Zealand Insigni?cant
Randoy and Jenssen (2004) Sweden Contingent
Anderson and Reeb (2004) USA Contingent
Chen et al. (2005) Hong Kong Insigni?cant
Krivogorsky (2006) Continental Europe Positive
Choi et al. (2007) South Korea Positive
Luan and Tang (2007) Taiwan Positive
Chan and Li (2008) USA Contingent
Table I.
Empirical evidence:
contribution of
independent/
non-executive directors
on ?rm performance
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2. Hypotheses
Denis and McConnell (2003) noted that the publication of Jensen and Meckling (1976),
in which the authors applied agency theory to corporations and modelled the agency
costs of outside equity, had produced voluminous works on corporate governance in
general, and boards of directors in particular. As de?ned by Jensen and Meckling
(1976), an agency relationship is a contract under which one party (the principal)
engages another party (the agent) to perform some services on the principal’s behalf.
Where both the principal and the agent are utility maximisers, there is no a priori
reason to believe that the agent will always act in the principal’s best interests. In
investor-owned ?rms, shareholders act as the principals with interests in deriving
maximum returns from the action of managers, serving as the agents; from this
agent-principal relationship, two agency problems may emerge – con?icting goals and
differing attitudes towards risk (Jensen and Meckling, 1976; Eisenhardt, 1989;
Ellstrand et al., 2002).
Agencytheory suggests that managers may pursue their own goals rather thanseek to
maximise shareholder wealth unless their discretion is kept in check by a vigilant board.
Therefore, where board of directors is more independent of management, company
performance would be higher (Fama, 1980; Scott, 1983; Castaldi and Wortmann, 1984;
Daily et al., 2002). However, as introduced earlier, the empirical evidence in this area is
mixed. Furthermore, some agency theorists assume that shareholders generally favour
actions that maximize returns, evenwhenaccompanied byhigher risk, because theycould
diversify against risk by selecting speci?c stocks for their portfolios. Managers, on the
other hand, cannot readilydiversifytheir employment risks across a range of investments,
as a result they tend to be more risk averse than may be in the interests of shareholders,
and would prefer low risk strategies (Jensen and Meckling, 1976; Mizruchi, 1983;
Eisenhardt, 1989; Beatty and Zajac, 1994; Coles et al., 2001).
Inother words, if there is a goodbusiness opportunityinvolvinghighrisk, shareholders
would expect managers to take the opportunity and maximize their investment return,
while managers may be hesitant to take the option because their rewards from the
risk-taking would be limited. Managers are more concerned about their employment risk
and ?rm survival than pro?t maximization of shareholders (Baysinger and Hoskisson,
1990; Kim and Buchanan, 2008). Therefore, it is expected that:
H1. There is a negative relationship between the proportion of executive directors
on the board and subsequent ?rm risk (agency theory).
The ASX Guidelines identi?es several personal and professional af?liations that may
limit the independence of non-executive directors. These af?liated directors, or “grey”
directors as termed by Baysinger and Butler (1985), are poised somewhere between
inside and independent directors. Although their primary employment does not
depend directly on the ?rms that they serve as directors, they have a personal stake in
the ?rms owing to ?nancial or kinship relationships with the ?rms or executives
(Ellstrand et al., 2002). The af?liation that they have may violate the monitoring role as
speci?ed by agency theory for outside directors. In order to maintain these
relationships, they could be inclined to support low risk strategies as favoured by the
management (Johnson et al., 1996; Ellstrand et al., 2002). It appears that:
H2. There is a negative relationship between the proportion of af?liated directors
on the board and subsequent ?rm risk (agency theory).
Board
composition and
?rm performance
199
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Heslin and Donaldson (1999) and Donaldson (2000) proposed a theory of organisational
change and success, i.e. organisational portfolio theory, which is built on the premise
that low performance is required to trigger adaptive organisational changes. It is
acknowledged that the theory is at present only “[. . .] a series of propositions waiting
for empirical testing. Only after it has received such empirical con?rmation would the
policy implications sketched here become valid prescriptions” (Donaldson, 2000, p. 395).
Contrary to the assumption of agency theory, Heslin and Donaldson (1999) argued that,
in general, executive directors would raise risk and independent directors would reduce
risk. During periods when executives constitute a large proportion of the board, risk
tends to increase; when peaks from the high risk strategy co-occur with favourable
combinations of the other portfolio factor[1], outstanding performance is likely to
result. This would reinforce con?dence in the integrity and competence of the largely
non-independent corporate governance structure, thus bolstering the position of
executives on the board.
When the troughs in the high risk strategy occur simultaneously with other
performance-depressing portfolio factors, the particularly lowperformance may trigger
the installation of an independent chairperson and a higher proportion of independent
directors on the board. The resulting risk-averse governance would tend to reduce ?rm
performance variance. It is considered that reducing ?rm risk may be a means of
increasing short-term economic value (Brealey and Myers, 1996). Heslin and Donaldson
(1999), however, asserted that low risk could prevent the performance crises needed to
trigger required structural adaptation. High economic value achieved by lowering risk is
thereby prone to inhibiting long-term growth and pro?tability. Thus, the link between
board composition and ?rmrisk as predicted by organisational portfolio theory may be
illustrated as follows:
H3. There is negative relationship between the proportion of independent directors
on the board and subsequent ?rm risk (organizational portfolio theory).
3. Method
This paper uses the top 500 companies listed on the ASX, ranked by market
capitalisation, as the initial dataset. Each year the ASX collects information on these
companies to calculate its All Ordinaries Index, the primary indicator of the Australian
equity market. At 31 December 2003, the top 500 companies represented 95 per cent of
the total market capitalisation of the ASX-listed companies (Standard & Poor’s, 2004).
Therefore, this dataset offers a reasonable coverage for the population of interest,
i.e. Australian public corporations.
Owing to lack of comparable data in ?nancial institutions, Muth and Donaldson
(1998) had to reduce their sample of Australian ?rms. Similarly, Kiel and Nicholson
(2003) excluded banks fromtheir analysis as the recorded assets of ?nancial institutions
consist of loans which represent the use of depositors’ funds. There are 503 ?rms in the
2003 list of top 500 companies as presented in Huntleys’ Shareholder (Aspect Huntley,
2003). After ?nancial institutions including property trusts and investment funds are
removed fromthe list, a sample of 384 ?rms is obtained. The sources of data used include
Connect 4 database containing the annual reports on the top 500 companies, Fin
Analysis database giving market information and statistics of Australian ?rms, and
Huntleys’ Shareholder (Aspect Huntley, 2003) providing data on ?rm age and lines of
business. The sample is further reduced to 243 ?rms due to missing data.
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In this study, board composition is measured by the proportions of executive,
af?liated and independent directors. If the sources of information only divide directors
into executive and non-executive directors, it would be necessary to divide
non-executive directors into af?liated and independent directors, using the de?nition
of independence proposed by the ASX (2003, p. 19) Corporate Governance Council as a
benchmark.
According to the Guidelines:
[. . .] [a]n independent director is independent of management and free of any business or
other relationship that could materially interfere with – or could reasonably be perceived to
materially interfere with – the exercise of their unfettered and independent judgement.
