Thesis on Corporate Governance and
Innovation
‘How do bundles of Corporate Governance affect the level of innovation of a
firm?’
Student: Björn Wekking Student number: 10516018
Supervisor: Dr. Ilir Haxhi Study: MSc Business Studies
Second reader: Drs. Erik Dirksen Specialization: International Management
Contents
1. Introduction ... 6
2. Literature review ... 12
2.1 Corporate Governance & Innovation ... 12
Agency Theory ... 12
Configurational and Complementary perspective ... 13
Innovation ... 15
Understanding & Defining Innovation ... 16
Measuring Innovation ... 20
2.2 Life Cycle & Stakeholder theory ... 22
2.3 Bundles of Corporate Governance on Innovation ... 25
Legal Pressures ... 26
Board Practice ... 28
Ownership Structure ... 30
2.3.1 The mediation effect ... 32
Figure 5: Conceptual Model of Hypotheses ... 34
3. Data and method ... 35
3.1 Data collection ... 35
3.2 Sample ... 36
3.2 Dependent & Mediating Variables ... 36
3.3 Data analysis ... 41
4. Results ... 44
4.3 Mediation ... 55 5. Discussion ... 57 5.1 Legal Pressures ... 58 5.2 Board Practice ... 59 5.3 Ownership structure ... 61 6. Limitations ... 62 7. Future Research ... 63 8. Conclusion ... 65 9. Attachements ... 65 10. References ... 72
List of Tables and Figures
Table 1: Overview words related to defining innovation linked to discipline 19
Table 2: Multicolliniearty testing 69
Table 3: Stepwise OLS regression, model development 44
Table 4: Stepwise OLS regression on Patents 44
Table 5: Scale Means, SD's, Inter Correlations and Reliability 50
Table 6: R&D Expenditure - Unstandardized Beta Coefficients 52
Table 7: Patents- Unstandardized Beta Coefficients 53
Table 8: Patents- Unstandardized Beta Coefficients- Significant variables 54
Table 9: Results of the mediation analysis using the PROCESS procedure 55
Figure 1: Multi-dimensional framework of organizational innovation 18
Figure 2:CG practice versus stages of life cycle 23
Figure 3: Governance functions and the life cycle stages 24
Figure 4: Corporate Governance model 26
Figure 5: Conceptual Model of Hypotheses 34
Figure 6: Overview positive and negative relations 62
Figure 7: Overview characteristics phases firm life cycle 70
Figure 8: Criteria phase of life cycle 71
Acknowledgements
My first and sincere appreciation goes to Dr. Ilir Haxhi, my thesis supervisor for his continuous help and support in all stages of this thesis. I would also like to thank him for encouraging me and helping me to shape my interest and ideas. But foremost, I would like to thank him for providing a manner of supervision that fits my personality; I cannot recall a meeting without provoking each other, sharp insights about life, and laughter.
I would like to express my respect to Bjorn Witlox whose advice on data collection was invaluable to me, in a period I had very little motivation left. His sessions helped me in finding the right data to build my first dataset ever.
I would like to thank my fellow students with whom I have developed close relations, for the critical and philosophical discussions that followed my thoughts, theories and findings. Thank them these discussions were mostly over a beer after a long day in the library.
I would like to thank my family, especially my mother and father, for always showing great interest, and for their continuous love and support for my decisions. Without them it would have been difficult to have finished this thesis.
Also a big thanks to my girlfriend, for always being there, listening to me rambling, checking my thesis, and motivating me when motivation was hard to find.
All in all, I would like to express my appreciation to all people who have contributed to this thesis by providing a listening ear, asking critical questions and in providing balance according to the ‘work hard, play hard’ philosophy.
Abstract
Corporate governance has been identified as one of the most important transitions in tackling misconduct of large corporations, but also as a tool to assure stakeholders of the good intentions of a firm, to boost performance or to increase the level of innovation. I argue that too much research is spread out across different perspectives, definitions and designs, which decreases the affect, and effects. Previous research has found ill support for a relationship between corporate governance and innovation. Through the bundling of complementary corporate governance characteristics, this study increases the measured level of effectiveness of corporate governance mechanisms in relation to innovation. Innovation is measured both by the amount of patents and research and development expenditure to control for their effects (and total affect) and to show the difference between measuring input (R&D expenditure) and the output (amount of patents) of innovation. Mediation of R&D expenditures between the different bundles and amount of patents is tested because ill support is found for direct relations between corporate governance mechanisms and amount of patents. This study uses a sample, originating from the FT 500, of 103 publically traded companies in the United States, Europe and Asia, active in the pharmaceutical and technical sector.
The outcome of this researched supports a mediating effect of R&D expenditure, in addition to a direct relationship. Furthermore this research has found that audit- and non audit costs have a positive influence on the amount of patents but are negatively related to R&D expenditures. While ownership structure and board practice only have a direct, negative effect on the amount of R&D expenditure. Mediation of R&D expenditure, between the different bundles and innovation even makes the effects stronger. These results show that, when bundled, CG mechanisms effectiveness on innovation increases.
1. Introduction
With companies becoming larger than most emerging, and even some developed, countries and an economic world in which it becomes harder to survive, is it still surprising business ethics are a lower priority than the assurance of continuing business (Potts & Matuszewski, 2004)? Through multiple corporate scandals, public outcry for reforms and adjusted legislation, voice was given to new developments in the area of corporate governance to tackle the misconduct in large corporations (Short, Keasey, Wright, & Hull, 1999). Development of corporate social responsibility as a research field, and the integration in everyday business processes, show that corporations want to create an image as a contributor to the social welfare of society (Rasche, De Bakker, & Moon, 2013). At the same time the financial crisis ripped away the curtains between the public and the core business of many corporate actors and exposed a wave of misconduct and stretching of the rules (Hausman & Johnston, 2013).