Although there is a list of the persons who should not be considered independent in
Box 2.1 of the Guidelines (ASX, 2003), it is unclear how long an independent director
could serve on the same board. This research follows the UK Higgs Report
(Department for Trade and Industry, 2003) which nominates ten years in relation to
director tenure consideration.
AASB1031 provides guidance in relation to a quantitative assessment of materiality.
An item is presumed to be material if it is equal to or greater than 10 per cent of the
appropriate base amount. As the ASX (2006) recommends that this would seem a
reasonable position for consideration by the board in determining materiality (ASX,
2006), the materiality threshold is set at 10 per cent of net assets or operating result
before tax, for balance sheet or pro?t and loss items, respectively. The details of directors
are available in corporate governance statement, director’s report and related party note
to the ?nancial statements. If a close analysis of the information could not provide an
objective basis for determining director independence, the company is excluded fromthe
analysis.
Following the approach supported by most prior studies on the boards of directors
as summarised in Table I, board composition for sample companies is assessed at one
point in time, i.e. mid-2003. As Australian listed companies have been subject to new
corporate governance requirements from 2003, the results of this study may indicate
the consequences of these recommendations regarding board composition on
performance variance of Australian ?rms. In addition to descriptive statistics and
correlation analysis, ordinary least squares (OLS) regressions are constructed for the
research variables. An algebraic statement of the models is as follows:
RISK ¼a þb
1
ðCompositionÞ
i
þb
2
ðAGEÞ
i
þb
3
ðBLOCKÞ
i
þb
4
ðDIVRÞ
i
þb
5
ðEQEDÞ
i
þb
6
ðGEARÞ
i
þb
7
ðLogMCAPÞ
i
þb
8
ðSEGMTÞ
i
þb
9
ðSHRETÞ
i
þb
10
ðSIZEÞ
i
þm
i
Firm risk could be measured in a number of ways (Baird and Thomas, 1990; Beatty
and Zajac, 1994). Baird and Thomas (1990) reviewed how risk had been conceptualized
in different disciplines of management, ?nance, marketing and psychology and
concluded that researchers in the area of strategic management typically de?ned risk
as unpredictability of business outcome variables, e.g. variability of accounting or
market return. Finance literature suggests that total risk consists of systematic risk –
the risk of the market, and unsystematic risk – the risk unique to the ?rm (Ross et al.,
2005; Reilly and Brown, 2006). Schellenger et al. (1989) suggested that board could
Board
composition and
?rm performance
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in?uence both the systematic and unsystematic risk, and Lorsch and MacIver (1989),
Baysinger et al. (1991), Davis and Thompson (1994), Heslin and Donaldson (1999) and
Donaldson (2000) believed that directors might raise or reduce total risk of the ?rm.
Thus, it is decided to choose a measure of total risk – the standard deviation of
shareholder return. To reduce the in?uence of short-term ?uctuations, the ?gures
tested in this study are the three-year averages over the 2003-2006 ?nancial years.
As shown in Table II, to identify the speci?c effect of different types of directors on
risk, drawing on some empirical models identi?ed in corporate governance research
(Bhagat and Black, 2000; Coles et al., 2001; Singh and Davidson, 2003; Randoy and
Jenssen, 2004; Krivogorsky, 2006), a number of covariates are introduced into the
analysis to control for confounding in?uence.
Coles et al. (2001) presumed that blockholders had the capacity to monitor their
investments and, by virtue of the magnitude of their investments, could affect
managerial behaviour. The threat that blockholders will sell large blocks of shares if
the ?rm fails to provide an acceptable return, or is not responsive to concerns that
investors view as critical, is a signi?cant issue for managers. There is empirical
evidence that institutional investors and other blockholders do impact managerial
behaviour (van Nuys, 1993; Brickley et al., 1994; Shome and Singh, 1995; Bethel et al.,
1998; Allen and Phillips, 2000).
Jensen and Meckling (1976) asserted that increasing managerial ownership could
mitigate agency con?icts. The higher the proportion of equity owned by managers, the
greater the alignment between managers and shareholder interests. Jensen (1986)
Measure Abbreviation De?nition
Firm risk
Firm risk RISK Standard deviation of shareholder return
Board composition
Executive directors PEXE Percentage of executive directors on the board
Af?liated directors PAFF Percentage of af?liated directors on the board
Independent directors PIND Percentage of independent directors on the board
Control
Firm age AGE Number of years listed on the ASX and one of the
stock exchanges which were amalgamated to form
the ASX in 1987
Blockholder ownership BLOCK Percentage of common stocks held by the top 20
shareholders
Dividend payout DIVR Ratio of dividend payments to pro?t after interest
and tax
Managerial ownership EQED Percentage of equity including options held by
executive directors
Leverage GEAR Ratio of short-term and long-term debt to book value
of equity
Firm size LogMCAP Natural logarithms of market value of common
stocks (in $million)
Diversi?cation SEGMT Number of industrial and geographical segments
Prior performance SHRET Realised rate of returns incorporating capital gains
and dividend payments
Board size SIZE Number of directors on the board
Table II.
Description of research
variables
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argued that the payment of dividends would reduce the agency con?icts as it would
reduce the free cash?ow available for managers to use for their own “perks” or invest
in projects with marginal returns. Similarly, Easterbrook (1984) noted that the regular
payment of dividends would reduce the free cash?ow and thereby require ?rms to seek
debt funds. The use of external funds would then leave them open to more monitoring
by outsiders which may act as a deterrent to opportunistic behaviours by managers.
Modigliani and Miller (1958) proposed that capital structure would be irrelevant in
determining ?rm value, because a ?rm cannot change the total value of its securities
just by splitting its cash ?ows into different streams. Jensen and Meckling (1976)
opposed this proposition by pointing out that the amount of debt ?nancing in a ?rm’s
capital structure would affect managers’ choice of operating activities. Consequently,
Balakrishnan and Fox (1993) believed that increasing leverage would increase
managers’ risk aversion and reduce their willingness to invest in more risky but
pro?table projects. Moreover, according to Amihud and Lev (1981), Dyl (1988), Tosi
and Gomez-Mejia (1989) and Hoskisson and Turk (1990), managerial motives for
diversi?cation may exist independent of resources, which include risk reduction and
desire for increased compensation.
Consistent with the risk measure, dividend payout, ?rm size and leverage are
calculated for the period of 2003-2006. Like the measures for board composition, data
on board size, blockholder ownership, diversi?cation, ?rm age and managerial
shareholdings are collected for the 2003 ?nancial year. Prior performance is measured
by the average shareholder return for the years 2000-2003.
4. Results
Table III gives a description of ?rmcharacteristics for the sample. Casual observation of
the table reveals that the sample contains a wide range of ?rms. The proportion of
executive, af?liated or independent directors on the board varies between 0 and
100 per cent, with a mean of 28.48, 29.86 or 41.65 per cent, respectively. The total number
of directors on the board ranges froma lowof three to a high of 15, with anaverage of just
over six. The number of years the company has been listed on the stock exchange ranges
Variable
a
Mean Median Maximum Minimum SD Skewness Kurtosis Unit
RISK 0.58 0.29 20.69 0.004 1.70 9.22 97.10 Number
PEXE 28.48 25.00 100 0 0.16 0.89 3.98 Percentage
PAFF 29.86 25.00 83.33 0 0.22 0.40 2.60 Percentage
PIND 41.65 40.00 100 0 0.22 0.03 2.56 Percentage
AGE 16.90 11.00 132.00 3.00 17.81 2.90 15.39 Number
BLOCK 65.10 67.09 99.86 13.60 0.18 20.42 2.74 Percentage
DIVR 0.51 0.51 3.39 0 0.47 1.50 8.59 Ratio
EQED 11.84 2.21 80.99 0 0.18 1.70 4.89 Percentage
GEAR 0.47 0.37 3.95 0 0.51 2.73 15.01 Ratio
LogMCAP 5.86 5.60 11.70 2.11 1.78 0.51 3.07 Number
SEGMT 4.46 4.00 11.00 1.00 2.23 0.84 3.19 Number
SHRET 0.06 0.09 4.00 23.00 0.61 1.34 23.16 Number
SIZE 6.33 6.00 15.00 3.00 2.05 1.02 4.53 Number
Notes: Sample period: 2003-2006 (n ¼ 243);
a
the explanation for each variable is included in Table II
Table III.
Descriptive statistics
Board
composition and
?rm performance
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from three to 132, and number of business segments ranges from one to 11, with an
average close to 18 or four. The percentage of equity held by blockholders or executive
directors varies between 0 and 99.86 per cent, with a mean of 65.10 or 11.84 per cent,
respectively.
Table IV provides Pearson product-moment correlations for the research variables,
which shows that the positive relation between RISK and PAFF is signi?cant at the 5
per cent level[2]. Thus, af?liated directors may increase ?rm performance variance.
RISK is negatively associated with DIVE or LogMCAP at the 1 or 5 per cent level. The
?ndings suggest that larger ?rms or ?rms paying higher dividends tend to have lower
performance variance.
Among the independent variables a few strongly signi?cant coef?cients can be seen
in Table IV. For example, PEXE is inversely related to PAFF, PIND, AGE, LogMCAP
or SIZE, and positively related to EQED. Therefore, larger ?rms or ?rms with longer
trading history or less-managerial shareholdings tend to have a larger board with more
independent directors and fewer executive directors. PAFF is negatively correlated
with PIND, and positively correlated with BLOCK – higher blockholder ownership
lead to more af?liated directors, who, in turn, would reduce the number of independent
directors on the board. PIND is positively associated with LogMCAP and SEEGMT,
and negative associated with BLOCK. The results indicate that larger ?rms or ?rms
with more reportable segments or lower blockholder ownership may have more
independent directors sitting on their boards.
Table V displays regression estimates for the effects of board composition and other
variables on ?rm risk. PEXE presents a negative in?uence on RISK at 5 per cent level
of signi?cance. There is no signi?cant association between PAFF, PIND and RISK.
Although the absolute values of correlation coef?cients for the explanatory variables,
as shown in Table IV, are well below the rule of thumb of 0.8 or 0.9, auxiliary
regressions for LogMCAP and SIZE are performed, which con?rm that there is no
multicollinearity concern for the regressions[3].
The regression results suggest that only one of the three hypotheses, H1 which is
proposed by the agency theory, is supported. Af?liated and independent directors, in
general, have no signi?cant in?uence on performance risk. With respect to the control
variables used in the regressions, consistent with the ?ndings in Kim and Buchanan
(2008) blockholder ownership gives a positive impact on risk. It is found that poor
dividend payout would lead to increased performance variance, and higher managerial
shareholdings would reduce ?rm risk-taking propensity. Thus, contrary to the opinion
of Jensen and Meckling (1976), Easterbrook (1984) and Jensen (1986), managerial
ownership and payment of dividends may in fact increase rather than reduce the
incentive of managers to avoid risk.
5. Conclusions
This study examines the impact of board composition on ?rm performance variance.
Other variables that may mitigate the agency con?icts, such as blockholder ownership,
managerial shareholdings and dividend payout, are also included in the analysis. The
results indicate that executive directors have a negative effect on subsequent risk.
Af?liated and independent directors, however, have no signi?cant in?uence on the
level of performance variance. It is found that blockholders give a positive impact on
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Table IV.
Pearson correlations:
board composition
and ?rm risk
Board
composition and
?rm performance
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?rm risk. In addition, companies with poor dividend payout or low-managerial
shareholdings tend to be riskier.
As introduced earlier, agency theory asserts that con?icts relating to managerial risk
aversion may arise because of portfolio diversi?cation constraints of managerial income
(Jensen and Meckling, 1976; Mizruchi, 1983; Eisenhardt, 1989; Beatty and Zajac, 1994;
Coles et al., 2001). According to some authors, for example, Fama (1980), Knoeber (1986),
Prentice (1993), Vafeas and Theodorou (1998) and Godfrey et al. (2003), the con?icts may
be heightened when executive compensation is composed largely of a ?xed salary, or
where their speci?c skills are dif?cult to transfer from one company to another.
Risk-increasing investment decisions may increase the likelihood of bankruptcy, which
could severely damage a manager’s reputation, making it dif?cult to ?nd alternative
employment (Jensen, 1986; McColgan, 2001). Managerial risk aversion may also affect
Coef?cient t-statistic RISK Predicted sign
a
Intercept 1.414 0.778 0.996
2.243
*
1.383 1.654
*
PEXE 21.249 Negative
21.699
*
PAFF 0.821 Negative
1.588
PIND 20.196 Negative
20.384
AGE 0.002 0.003 0.003 Unclear
0.267 0.417 0.511
BLOCK 1.555 1.369 1.611 Positive
2.517
*
2.133
*
2.544
*
DIVR 20.602 20.591 20.575 Positive
22.506
*
22.460
*
22.381
*
EQED 20.998 21.153 21.416 Positive
21.445 21.730
*
22.180
*
GEAR 0.034 0.034 0.035 Negative
0.649 0.645 0.672
LogMCAP 20.108 20.087 20.100 Unclear
21.221 20.974 21.106
SEGMT 20.030 20.026 20.030 Negative
20.514 20.454 20.511
SHERT 20.056 20.063 20.066 Unclear
20.774 20.878 20.904
SIZE 20.050 20.048 20.040 Unclear
20.715 20.683 20.562
R
2
0.098 0.097 0.087
Std error (regression) 1.647 1.648 1.657
F-statistic 2.521
* *
2.481
* *
2.221
*
Durbin-Watson 1.990 1.994 1.989
Notes: Sample period: 2003-2006 (n ¼ 243); dependent variable: RISK; signi?cance at the
*
5 and
* *
1
per cent levels, respectively; the predicted signs for PEXE, PAFF and PIND are based on the three
hypotheses being tested. The sign for BLOCK, DIVR, EQED, GEAR and SEGMT is suggested by the
agency literature as introduced in Section 3. The effects of other research variables on ?rm
performance variance remain unclear, although, as noted by Thornhill and Amit (2003), from the
resource-based view ?rms may be at the greatest risk of bankruptcy when they are young and small
Table V.