The reaction of the government to these issues was largely dependent on the institutional context of the specific country (Aguilera, Filatotchev, Gospel, & Jackson, 2008). In the U.S. some hard laws were passed down in the form of corporate governance regulations under the Sarbanes- Oxley Act (2002) raising litigation risks (Gillan, 2006). This law redefined structural aspects of the board with the aim of increasing its independence and monitoring abilities (Linck, Netter, & Yang, 2009). It also created a new oversight body to regulate auditors, make executive actions more transparent to shareholders, and increase punishment for fraud. This resulted in higher expenditures on directors’ insurance and indemnity policies for corporations (Aguilera, Filatotchev, Gospel, & Jackson, 2008). An externality of these actions was noticed in the audit branch, which developed codes of conduct for themselves because of the risk of being sued for malpractice (Carcello, Hollingsworth, & Klein, 2006).
Another reaction to the financial crisis came from the scholarly side, through the proposition that corporations lost their innovative capabilities and focused only on marginal and safe product improvements instead of real product breakthroughs (Eisenhardt & Martin, 2000; Hausman & Johnston, 2013). There are only a few companies well known to us as truly innovative companies, and even their focus starts to shift to the safe side of production. Think only of Samsung and the reception of the new Samsung S4. It featured some new applications, neat tricks and gadgets but no true innovative features. Innovation is seen as a good way to boost firms’ performance but seems to flatten when corporations reach a certain age or size (Filatotchev, Toms, & Wright, 2006).
While the U.S. focused on strengthening the rules, the UK focused on these codes of conduct. This form of law is called soft law, and entails that when corporations do not follow these rules they need to explain why this choice was made, but they cannot be punished for their practices (García‐Castro, Aguilera, & Ariño, 2013). The expected result of these adjustments was an increase in transparency by the corporations towards the public and their stakeholders through the use of corporate governance. Corporate governance (CG) practices struggle with the right balance of compliance versus voluntary initiatives, especially when they are active in a multinational setting (Kolk & Pinkse, 2010). CG refers to the structure and processes by which an organization’s assets and activities are overseen (Hambrick, Werder, & Zajac, 2008). It also relates to the structure of rights and responsibilities of the different stakeholders (Aoki, 2001). Meaning that managing a firm is equal to managing the stakeholders, and even increases performance or the level of innovation of the firm.
When corporations become larger the need for external resources grows with the organization (Aguilera et al., 2008). As a possible result, the amount of - and the different
intervene, which entails that outside monitoring can complement internal monitoring by boards of directors (Ward, Brown, & Rodriguez, 2009). Literature on the subject of the agency theory is extensive but only starts to shift towards the contextual and organizational sociology view (account for the different organizational environments) (Aguilera et al., 2008).
This entails a possible link between the effective use of corporate practices (governance) to outperform competitors through innovation. Can the use of specific corporate governance practices, or the combination of these practices, be structured in such a way that they contribute to the level of innovation of the firm? And what about the context in which the firm must act? As noted earlier, every country has its own organizational environment (context) in which certain corporate practices may be more or less effective (Aguilera et al., 2008). The development of codes suggests that there must be some best practice that firms could follow, but these studies immediately overlook the different contexts (García‐Castro et al., 2013). Differing in codes across these diverse contexts could only make one context preferable over the other, while most countries have policies that are aimed at attracting international business. This could be the reason that there is no set of best practices, and is supportive of the statements of critics of the agency theory (Aguilera et al., 2008).
Important and relatively new research on this subject tries to understand how the effectiveness of governance practices is mediated by their possible fit or alignment with their context (García‐Castro, Aguilera, & Ariño, 2013). Scholars have a hard time finding significant results of the link between CG, innovation and performance. One of the reasons is the tendency to neglect CG patterned variations dependent on different institutional contexts. The other reason is the limited research in the field in which governance practices are highly interrelated and costly to adopt (García‐Castro et al., 2013).
In this thesis, I aim to increase the understanding between the effectiveness of governance practices and innovation. As such, I explore how the CG mechanisms, when bundled together, affect the change in innovation. Bundling comparable, but different, mechanism together should result in an increase in the explanatory values of the different concepts, in relation to innovation (García‐Castro, Aguilera, & Ariño, 2013). In more concrete terms, the research question of this thesis is:
How do bundles of Corporate Governance affect the level of innovation of a firm
?
For corporations the creation, protection and distribution of wealth through effective governance is key to their continuity (Aguilera et al., 2008). This entails a view in which the context of the corporation is central. It makes it more difficult to be held accountable by one of the stakeholders, because of all possible different objectives (Aguilera & Jackson, 2003). When dealing with something as broad as ‘context’ the need to develop a framework is high. Governance practices integrated in the national systems affect the governance structures on firm level and thus form the context in this study (Aguilera, Desender, & de Castro, Luiz Ricardo Kabbach, 2011). Innovation is the creation of wealth and CG oversees the protection and distribution of the wealth (Chanaron, 2013; Fischer & Henkel, 2012; Hausman & Johnston, 2013). Balancing, or rebalancing between the wealth creation and the wealth protection functions of governance may be associated with the strategic positioning of a firm and can be influenced by the different objectives of the stakeholders (Aguilera & Jackson, 2003; Filatotchev et al., 2006).
As can be noted from the reasoning above, CG practices need to be studied as interdependent and within their context (Aguilera et al., 2011; García‐Castro et al., 2013; Ward, Brown, & Rodriguez, 2009). This study has singled out characteristics that define the interdependence of CG practices. More specifically, and following the study of comparative
corporate governance, this study tests the relationship between bundled corporate governance practices (legal, ownership and board practices) and innovation (Brown & Caylor, 2006). Innovation stems from firm level innovation, and it is at firm level that CG is practiced (Aghion & Howitt, 2006). Interaction among the market for corporate control, contracts and private benefits could also drive innovation (Gillan, 2006). Therefore, integrating external and internal governance mechanisms is needed (Ettredge, Reed, & Stone, 2000).
To provide an example through legal practices, which include laws that make it harder to wrongful discharge employees make it costly for a firm to arbitrarily discharge employees (Acharya, Baghai, & Subramanian, 2012). As a result, firms do no punish short run failures of employees and enable employees to exert greater effort in risky but potentially breakthrough projects (Manso, 2011). This legal practice can come from the national level but needs to be integrated (hard law) in the firm’s own regulations and processes, and becomes part of the CG practices which influence the level of innovation of the firm.
This example shows a relation between CG practice and innovation but overlooks the influence of the stakeholders and their different objectives (Jensen, 2001). In this thesis I consider whether CG bundles provide a better explanation of the influence of CG on innovation.
To study the association between bundles of CG and innovation I looked at a sample of 103 publically traded companies in the United States, Europe and Asia. I researched scores on legal pressures (audit & nonaudit fees), ownership structure (amount of shareholder rights & board compensation) and board practice (independent board members, activities of the board & diverse membership of the board).
To measure and control innovation I have chosen to measure the level of innovation by the research and development expenditure and amount of patents (Hoskisson, Hitt, & Hill, 1993;
Lisboa, Skarmeas, & Lages, 2011; Manso, 2011). The affect is controlled through use of the Tobin’s Q measure, the size of the total investments and the industry type.
The framework that is used stems from literature on CG indices. Bhagat, Bolton and Romano (2008) compared multiple indexes for the taxation of CG practices. These indexes are applied to study CG practices, but also to compare the level of CG between firms. A high score on a CG index can be employed to attract new investors, but is also used to communicate a trustworthy image to stakeholders (Gompers, Ishii, & Metrick, 2003). On the other hand, stakeholders can use the service to better manage the risk of investing in a firm (R. La Porta, Lopez-De-Silanes, Shleifer, & Vishny, 2002). A major firm in this sector is Institutional Shareholder Services (ISS). ISS provides extensive governance information that forms the basis for the Gov- Score, developed by Brown and Caylor (2006) (Bhagat, Bolton and Romano, 2008). The Gov- Score uses data that measures both internal and external governance, and is created with data of the post Enron environment, which makes it more relevant (Bhagat, Bolton and Romano, 2008). Prior to the development of this index other indexes were developed, but these only measure external governance mechanisms (Gompers, Ishii & Metrick, 2003; Bebchuk, Cohen & Ferrel, 2005).
The thesis is structured in the following way. The first part introduces the fields of corporate governance and innovation. Also, life cycle theory and stakeholder- oriented views of the firm are being discussed. Thereafter, I will discuss the bundles of corporate governance as the common ground where insights come together. This paves the way for the development of six hypotheses, presupposing a link between bundles of CG and innovation.
In the second part the study’s methodology, reflection of the chosen sample and a description of the data collection process will be introduced. The results, limitations and a
discussion of the findings will follow. The last chapter reflects on the implications for managers and provides an overall conclusion, including consideration for future directions.
2. Literature review
2.1 Corporate Governance & Innovation
Corporate governance entails the study of power and influence over decision making within the firm (Aguilera & Jackson, 2010). Looking at firms and their fit with their environment it is hard enough to analyse the interaction between them. A lot of theory focuses on this fit and the involved actors. Aguilera and Jackson (2003) take the actor- centred approach and use it to specify the role of each stakeholder (management, capital and labour) towards the firm. Each role is shaped by different institutional domains and generates different types of conflicts and coalitions in corporate governance (CG).
Research combines characteristics of governance on a firm level with the characteristics of the national level and comes up with two national models of CG (García‐Castro et al., 2013). The outsider model, which is focused on the shareholders, represented by capital and the insider model, which is stakeholder oriented, and is represented by management and labour (Aguilera & Jackson, 2003). It is argued that the different sets of coalitions of governance practices among the stakeholders are competing for firm resources. These practices will align in bundles within these national models (García‐Castro et al., 2013).
Agency Theory
The basis for this reasoning is found in the agency theory, which entails that firms will operate more efficiently by managing the problems between stakeholders and managers (Aguilera et al., 2008). Here the difference between the interests of the stakeholders becomes most clear. The
insiders (management and labour) may favour internal diversification while the outsiders (capital) just want greater liquidity and financial returns (R. La Porta, Lopez-de-Silanes, Shleifer, & Vishny, 2000). This view on CG focuses on the link between governance practices and the firm performance, but it overlooks the distinct contexts in which firms are embedded (Aguilera et al., 2008). This is called the closed system approach. Useful insights about CG entail more complex matters than the principal- agent theory (Gillan, 2006). It also encompassed handling of multiple stakeholders, boardroom dynamics, managerial processes, managerial values and motives or even national systems (e.g. culture, legal) (Bebchuk, Cohen, & Ferrell, 2009; Brown & Caylor, 2006; Gompers, Ishii, & Metrick, 2003; Hambrick, Werder, & Zajac, 2008; Ward et al., 2009). The open system approach suggests that different CG practices may be less or more effective depending on the contexts of different organizational environments (Aguilera et al., 2008). Following this approach, CG must be viewed in terms of its effectiveness or the degree of goal attainment by the most important elements of the firm.