OLS regressions: board
composition and ?rm risk
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the ?nancial policy of the ?rm. Higher debt is believed to reduce agency con?icts and
carries potentially valuable tax shields (Jensen, 1986; Haugen and Sendbet, 1986).
Managers, however, may prefer equity ?nancing because debt increases the risk of
bankruptcy and default (Brennan, 1995).
Therefore, corporate governance mechanisms, including board of directors
comprising a majority of independent outsiders, should harmonize agency con?icts
and safeguard invested capital. The board could ensure that managers are not the sole
evaluators of their own performance, and the board’s legal responsibilities to hire, ?re
and reward executives are seen as key elements in controlling con?icts of interest
(Fama and Jensen, 1983; Williamson, 1984; Baysinger and Hoskisson, 1990; McColgan,
2001). However, the evidence reported here indicates that, although executive directors
may tend to be risk averse, independent directors have no signi?cant effect on
subsequent risk. The ?ndings cast doubts on the hope that promoting board
independence would reduce agency con?icts relating to managerial risk aversion.
The literature gives some potential explanations for the results. Although ?rms may
comply with the demands for more independent directors, they could employ a number of
tactics to neutralize the power of outsiders (Oliver, 1991; Zajac and Westphal, 1996;
Westphal, 1999). This can be done, for example, by appointing individuals who are
demographically similar and therefore more sympathetic to executives (Westphal and
Zajac, 1995), or individuals with experience onother passive boards instead of more active
boards (Zajac and Westphal, 1996), or individuals who are from strategically irrelevant
backgrounds without the knowledge base to effectively participate in strategic decision
making and challenge executives’ power (Carpenter and Westphal, 2001).
The absence of a clear relationship between af?liated directors and risk could be an
outcome of the multifaceted interests represented by af?liated directors. As noted by
Ellstrand et al. (2002), the suppliers, consultants and attorneys who would be classi?ed
as af?liated directors may be less-risk averse than insiders since they do business with
multiple ?rms and are naturally diversi?ed. In contrast, directors with personal
relationships to executives may have singular stakes in the ?rm, and therefore share
insiders’ aversion to high-risk initiatives. Future study in this area may examine the
speci?c attributes towards risk for each type of af?liations in the Australian market.
It should be noted that the focus of this paper is on the empirical link between board
composition and ?rm performance variance. It does not examine the actual risk
preference of individual directors, which could involve an attitudinal survey of board
members. Another potential weakness may be the assumption of the hypotheses being
tested. Agency theory and organisational portfolio theory assume that companies
whose boards have higher risk preference would have higher performance variance.
However, there may be a situation where companies have similar risk preference
pro?les of directors but their variances differ. Although this study provides some
insights on this issue by introducing some controls into the data analysis, further
research is required to investigate the impact of other factors that bear no relationship
with the risk preference of directors on performance variance.
Notes
1. In Heslin and Donaldson (1999), three factors, namely, diversi?cation, divisionalization and
divestment, are identi?ed that are likely to prevent instances of poor performance and so
forestall calls for a tougher and more independent board. There are also three factors that
Board
composition and
?rm performance
207
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could contribute to poor performance and lead to the appointment of more non-executives as
board members or chair – business cycles, competition and debt.
2. The levels of signi?cance reported in this paper are for two-tailed tests.
3. The results of auxiliary regressions are available from the authors.
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Corresponding author
Yi Wang can be contacted at: [email protected]
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This article has been cited by:
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doc_403549032.pdf
The purpose of this paper is to investigate the relationship between board composition
and firm performance variance in the context of recent corporate governance reforms, based on the
agency and organisational literatures.
Accounting Research Journal
Board composition and firm performance variance: Australian evidence
Yi Wang, and J udith Oliver
Article information:
To cite this document:
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evidence", Accounting Research J ournal, Vol. 22 Iss 2 pp. 196 - 212
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Board composition and ?rm
performance variance: Australian
evidence
Yi Wang
School of Accounting and Corporate Governance, University of Tasmania,
Launceston, Australia, and
Judith Oliver
Faculty of Business and Enterprise, Swinburne University of Technology,
Hawthorn, Australia
Abstract
Purpose – The purpose of this paper is to investigate the relationship between board composition
and ?rm performance variance in the context of recent corporate governance reforms, based on the
agency and organisational literatures.
Design/methodology/approach – This paper uses 384 of the top 500 Australian companies as its
dataset. Board composition measures include the percentages of af?liated, executive and independent
members on the board. Firm risk is represented by the standard deviation of shareholder return.
Several control variables are introduced in the regression analysis.
Findings – The results show a negative impact of executive directors on subsequent risk. Af?liated
and independent directors, however, have no signi?cant effect on the level of performance variance.
Blockholders give a positive in?uence on ?rm risk. Moreover, companies with poor dividend payout or
low managerial shareholdings tend to be riskier.
Research limitations/implications – This paper does not examine the actual risk preference of
individual directors, which could involve an attitudinal survey of board members. Future research
may also examine the speci?c attributes towards risk for each type of af?liated directors.
Practical implications – The ?ndings cast doubts on the hope that promoting board independence
would reduce agency con?icts relating to managerial risk aversion, and support the proposition that,
although ?rms may comply with the demands for more independent directors, they could employ a
number of tactics to neutralize the power of outsiders.
Originality/value – The empirical work surrounding this topic has been scant. This study may
present the ?rst Australian empirical evidence on the relationship between board composition and
?rm performance variance.
Keywords Boards of Directors, Corporate governance, Organizational performance, Australia
Paper type Research paper
1. Introduction
In 2002, in response to corporate collapses resulting from accounting irregularities and
failures of ethics and controls, the New York Stock Exchange and NASDAQ Stock
Market started corporate governance reforms to help win back the trust and con?dence
of investors. One year later, the Securities and Exchange Commission approved their
corporate governance listing standards. Also in 2003, the London Stock Exchange
(1998) revised its Combined Code, and the Australian Securities Exchange (ASX)
endorsed Principles of Good Corporate Governance and Best Practice Recommendations
The current issue and full text archive of this journal is available at
www.emeraldinsight.com/1030-9616.htm
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Accounting Research Journal
Vol. 22 No. 2, 2009
pp. 196-212
qEmerald Group Publishing Limited
1030-9616
DOI 10.1108/10309610910987510
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(Guidelines) which re?ect “best international practice” by highlighting the importance
of independent directors.
The New York Stock Exchange, NASDAQ, London Stock Exchange and ASX
require that a majority of each listed company’s directors qualify as independent
directors. The de?nitions of “independence” proposed by the stock exchanges vary.
It appears that they are sourced fromthe statement in the Cadbury Report (Department
for Trade and Industry, 1992, Code 2.2) – an independent director:
[. . .] should be independent of management and free from any business or other relationship
which could materially interfere with the exercise of their independent judgement, apart from
their fees and shareholding.
Although it is for the board to decide in particular cases whether the de?nition of
independence is met, there are lists of the categories of persons who should not be
considered independent.
The New York Stock Exchange and NASDAQ take a mandatory approach in which
companies must comply with their standards in order to be listed on the exchanges.
The ASX (2003, p. 5) and London Stock Exchange, on the other hand, follow a
voluntary approach:
[. . .] f a company considers that a recommendation is inappropriate to its particular
circumstances, it has the ?exibility not to adopt it – a ?exibility tempered by the requirement
to explain why.
In August 2007, the ASX released the second edition of the Guidelines, which contains
no signi?cant changes to the recommendations to “structure the board to add value” as
introduced above, except that the term “best practice” has also been removed from the
title and text to eliminate any perception that the recommendations are prescriptive
and so not to discourage companies from adopting alternative practices and “if not,
why not” reporting where appropriate.
Matching the trend towards greater board independence, empirical research on the
board composition-?rm performance link has become a popular topic. Ellstrand et al.
(2002) noted that, although board composition had many dimensions, in literature the
term typically referred to the proportions of inside (individuals employed by the ?rm)
and outside directors serving on the boards. The results, as shown in Table I,
have been inconsistent. Zahra and Pearce (1989) identi?ed some sources of these
con?icting ?ndings, including differences in time-frames, samples, performance
measures, and the operational de?nitions employed with regard to the outsiders’
variable.
Several academics attempted to investigate the potential in?uence of directors on
?rm risk. Schellenger et al. (1989) believed that the con?icting empirical evidence with
respect to the existence or non-existence of a board composition effect on ?nancial
performance might be due to failure to control risk. After testing a sample of 526 US
?rms with complete data for the year 1986, they located a negative association between
the percentage of outside directors and standard deviation of shareholder return. The
proportion of outside directors and beta, however, were positively correlated. According
to Schellenger et al. (1989, p. 463), “[w]hat this suggests is that ?rms with a greater
percentage of outsiders on the board have greater systematic risk, but less total risk”.
In another US study, Kim and Buchanan (2008) observed that the literature had
paid little attention to exploring the implications of chief executive of?cer (CEO)
Board
composition and
?rm performance
197
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duality on strategic management such as ?rm risk-taking behaviour; little is known on
whether the presence of duality contributes to agent opportunism or promotes
stewardship pro-organisational behaviour in ?rm strategic management practices.
Thus, using a sample of 290 large US corporations, they examined the empirical
relationship between CEO duality and ?rm risk-taking propensity. Their results show
that, consistent with the agency theory perspective, CEO duality reduces income
stream risk as measured by the standard deviation of return on assets. It is also found
that institutional ownership moderates the negative correlation between duality
structure and ?rm risk.
This study intends to extend the works of Schellenger et al. (1989) and Kim and
Buchanan (2008) by examining the impact of other board members on the level of
performance risk, in the recently altered regulatory environment with respect to the
requirement for a majority of independent directors. It may present the ?rst empirical
evidence on the relationship between board composition and ?rm performance
variance in the Australian context.
Authors Country Results
Pfeffer (1972) USA Contingent
Baysinger and Butler (1985) USA Positive
Fosberg (1989) USA Insigni?cant
Schellenger et al. (1989) USA Positive
Hermalin and Weisbach (1991) USA Insigni?cant
Pearce and Zahra (1992) USA Positive
Daily and Dalton (1992) USA Positive
Yermack (1996) USA Insigni?cant
Agrawal and Knoeber (1996) USA Negative
Muth and Donaldson (1998) Australia Negative
Vafeas and Theodorou (1998) UK Insigni?cant
Dalton et al. (1998) USA Insigni?cant
Lawrence and Stapledon (1999) Australia Negative
Bhagat and Black (2000) USA Insigni?cant
Coles et al. (2001) USA Insigni?cant
Dehaene et al. (2001) Belgium Positive
Hossain et al. (2001) New Zealand Positive
Panasian et al. (2003) Canada Contingent
Kiel and Nicholson (2003) Australia Negative
Cotter and Silverster (2003) Australia Insigni?cant
Singh and Davidson (2003) USA Insigni?cant
Balatbat et al. (2004) Australia Insigni?cant
Peng (2004) China Insigni?cant
Chang and Leng (2004) Malaysia Insigni?cant
Chin et al. (2004) New Zealand Insigni?cant
Randoy and Jenssen (2004) Sweden Contingent
Anderson and Reeb (2004) USA Contingent
Chen et al. (2005) Hong Kong Insigni?cant
Krivogorsky (2006) Continental Europe Positive
Choi et al. (2007) South Korea Positive
Luan and Tang (2007) Taiwan Positive
Chan and Li (2008) USA Contingent
Table I.
Empirical evidence:
contribution of
independent/
non-executive directors
on ?rm performance
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2. Hypotheses
Denis and McConnell (2003) noted that the publication of Jensen and Meckling (1976),
in which the authors applied agency theory to corporations and modelled the agency
costs of outside equity, had produced voluminous works on corporate governance in
general, and boards of directors in particular. As de?ned by Jensen and Meckling
(1976), an agency relationship is a contract under which one party (the principal)
engages another party (the agent) to perform some services on the principal’s behalf.
Where both the principal and the agent are utility maximisers, there is no a priori
reason to believe that the agent will always act in the principal’s best interests. In
investor-owned ?rms, shareholders act as the principals with interests in deriving
maximum returns from the action of managers, serving as the agents; from this
agent-principal relationship, two agency problems may emerge – con?icting goals and
differing attitudes towards risk (Jensen and Meckling, 1976; Eisenhardt, 1989;
Ellstrand et al., 2002).
Agencytheory suggests that managers may pursue their own goals rather thanseek to
maximise shareholder wealth unless their discretion is kept in check by a vigilant board.
Therefore, where board of directors is more independent of management, company
performance would be higher (Fama, 1980; Scott, 1983; Castaldi and Wortmann, 1984;
Daily et al., 2002). However, as introduced earlier, the empirical evidence in this area is
mixed. Furthermore, some agency theorists assume that shareholders generally favour
actions that maximize returns, evenwhenaccompanied byhigher risk, because theycould
diversify against risk by selecting speci?c stocks for their portfolios. Managers, on the
other hand, cannot readilydiversifytheir employment risks across a range of investments,
as a result they tend to be more risk averse than may be in the interests of shareholders,
and would prefer low risk strategies (Jensen and Meckling, 1976; Mizruchi, 1983;
Eisenhardt, 1989; Beatty and Zajac, 1994; Coles et al., 2001).
Inother words, if there is a goodbusiness opportunityinvolvinghighrisk, shareholders
would expect managers to take the opportunity and maximize their investment return,
while managers may be hesitant to take the option because their rewards from the
risk-taking would be limited. Managers are more concerned about their employment risk
and ?rm survival than pro?t maximization of shareholders (Baysinger and Hoskisson,
1990; Kim and Buchanan, 2008). Therefore, it is expected that:
H1. There is a negative relationship between the proportion of executive directors
on the board and subsequent ?rm risk (agency theory).
The ASX Guidelines identi?es several personal and professional af?liations that may
limit the independence of non-executive directors. These af?liated directors, or “grey”
directors as termed by Baysinger and Butler (1985), are poised somewhere between
inside and independent directors. Although their primary employment does not
depend directly on the ?rms that they serve as directors, they have a personal stake in
the ?rms owing to ?nancial or kinship relationships with the ?rms or executives
(Ellstrand et al., 2002). The af?liation that they have may violate the monitoring role as
speci?ed by agency theory for outside directors. In order to maintain these
relationships, they could be inclined to support low risk strategies as favoured by the
management (Johnson et al., 1996; Ellstrand et al., 2002). It appears that:
H2. There is a negative relationship between the proportion of af?liated directors
on the board and subsequent ?rm risk (agency theory).