Effective CG ensures, through mechanisms, that executives respect the rights and interests of stakeholders (Desender, Aguilera, Crespi-Cladera, & Garcia-Cestona, 2009). On the other hand, it ensures that stakeholders can be held accountable for their actions regarding the wealth invested in the firm (Aguilera et al., 2008). This effectiveness may come from different characteristics of governing the firm (e.g. monitoring, advising and/ or promotion of innovation) (Aguilera et al., 2008).
Configurational and Complementary perspective
A fairly new stream of research on CG has adopted the configurational perspective (Aguilera et al., 2011). This view refers to the idea of organizational practices interacting with each other.
reasoning, it states there is no best fit of the configuration of bundles (García‐Castro et al., 2013). Here the idea of equifinality comes into play (Aguilera et al., 2011). Equifinality entails the idea of alternative configurations, which lead, through different paths, to the same outcome. Consequently, different bundles of organizational practices can have the same outcome (Aguilera et al., 2008). It is the presence or absence of particular factors that gives a variable meaning or not (Fiss, 2007).
A preferred outcome of a firm in the mobile devices industry could be to be highly innovative, because the firm estimates that it will create an advantage on its competition through attaining this goal. Profit maximisation then comes in second place as far as the preferred outcomes go.
A different perspective on this subject is provided by the complementary view. This view is developed around the concept of internal fit in the interaction among different organizational characteristics (Filatotchev, 2008). When related to CG, it refers to the overall bundles of practices that are aligned to mutually enhance the ability to achieve effective CG (Aguilera et al., 2008). To provide an example, the effectiveness of independent board members depends on high share holder involvement and a strong legal protection of the investors (Desender, Aguilera, Crespi-Cladera, & Garcia-Cestona, 2009).
With the configurational view, a concept as innovation thus focuses on the whole set of tightly grouped practices. The complementary view states that innovation will arise only when a particular combination of practices, with similar or different attributes, interacts with each other in a positive way.
Innovation
Context can have a big impact on the way firms explore and exploit opportunities through innovation, especially one in which rapid technological change, increasing globalization and intense competition form everyday challenges (Schramm et al., 2008).For a firm, the main goals in this type of context are to grow and stay viable in the long run (Lisboa, Skarmeas, & Lages, 2011). Managing innovation requires sets of best practices and a good assessment of firm and industry level measures (Schramm et al., 2008). But why should managers be motivated to focus on innovation instead of profit maximization (Daellenbach, McCarthy, & Schoenecker, 1999)?
It is argued that innovation is the main driver behind economic growth (Crossan & Apaydin, 2010; Hausman & Johnston, 2013). The government of the United States even formed a committee on how to measure and spur innovation, in which many business leaders took part (Schramm et al., 2008). Although the attention to the subject was raised, many questions were left unanswered. Luckily, there are multiple scholars who researched the possible relation between innovation and growth, and provide us with frameworks to discuss innovation and its capabilities (Aghion & Howitt, 2006).
The ‘Schumpeterian’ theory is the most widely used framework and emphasizes on ‘creative destruction’ (quality improving innovations that render old products obsolete). Another economic growth theory is the AK paradigm, which stipulates that the problem of economic development lies in the underaccumulation of capital. This can be cured by subsidizing, and giving aid to large investment projects which would result in more jobs and consequently greater spending by consumers (Aghion & Howitt, 2006). Critics of this theory argue that it is only used to support the government policies of the 1990’s, which is a good example of contextual influence on a firm. A third theory, the product-variety paradigm, originates in international trade
theory and states that innovation causes growth of the productivity by creating new, but not necessarily improved, varieties of products (Aghion & Howitt, 2006).
In this thesis, the first theory is used as most firms have a strong customer focus and want to develop products and services to enhance the life of customers (Hausman & Johnston, 2013). An externality, or other goal, resulting from this strategy is rendering products and services of competitors obsolete, thereby limiting their competitive advantage and increasing your own (Filatotchev, Toms, & Wright, 2006).
Manso (2011) argues that incentives to innovate, coming from shareholders to pursue managers, show large tolerance for early failure and reward for long term success. This tolerance is not created by shareholders being nice towards managers but is created through CG mechanisms like legal pressures (Gillan, 2006). Besides legal pressures, predispositions of a board can also have an effect on the policy regarding R&D spending and the total level of innovation of a firm (Hoskisson et al., 1993). The last mechanism shareholders can use to have an impact on a firm, is limited or supported by the ownership structure (Desender, Aguilera, Crespi-Cladera, & Garcia-Cestona, 2009; Jensen, 2001; R. La Porta et al., 2000). These mechanisms will be explained more thoroughly later in this chapter. For now, the focus will shift to develop a working definition of innovation.
Understanding & Defining Innovation
A lot of research is done on the subject of innovation, but a good working definition is still missing. Most scholars pick a well-argued definition that fits their study, and develop own measures for that study (Johannessen, Olsen, & Lumpkin, 2001). As reported by Schramm et al. (2008), the need to develop best management practices and industry- and firm level measures is high but first the need for a definition must be met.
Schumpeter came up with one of the first definitions for innovation that emphasizes the novel aspect, summarized as ‘doing things differently’ (Crossan & Apaydin, 2010). This means the definition of innovation is supported by the concept of newness (Baregheh, Rowley, & Sambrook, 2009). Innovation is not only something new, but also needs to add value for the customer, the firm and the stakeholders (Schramm et al., 2008). Unfortunately this makes any change an innovation and is therefore the opposite of clearly defining the concept (Crossan & Apaydin, 2010). What separates change from innovation, must come from the diverse characteristics of both concepts. But the interrelatedness should not be denied; innovation presupposes changes, but not all change presupposes innovation (Johannessen et al., 2001).
An important aspect of innovation is that it can be produced (internally through R&D) or adopted (externally bought) (Crossan & Apaydin, 2010). After the acquisition, it must be exploited and add value to the firm. Baregheh et al. (2009) also make clear that it can entail a process, a discrete item (product, program and/ or service) and an attribute of firms. Complementing this view are three sequential components; leadership innovation, innovation as process and innovation as outcome (Crossan & Apaydin, 2010). To clarify: a positive predisposition of a board can help maintaining momentum during the process at all levels of the firm until innovation as an outcome ensues (Daellenbach et al., 1999).
Innovation is used in many different fields and has many implications. This resulted in a lot of different perspectives, theories and determinants as to what determines innovation (Baregheh et al., 2009; Crossan & Apaydin, 2010; Fischer & Henkel, 2012; Hausman & Johnston, 2013). Based on an extensive review of the literature on innovation Crossan and Apaydin (2010) developed a multi- dimensional framework of organizational innovation, as seen in figure one.
The Upper Echelon Theory argues that composition and characteristics of top management, have greater explanation power than a leader’s characteristics alone and support he innovation leadership component (Hambrick & Mason, 1984).
Figure 1: Multi-dimensional framework of organizational innovation (Crossan & Apaydin, 2010, p. 1167) The Dynamic Capabilities theory, a strain of the resource- bases view of Barney, argues that the different resource bases of firms provide the source of variation for innovation (Eisenhardt & Martin, 2000). The market then selects the products. The firm must combine exploitation of the existing resources with exploration of new opportunities, and anticipate on the changes in the context that can destroy current valuable resources (Aghion & Howitt, 2006). Developing new resources and capabilities takes time, investments and effort from managers, but can prove to be a source of competitive advantage (Eisenhardt & Martin, 2000; Fischer &
Henkel, 2012). This theory explains the determinant of innovation through managerial levers (Crossan & Apaydin, 2010).
Process theory entails the study of how organizational processes convert inputs into outputs, and means in this context the processes going on within the firm, and between the firm and its context. For this research it is sufficient to state that managers can make use of different mechanisms (e.g. initiation, portfolio management, project management etc.). A process is defined as ‘’a category of concepts of organizational actions, such as rates of communications, work flows, decision making techniques, or methods for strategy creation’’ (Crossan & Apaydin, 2010, p. 1173). As the interest of this thesis lays in innovation as an outcome the remaining part of figure one is used to provide an overview of the broadness of the concept but will not be further discussed.
As figure one shows, it is no wonder there exists more than one definition. However, the different perspectives are comparable through their use of words in defining innovation (Baregheh et al., 2009). According to Baregheh, Rowley, and Sambrook (2009) innovation is mostly defined by the type and nature of the innovation. This means that innovation is mostly defined by something new or improved (nature) or by the type of output or result (e.g. product or service). An overview is provided in the table below.
Attributes Technology Organization study
Nature New, Challenge, Change New
Type Product, Service, Process,
Technical
Product, Process, Service
Following this analysis a definition is provided by Baregheh et al. (2009) ’Innovation is the
multi-stage process whereby organizations transform ideas into new/ improved products, service or processes, in order to advance, compete and differentiate themselves successfully in their marketplace.’ (p. 1334). With this definition the focus can shift to making innovation measurable.
Measuring Innovation
The definition of innovation also sums up the problems surrounding the measurement (Smith, 2005). Trying to measure something that is in itself a novelty, requires specification of innovation indicators that are dependent on the object or situation (Edison, Bin Ali, & Torkar, 2013). Scholars are still searching for generally acceptable indicators of innovation, or at least a common set of them (Hagedoorn & Cloodt, 2003). The current level of research suggests choosing innovation indicators by looking at what is being investigated (Kleinknecht, Van Montfort, & Brouwer, 2002). The goal in this thesis is measuring the level of innovation of the firm and this will be done by measurement of the input (R&D expenditure) and the output (patents) (Hagedoorn & Cloodt, 2003).
The reason for multiple indicators is because of the varying degrees of overlap between R&D and patents of firms. In a broader context R&D as input of innovation also shows routines that companies follow in their innovative efforts. So, previous R&D expenditures affect future R&D inputs (Hagedoorn & Cloodt, 2003; Hausman & Johnston, 2013). It also increases the commitment of management to the allocation of resources towards R&D (Hoskisson et al., 1993).
R&D as an indicator has several strong and weak points. Data has been gathered regularly, is used by renowned institutions, and is easily comparable across different firms and industries (Kleinknecht et al., 2002). On the other hand, R&D says nothing about the output like
the real introduction of new products, services or processes into commercial use and is only one of several inputs (Griliches, 1998; Kleinknecht et al., 2002).