Board
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Heslin and Donaldson (1999) and Donaldson (2000) proposed a theory of organisational
change and success, i.e. organisational portfolio theory, which is built on the premise
that low performance is required to trigger adaptive organisational changes. It is
acknowledged that the theory is at present only “[. . .] a series of propositions waiting
for empirical testing. Only after it has received such empirical con?rmation would the
policy implications sketched here become valid prescriptions” (Donaldson, 2000, p. 395).
Contrary to the assumption of agency theory, Heslin and Donaldson (1999) argued that,
in general, executive directors would raise risk and independent directors would reduce
risk. During periods when executives constitute a large proportion of the board, risk
tends to increase; when peaks from the high risk strategy co-occur with favourable
combinations of the other portfolio factor[1], outstanding performance is likely to
result. This would reinforce con?dence in the integrity and competence of the largely
non-independent corporate governance structure, thus bolstering the position of
executives on the board.
When the troughs in the high risk strategy occur simultaneously with other
performance-depressing portfolio factors, the particularly lowperformance may trigger
the installation of an independent chairperson and a higher proportion of independent
directors on the board. The resulting risk-averse governance would tend to reduce ?rm
performance variance. It is considered that reducing ?rm risk may be a means of
increasing short-term economic value (Brealey and Myers, 1996). Heslin and Donaldson
(1999), however, asserted that low risk could prevent the performance crises needed to
trigger required structural adaptation. High economic value achieved by lowering risk is
thereby prone to inhibiting long-term growth and pro?tability. Thus, the link between
board composition and ?rmrisk as predicted by organisational portfolio theory may be
illustrated as follows:
H3. There is negative relationship between the proportion of independent directors
on the board and subsequent ?rm risk (organizational portfolio theory).
3. Method
This paper uses the top 500 companies listed on the ASX, ranked by market
capitalisation, as the initial dataset. Each year the ASX collects information on these
companies to calculate its All Ordinaries Index, the primary indicator of the Australian
equity market. At 31 December 2003, the top 500 companies represented 95 per cent of
the total market capitalisation of the ASX-listed companies (Standard & Poor’s, 2004).
Therefore, this dataset offers a reasonable coverage for the population of interest,
i.e. Australian public corporations.
Owing to lack of comparable data in ?nancial institutions, Muth and Donaldson
(1998) had to reduce their sample of Australian ?rms. Similarly, Kiel and Nicholson
(2003) excluded banks fromtheir analysis as the recorded assets of ?nancial institutions
consist of loans which represent the use of depositors’ funds. There are 503 ?rms in the
2003 list of top 500 companies as presented in Huntleys’ Shareholder (Aspect Huntley,
2003). After ?nancial institutions including property trusts and investment funds are
removed fromthe list, a sample of 384 ?rms is obtained. The sources of data used include
Connect 4 database containing the annual reports on the top 500 companies, Fin
Analysis database giving market information and statistics of Australian ?rms, and
Huntleys’ Shareholder (Aspect Huntley, 2003) providing data on ?rm age and lines of
business. The sample is further reduced to 243 ?rms due to missing data.
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In this study, board composition is measured by the proportions of executive,
af?liated and independent directors. If the sources of information only divide directors
into executive and non-executive directors, it would be necessary to divide
non-executive directors into af?liated and independent directors, using the de?nition
of independence proposed by the ASX (2003, p. 19) Corporate Governance Council as a
benchmark.
According to the Guidelines:
[. . .] [a]n independent director is independent of management and free of any business or
other relationship that could materially interfere with – or could reasonably be perceived to
materially interfere with – the exercise of their unfettered and independent judgement.
Although there is a list of the persons who should not be considered independent in
Box 2.1 of the Guidelines (ASX, 2003), it is unclear how long an independent director
could serve on the same board. This research follows the UK Higgs Report
(Department for Trade and Industry, 2003) which nominates ten years in relation to
director tenure consideration.
AASB1031 provides guidance in relation to a quantitative assessment of materiality.
An item is presumed to be material if it is equal to or greater than 10 per cent of the
appropriate base amount. As the ASX (2006) recommends that this would seem a
reasonable position for consideration by the board in determining materiality (ASX,
2006), the materiality threshold is set at 10 per cent of net assets or operating result
before tax, for balance sheet or pro?t and loss items, respectively. The details of directors
are available in corporate governance statement, director’s report and related party note
to the ?nancial statements. If a close analysis of the information could not provide an
objective basis for determining director independence, the company is excluded fromthe
analysis.
Following the approach supported by most prior studies on the boards of directors
as summarised in Table I, board composition for sample companies is assessed at one
point in time, i.e. mid-2003. As Australian listed companies have been subject to new
corporate governance requirements from 2003, the results of this study may indicate
the consequences of these recommendations regarding board composition on
performance variance of Australian ?rms. In addition to descriptive statistics and
correlation analysis, ordinary least squares (OLS) regressions are constructed for the
research variables. An algebraic statement of the models is as follows:
RISK ¼a þb
1
ðCompositionÞ
i
þb
2
ðAGEÞ
i
þb
3
ðBLOCKÞ
i
þb
4
ðDIVRÞ
i
þb
5
ðEQEDÞ
i
þb
6
ðGEARÞ
i
þb
7
ðLogMCAPÞ
i
þb
8
ðSEGMTÞ
i
þb
9
ðSHRETÞ
i
þb
10
ðSIZEÞ
i
þm
i
Firm risk could be measured in a number of ways (Baird and Thomas, 1990; Beatty
and Zajac, 1994). Baird and Thomas (1990) reviewed how risk had been conceptualized
in different disciplines of management, ?nance, marketing and psychology and
concluded that researchers in the area of strategic management typically de?ned risk
as unpredictability of business outcome variables, e.g. variability of accounting or
market return. Finance literature suggests that total risk consists of systematic risk –
the risk of the market, and unsystematic risk – the risk unique to the ?rm (Ross et al.,
2005; Reilly and Brown, 2006). Schellenger et al. (1989) suggested that board could
Board
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in?uence both the systematic and unsystematic risk, and Lorsch and MacIver (1989),
Baysinger et al. (1991), Davis and Thompson (1994), Heslin and Donaldson (1999) and
Donaldson (2000) believed that directors might raise or reduce total risk of the ?rm.
Thus, it is decided to choose a measure of total risk – the standard deviation of
shareholder return. To reduce the in?uence of short-term ?uctuations, the ?gures
tested in this study are the three-year averages over the 2003-2006 ?nancial years.
As shown in Table II, to identify the speci?c effect of different types of directors on
risk, drawing on some empirical models identi?ed in corporate governance research
(Bhagat and Black, 2000; Coles et al., 2001; Singh and Davidson, 2003; Randoy and
Jenssen, 2004; Krivogorsky, 2006), a number of covariates are introduced into the
analysis to control for confounding in?uence.