Another critical aspect of measuring input is that it is not about the amount of money or capital you spend on something that will make it successful, it is better to look where and how is it spend (Jaruzelski, Loehr, & Holman, THE GLOBAL INNOVATION 1000: Making Ideas Work, 2012). That is why patents and the amount of money that is put into R&D development are balancing each other out (Arundel & Kabla, 1998; Hagedoorn & Cloodt, 2003). The biggest spenders do not have to be the most innovative firms. The customers do not look at this amount; they value the products that a firm tries to sell to them. That is why firms who co- create with their customers outperform firms that are spending more on R&D (Prahalad & Ramaswamy, 2012).
Patents show, on their part, how initial ideas for a new product, service, process or technical development are conversed into manageable and tangible products (Jaruzelski, Loehr, & Holman, THE GLOBAL INNOVATION 1000: Making Ideas Work, 2012). Especially with product related innovation, patents can be used to measure the level of innovation of a firm (Fischer & Henkel, 2012). Even scholars who are critical towards the use of patents when measuring the inventive, or innovative performance of a firm, admit that patents can be an appropriate indicator in the context of high- tech sector’s (Arundel & Kabla, 1998; Hagedoorn & Cloodt, 2003). Arundel and Kabla (1998) note that especially the choice of the studied industry is important when using patents as indicator, because the level of competitiveness forces firms to build protective walls of patents. The chosen industries for this study (pharmaceutical and high- tech) fit this statement and the advice of using different indicators to measure innovative activity is therefore followed (Arundel & Kabla, 1998).
A nice example of the controversy between R&D spending and patent application, is the firm Apple. Apple spends less than half of the average percentage that firms spends on R&D, but has greater revenue than its competitors (Jaruzelski, Loeh, & Holman, Booz.com, 2012). R&D expenditure and patent application together, can provide a better analysis of the level of innovation a firm has. Both will be used in this study.
2.2 Life Cycle & Stakeholder theory
It is unlikely for firms to fulfil all the responsibilities they have towards their stakeholders. Dealing with finite resources, managers must make choices, and it seems a firm is more likely to focus on the stakeholders that are most important to them in that period of time (Jawahar & McLaughlin, 2001). Start-up firms, or firms in the revival stage, are far more focused on stakeholders that provide essential resources for the firms’ development and growth. This argument stems from resource dependency theory which states that firms pay more attention, and are more concerned with issues of stakeholders who control resources critical to the survival of the firm (Agle, Mitchell, & Sonnenfeld, 1999).
The variation of interest shows that, although firms have a long term goal, the emphasis may shift to a short term focus according to the different life cycle stages (Filatotchev et al., 2006). The different stages of the organizational life cycle theory are: birth, growth, maturity, revival, and decline (see also figure seven in the attachment). However, a firm does not always follow the different stages in a linear way (Miller & Friesen, 1984). Each stage can be linked to different manifestations of the context; structure, strategy and decision making process, and all have different influences on the firm (see also figure six & eight in the attachment) (Filatotchev et al., 2006). Thus the strategy of a board, different laws, and ownership of the firm, will differ
according to the stage in which the firm is, which in turn can influence the focus on innovation (Daellenbach et al., 1999; Miller & Friesen, 1984).
Figure two shows a different approach in explaining shifts through the stages, by looking at organizational development, the combination of resource diversity, and accountability (Filatotchev et al., 2006).
Figure 2: CG practice versus stages of life cycle (Filatotchev et al., 2006, p. 259)
This approach argues from a strategic perspective, and positions an individual firm to its context. This complements the life cycle theory by incorporating the specific context of the firm, and creates a better understanding of factors that affect the balance between functions of CG (board practice, ownership structure & legal pressures).
The impact this framework has on the roles of CG is clarified by figure two. The high ‘velocity’ environment is characterized by fast and difficult to predict change, with the potential to be disruptive (Doh & Pearce, 2004). This context fits the high –tech and pharmaceutical firms which are studied, and result in managers responding in a highly adaptive manner to secure
competitive advantages (think of the example about protecting wealth through building patent walls) (Filatotchev et al., 2006).
Figures two and three also show that in the first stage of the life cycle model, flexibility, growth and innovation are important goals.
Figure 3: Governance functions and the life cycle stages (Filatotchev et al., 2006, p. 261)
In a later stage (maturity), control, stability and efficiency are more important for a firm. Compared to other literature on innovation it complements the idea of firms, which still are in their growth phase, to be dependent on stakeholders that provide the right resources for the firm to grow (Jawahar & McLaughlin, 2001). However, it is argued that in a later stage, innovation becomes less important and firms focus more on protecting their wealth instead of creating more wealth through new innovations (Aguilera et al., 2008). Furthermore, as stated by Aghion and Howitt (2006), a firm must find a balance between wealth creation and protection because only focusing on stable rents can lead to inertia and loss of innovative capabilities (Eisenhardt & Martin, 2000).
2.3 Bundles of Corporate Governance on Innovation
This link explores the opportunities for firms across different contexts to use similar governance systems to reach a higher level of innovation. The study of Ward et al. (2009) identified characteristics by which CG can be measured and that relate to each other and form bundles. Important to note is that characteristics of CG can differ across firms, but still prove to have the same outcome, which is called equifinality (Rediker & Seth, 1995). This would mean that the firms which are studied differ in CG structure, because of their context, but still manage to have the same preferred outcome as other firms in the industry. The bundles thus allow us to look across borders and compare firms, within their own context, to each other (Aguilera, Desender, & de Castro, Luiz Ricardo Kabbach, 2011). Therefore the choice for certain constructs must comprise of universal characteristics. An important thought is that innovation is dependent on the effectiveness of the bundle of governance mechanisms rather than the effectiveness of any one mechanism (Aguilera et al., 2011).