Coles et al. (2001) presumed that blockholders had the capacity to monitor their
investments and, by virtue of the magnitude of their investments, could affect
managerial behaviour. The threat that blockholders will sell large blocks of shares if
the ?rm fails to provide an acceptable return, or is not responsive to concerns that
investors view as critical, is a signi?cant issue for managers. There is empirical
evidence that institutional investors and other blockholders do impact managerial
behaviour (van Nuys, 1993; Brickley et al., 1994; Shome and Singh, 1995; Bethel et al.,
1998; Allen and Phillips, 2000).
Jensen and Meckling (1976) asserted that increasing managerial ownership could
mitigate agency con?icts. The higher the proportion of equity owned by managers, the
greater the alignment between managers and shareholder interests. Jensen (1986)
Measure Abbreviation De?nition
Firm risk
Firm risk RISK Standard deviation of shareholder return
Board composition
Executive directors PEXE Percentage of executive directors on the board
Af?liated directors PAFF Percentage of af?liated directors on the board
Independent directors PIND Percentage of independent directors on the board
Control
Firm age AGE Number of years listed on the ASX and one of the
stock exchanges which were amalgamated to form
the ASX in 1987
Blockholder ownership BLOCK Percentage of common stocks held by the top 20
shareholders
Dividend payout DIVR Ratio of dividend payments to pro?t after interest
and tax
Managerial ownership EQED Percentage of equity including options held by
executive directors
Leverage GEAR Ratio of short-term and long-term debt to book value
of equity
Firm size LogMCAP Natural logarithms of market value of common
stocks (in $million)
Diversi?cation SEGMT Number of industrial and geographical segments
Prior performance SHRET Realised rate of returns incorporating capital gains
and dividend payments
Board size SIZE Number of directors on the board
Table II.
Description of research
variables
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argued that the payment of dividends would reduce the agency con?icts as it would
reduce the free cash?ow available for managers to use for their own “perks” or invest
in projects with marginal returns. Similarly, Easterbrook (1984) noted that the regular
payment of dividends would reduce the free cash?ow and thereby require ?rms to seek
debt funds. The use of external funds would then leave them open to more monitoring
by outsiders which may act as a deterrent to opportunistic behaviours by managers.
Modigliani and Miller (1958) proposed that capital structure would be irrelevant in
determining ?rm value, because a ?rm cannot change the total value of its securities
just by splitting its cash ?ows into different streams. Jensen and Meckling (1976)
opposed this proposition by pointing out that the amount of debt ?nancing in a ?rm’s
capital structure would affect managers’ choice of operating activities. Consequently,
Balakrishnan and Fox (1993) believed that increasing leverage would increase
managers’ risk aversion and reduce their willingness to invest in more risky but
pro?table projects. Moreover, according to Amihud and Lev (1981), Dyl (1988), Tosi
and Gomez-Mejia (1989) and Hoskisson and Turk (1990), managerial motives for
diversi?cation may exist independent of resources, which include risk reduction and
desire for increased compensation.
Consistent with the risk measure, dividend payout, ?rm size and leverage are
calculated for the period of 2003-2006. Like the measures for board composition, data
on board size, blockholder ownership, diversi?cation, ?rm age and managerial
shareholdings are collected for the 2003 ?nancial year. Prior performance is measured
by the average shareholder return for the years 2000-2003.
4. Results
Table III gives a description of ?rmcharacteristics for the sample. Casual observation of
the table reveals that the sample contains a wide range of ?rms. The proportion of
executive, af?liated or independent directors on the board varies between 0 and
100 per cent, with a mean of 28.48, 29.86 or 41.65 per cent, respectively. The total number
of directors on the board ranges froma lowof three to a high of 15, with anaverage of just
over six. The number of years the company has been listed on the stock exchange ranges
Variable
a
Mean Median Maximum Minimum SD Skewness Kurtosis Unit
RISK 0.58 0.29 20.69 0.004 1.70 9.22 97.10 Number
PEXE 28.48 25.00 100 0 0.16 0.89 3.98 Percentage
PAFF 29.86 25.00 83.33 0 0.22 0.40 2.60 Percentage
PIND 41.65 40.00 100 0 0.22 0.03 2.56 Percentage
AGE 16.90 11.00 132.00 3.00 17.81 2.90 15.39 Number
BLOCK 65.10 67.09 99.86 13.60 0.18 20.42 2.74 Percentage
DIVR 0.51 0.51 3.39 0 0.47 1.50 8.59 Ratio
EQED 11.84 2.21 80.99 0 0.18 1.70 4.89 Percentage
GEAR 0.47 0.37 3.95 0 0.51 2.73 15.01 Ratio
LogMCAP 5.86 5.60 11.70 2.11 1.78 0.51 3.07 Number
SEGMT 4.46 4.00 11.00 1.00 2.23 0.84 3.19 Number
SHRET 0.06 0.09 4.00 23.00 0.61 1.34 23.16 Number
SIZE 6.33 6.00 15.00 3.00 2.05 1.02 4.53 Number
Notes: Sample period: 2003-2006 (n ¼ 243);
a
the explanation for each variable is included in Table II
Table III.
Descriptive statistics
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from three to 132, and number of business segments ranges from one to 11, with an
average close to 18 or four. The percentage of equity held by blockholders or executive
directors varies between 0 and 99.86 per cent, with a mean of 65.10 or 11.84 per cent,
respectively.
Table IV provides Pearson product-moment correlations for the research variables,
which shows that the positive relation between RISK and PAFF is signi?cant at the 5
per cent level[2]. Thus, af?liated directors may increase ?rm performance variance.
RISK is negatively associated with DIVE or LogMCAP at the 1 or 5 per cent level. The
?ndings suggest that larger ?rms or ?rms paying higher dividends tend to have lower
performance variance.
Among the independent variables a few strongly signi?cant coef?cients can be seen
in Table IV. For example, PEXE is inversely related to PAFF, PIND, AGE, LogMCAP
or SIZE, and positively related to EQED. Therefore, larger ?rms or ?rms with longer
trading history or less-managerial shareholdings tend to have a larger board with more
independent directors and fewer executive directors. PAFF is negatively correlated
with PIND, and positively correlated with BLOCK – higher blockholder ownership
lead to more af?liated directors, who, in turn, would reduce the number of independent
directors on the board. PIND is positively associated with LogMCAP and SEEGMT,
and negative associated with BLOCK. The results indicate that larger ?rms or ?rms
with more reportable segments or lower blockholder ownership may have more
independent directors sitting on their boards.
Table V displays regression estimates for the effects of board composition and other
variables on ?rm risk. PEXE presents a negative in?uence on RISK at 5 per cent level
of signi?cance. There is no signi?cant association between PAFF, PIND and RISK.
Although the absolute values of correlation coef?cients for the explanatory variables,
as shown in Table IV, are well below the rule of thumb of 0.8 or 0.9, auxiliary
regressions for LogMCAP and SIZE are performed, which con?rm that there is no
multicollinearity concern for the regressions[3].