The characteristics which are mostly used in the literature to describe bundles of CG fall under incentive alignment and monitoring mechanisms (Ward et al., 2009). However this is argued in literature with a focus on performance. Looking at innovation other traits of CG could be more important.
To come up with universal represented constructs this study uses the constructs provided by Aguilera et al. (2011); legal pressures, ownership structures and board practice. All three have their influence on CG and thus on specific traits of a firm’s structure. They represent also the balance between external and internal forces, as displayed in the corporate governance model on the next page (Gillan, 2006).
Figure 4: Corporate Governance model (Gillan, 2006, p. 384)
Legal Pressures
As can be seen in figure four, legal pressures are part of external pressures (Gillan, 2006). These pressures are an important part of the context of a firm. A firm has only limited influence on the decision making of the government, and stands at the receiving end of new and changing policies, codes and regulations. Legal pressures comprise of hard law (rules) and soft law (standards). Soft law allows firms to be flexible about the form and structure of CG, while hard law has clear regulations of how a firm must be governed (García‐Castro et al., 2013). Examples of positive, hard, legal pressures are laws regarding wrongful discharge of employees, which spur innovation by ensuring employers cannot act in bad faith (ex post) (Acharya et al., 2012). Anti- takeover laws protect managers against short term pressures from the equity market, providing space to focus on long term value creation (Chemmanur & Tian, 2013; Sapra, Subramanian, & Subramanian, 2013). These examples also support the interrelatedness of the different characteristics. Legal pressures influence board practice and ownership, by providing assurance
for managers, employees and shareholders. On the other hand, the market attaches more credibility to earnings announcements when boards and audit committees are both independent and active (Gillan, 2006). Hard law context may provide more security for employees from being discharged by their employers, but can also mean higher accounting costs and service fees (Acharya et al., 2012).
Work on the subject of interdependence between external auditors and firms states that non- audit services compromise the integrity of the audit process, as was suggested with Enron (Gul, Jaggi, & Krishnan, 2007). Research on this subject is ambiguous, and other characteristics like auditor tenure seem to have an important impact on the association between non audit fees and auditor independence (Gul et al., 2007). Brown and Caylor (2006) state there is no positive and significant relation between auditing and the valuation of the firm. They looked at audit committee independence in relation with profitability of the firm and compared the magnitude of non audit services versus audit services. The latter shows no relation to earnings management (managers taking real economic actions to manage earnings), while the first statement looks at the financial performance (Carcello et al., 2006). As Brown and Caylor (2006) state, Tobin’s Q only proves useful in some corporate governance research and fails to do so in their research. Valuation is not measured the same as innovation; literature on bundles of CG suggests that legal pressures do have a relation with performance of a firm (García‐Castro et al., 2013). Especially through legal traditions of a country, pressures on firms and investors differ (López de Silanes, La Porta, Shleifer, & Vishny, 1998). A large amount of literature focuses on legal pressures, to be more precise, on the protection of shareholders and investors of firms (La Porta et al., 2000). The focus on audit expenditures and non audit fees of firms is less seen as legal pressure and more seen as a pressure of the market (Gillan, 2006).
However various monitoring and bonding devices are used to reduce the agency costs arising in firms (Ettredge et al., 2000). Besides control systems, budgeting systems, incentive compensation schemes and corporate ownership structures, an important method is financial reporting and auditing (Jensen & Meckling, 1976). The monitoring is not only done by external auditors, but relies to some extent on work performed by internal auditors. To keep their own costs low, and keep their competitiveness at a high level, external auditors sensibly rely on the work done internally (Ettredge et al., 2000). The extent to which this happens is still unresolved, but fuels the debate on the interdependence of external auditors and their clients, as mentioned earlier. This debate is related to discussions surrounding the independence of board members, but will be discussed in the section of ‘board practice’ (Desender, Aguilera, Crespi-Cladera, & Garcia-Cestona, 2009).
The audit expenditures and non audit fees represent the effort and capital the firm puts in to be more transparent towards shareholders and stakeholders. It is a mixture between complying with laws, regulations and the firms’ own policies. It is not only a measure of their compliance but also a measure of how big of a pressure the firm feels to comply with the market’s wishes. This represents chances for the firm to be valued higher by its share- and stakeholders, having a positive influence on the level of innovation. Hence the hypothesis:
H1A: Legal pressure (i.e. audit- and non audit costs) positively affect innovation (i.e. R&D expenditures and amount of patents).
Board Practice
Boards are the governing mechanisms that internally shape corporate governance (Aguilera et al., 2011). An important aspect of the duty of the board is monitoring the firms’ affairs. The previous
section (legal pressures) explained the manipulation of R&D expenditure by boards to ensure certain earnings (Carcello et al., 2006). Osma (2008) states that the level of independence (when higher) in a board constrains the manipulation of R&D expenditures. Most audit committees of firms consist out of independent members to minimize conflicts of interest (Ettredge et al., 2000). The reaction of the market on selecting independent members, who are also accounting experts, is positive (DeFond, Hann, & Hu, 2005). A side note is that this effect is concentrated in firms with relatively strong corporate governance. This would seem logical because strong governance helps to channel the expertise towards a higher shareholder value. This could results in a higher level of innovation because managers do not reduce R&D expenditures to ensure a certain level of earnings.