The regression results suggest that only one of the three hypotheses, H1 which is
proposed by the agency theory, is supported. Af?liated and independent directors, in
general, have no signi?cant in?uence on performance risk. With respect to the control
variables used in the regressions, consistent with the ?ndings in Kim and Buchanan
(2008) blockholder ownership gives a positive impact on risk. It is found that poor
dividend payout would lead to increased performance variance, and higher managerial
shareholdings would reduce ?rm risk-taking propensity. Thus, contrary to the opinion
of Jensen and Meckling (1976), Easterbrook (1984) and Jensen (1986), managerial
ownership and payment of dividends may in fact increase rather than reduce the
incentive of managers to avoid risk.
5. Conclusions
This study examines the impact of board composition on ?rm performance variance.
Other variables that may mitigate the agency con?icts, such as blockholder ownership,
managerial shareholdings and dividend payout, are also included in the analysis. The
results indicate that executive directors have a negative effect on subsequent risk.
Af?liated and independent directors, however, have no signi?cant in?uence on the
level of performance variance. It is found that blockholders give a positive impact on
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5
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Table IV.
Pearson correlations:
board composition
and ?rm risk
Board
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?rm performance
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?rm risk. In addition, companies with poor dividend payout or low-managerial
shareholdings tend to be riskier.
As introduced earlier, agency theory asserts that con?icts relating to managerial risk
aversion may arise because of portfolio diversi?cation constraints of managerial income
(Jensen and Meckling, 1976; Mizruchi, 1983; Eisenhardt, 1989; Beatty and Zajac, 1994;
Coles et al., 2001). According to some authors, for example, Fama (1980), Knoeber (1986),
Prentice (1993), Vafeas and Theodorou (1998) and Godfrey et al. (2003), the con?icts may
be heightened when executive compensation is composed largely of a ?xed salary, or
where their speci?c skills are dif?cult to transfer from one company to another.
Risk-increasing investment decisions may increase the likelihood of bankruptcy, which
could severely damage a manager’s reputation, making it dif?cult to ?nd alternative
employment (Jensen, 1986; McColgan, 2001). Managerial risk aversion may also affect
Coef?cient t-statistic RISK Predicted sign
a
Intercept 1.414 0.778 0.996
2.243
*
1.383 1.654
*
PEXE 21.249 Negative
21.699
*
PAFF 0.821 Negative
1.588
PIND 20.196 Negative
20.384
AGE 0.002 0.003 0.003 Unclear
0.267 0.417 0.511
BLOCK 1.555 1.369 1.611 Positive
2.517
*
2.133
*
2.544
*
DIVR 20.602 20.591 20.575 Positive
22.506
*
22.460
*
22.381
*
EQED 20.998 21.153 21.416 Positive
21.445 21.730
*
22.180
*
GEAR 0.034 0.034 0.035 Negative
0.649 0.645 0.672
LogMCAP 20.108 20.087 20.100 Unclear
21.221 20.974 21.106
SEGMT 20.030 20.026 20.030 Negative
20.514 20.454 20.511
SHERT 20.056 20.063 20.066 Unclear
20.774 20.878 20.904
SIZE 20.050 20.048 20.040 Unclear
20.715 20.683 20.562
R
2
0.098 0.097 0.087
Std error (regression) 1.647 1.648 1.657
F-statistic 2.521
* *
2.481
* *
2.221
*
Durbin-Watson 1.990 1.994 1.989
Notes: Sample period: 2003-2006 (n ¼ 243); dependent variable: RISK; signi?cance at the
*
5 and
* *
1
per cent levels, respectively; the predicted signs for PEXE, PAFF and PIND are based on the three
hypotheses being tested. The sign for BLOCK, DIVR, EQED, GEAR and SEGMT is suggested by the
agency literature as introduced in Section 3. The effects of other research variables on ?rm
performance variance remain unclear, although, as noted by Thornhill and Amit (2003), from the
resource-based view ?rms may be at the greatest risk of bankruptcy when they are young and small
Table V.
OLS regressions: board
composition and ?rm risk
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the ?nancial policy of the ?rm. Higher debt is believed to reduce agency con?icts and
carries potentially valuable tax shields (Jensen, 1986; Haugen and Sendbet, 1986).
Managers, however, may prefer equity ?nancing because debt increases the risk of
bankruptcy and default (Brennan, 1995).
Therefore, corporate governance mechanisms, including board of directors
comprising a majority of independent outsiders, should harmonize agency con?icts
and safeguard invested capital. The board could ensure that managers are not the sole
evaluators of their own performance, and the board’s legal responsibilities to hire, ?re
and reward executives are seen as key elements in controlling con?icts of interest
(Fama and Jensen, 1983; Williamson, 1984; Baysinger and Hoskisson, 1990; McColgan,
2001). However, the evidence reported here indicates that, although executive directors
may tend to be risk averse, independent directors have no signi?cant effect on
subsequent risk. The ?ndings cast doubts on the hope that promoting board
independence would reduce agency con?icts relating to managerial risk aversion.
The literature gives some potential explanations for the results. Although ?rms may
comply with the demands for more independent directors, they could employ a number of
tactics to neutralize the power of outsiders (Oliver, 1991; Zajac and Westphal, 1996;
Westphal, 1999). This can be done, for example, by appointing individuals who are
demographically similar and therefore more sympathetic to executives (Westphal and
Zajac, 1995), or individuals with experience onother passive boards instead of more active
boards (Zajac and Westphal, 1996), or individuals who are from strategically irrelevant
backgrounds without the knowledge base to effectively participate in strategic decision
making and challenge executives’ power (Carpenter and Westphal, 2001).
The absence of a clear relationship between af?liated directors and risk could be an
outcome of the multifaceted interests represented by af?liated directors. As noted by
Ellstrand et al. (2002), the suppliers, consultants and attorneys who would be classi?ed
as af?liated directors may be less-risk averse than insiders since they do business with
multiple ?rms and are naturally diversi?ed. In contrast, directors with personal
relationships to executives may have singular stakes in the ?rm, and therefore share
insiders’ aversion to high-risk initiatives. Future study in this area may examine the
speci?c attributes towards risk for each type of af?liations in the Australian market.
It should be noted that the focus of this paper is on the empirical link between board
composition and ?rm performance variance. It does not examine the actual risk
preference of individual directors, which could involve an attitudinal survey of board
members. Another potential weakness may be the assumption of the hypotheses being
tested. Agency theory and organisational portfolio theory assume that companies
whose boards have higher risk preference would have higher performance variance.
However, there may be a situation where companies have similar risk preference
pro?les of directors but their variances differ. Although this study provides some
insights on this issue by introducing some controls into the data analysis, further
research is required to investigate the impact of other factors that bear no relationship
with the risk preference of directors on performance variance.
Notes
1. In Heslin and Donaldson (1999), three factors, namely, diversi?cation, divisionalization and
divestment, are identi?ed that are likely to prevent instances of poor performance and so
forestall calls for a tougher and more independent board. There are also three factors that
Board
composition and
?rm performance
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could contribute to poor performance and lead to the appointment of more non-executives as
board members or chair – business cycles, competition and debt.
2. The levels of signi?cance reported in this paper are for two-tailed tests.
3. The results of auxiliary regressions are available from the authors.
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Corresponding author
Yi Wang can be contacted at: [email protected]
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1. Stephen Gray, John Nowland. 2015. The diversity of expertise on corporate boards in Australia. Accounting
& Finance n/a-n/a. [CrossRef]
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