Through public pressures and regulatory requirements, boards consist in the majority of independent members and they are under more surveillance regarding what constitutes independence (Aguilera et al., 2011). As a result of these changes the boards became larger, were given more tasks, got more diverse and created a strong demand in the market for independent members (Linck et al., 2009). Still, the board of directors is dependent on information the CEO and his managers provide. Research by Duchin, Matsusaka, and Ozbas (2010) found a relation between the cost of acquiring information and the performance of the firm. Meaning the effectiveness of outside directors is dependent on the cost of acquiring information. With low costs, the performances increase when outsiders are added to the board, supporting the statement that independent board members help to increase performance.
Two main functions of the board are the monitoring and advising roles (Linck, Netter, & Yang, 2008). Different board structures are consistent with the roles a board mostly applies (monitoring or advising). When a firm has controlling shareholders the board can shift its focus
dependent on the level of activity (e.g. amount of meetings they have) a board shows (Vafeas, 1999). After a couple of poor performing years, the board meetings increase abnormally and board activity rises. It seems that activity of the board is a good estimate of involvement of the board and the monitoring they do. One can imagine that when the CEO (in most US firms also the president of the board) and the top managers have a positive predisposition towards innovation, this will also be promoted throughout the firm (Daellenbach et al., 1999). The stakeholders will also be aware of this predisposition and will accept the long term value creation through innovation. This shows that activities, independence and diverse membership of a board are well received by stake- and mostly shareholders.
As mentioned earlier the theory of bundles of corporate governance is followed in this thesis. Arguing that how well a firm ensures its goals is dependent on the effectiveness of the total bundle of governance mechanisms, not on the effectiveness of any one mechanism (Aguilera et al., 2011; Rediker & Seth, 1995; Ward et al., 2009). Therefore all three mechanisms of board practices shall be researched as one bundle. Hence the hypothesis:
H2A: Board practices (i.e. independent board members, board membership and board activities/ functions) positively affect innovation (i.e. R&D expenditures and amount of patents).
Ownership Structure
The suppliers of finance use corporate governance to ensure that they will get a return on their investment (Shleifer & Vishny, 1997). Many view the board of directors as the backbone of corporate governance. Not in the least because their fiduciary obligation to shareholders, the responsibility in providing strategic direction and monitoring of the firm (Gillan, 2006).
Some literature suggests that the use of long- term incentive plans for CEOs are negatively related to the monitoring process (Zajac & Westphal, 1994). Meaning that firms with stronger incentive alignment tend to have weaker monitoring mechanisms and vice versa. This way a general level of governance effectiveness is provided when controlling for agency issues (López de Silanes et al., 1998). Other literature suggests they act as complements, stating that the addition or presence of one mechanism strengthens the other, leading to more effective governance (Ward et al., 2009). Scholars focused on this complementary view stress that the simultaneous operation of multiple mechanisms limits managerial opportunism (Rediker & Seth, 1995).
Differences in ownership structure have consequences for CG. Dominant shareholders possess the power to discipline management, but also have the incentive to do so (Aguilera et al., 2011). A concentration of ownership can also create conditions in which the interest of the controlling and the minority shareholders are not aligned (Desender, Aguilera, Crespi-Cladera, & Garcia-Cestona, 2009). In that case the minority shareholders can be bought out, even if they do not want to. It even sometimes happens these shareholders can influence executives by promoting strategies they like best (Cremers & Nair, 2005). With mature firms the shareholders would not prefer riskier investment decision, and this could have a bad influence on the level of innovation (Jaruzelski, Loeh, & Holman, Booz.com, 2012).
The alignment between managers and shareholders could improve through providing the managers with the same perspective as the shareholders through aligning their compensation (Rediker & Seth, 1995). Stock options with long vesting periods are one of the incentives that can be implemented to motivate managers to innovate (Manso, 2011). The contract of the manager exhibits the, earlier mentioned, features of tolerance for failure in the short term, and reward for
facilitating long term contracting (Chemmanur & Tian, 2013). As mentioned in the legal pressures section, certain characteristics complement each other, rather than substituting.
Compensation of board members and the amount of shareholders rights are mechanisms that complement each other (Cremers & Nair, 2005). Gompers, Ishii, and Metrick (2003) found that lower firm valuations and lower stock returns are a result of fewer stockholder rights. Depending on the goal of the mechanisms scholars differ in their results. Desender, Aguilera, Crespi-Cladera, and Garcia-Cestona (2009) state that there could be substitution or/ and complementary effect between ownership structure and the board of directors in terms of monitoring management. It seems that ownership structure and board practices are interrelated, as assumed earlier. A firm that has controlling shareholders could benefit more when putting emphasis on the advisory role of the board, compared to firms with non controlling shareholders (Aguilera et al., 2011). For now the focus lies on the link between the compensation of the board, dependent on external forces (shareholders return), the amount of rights shareholders have to control, or monitor the firm, and the level of innovation of the firm. Hence the hypothesis:
H3A: Ownership structure (i.e. shareholder rights and board compensation) positively affects the level of innovation (i.e. R&D expenditures and amount of patents).
2.3.1 The mediation effect
Legal Pressures
An important argument for the mediation effect is the smaller influence of CG mechanisms on something as distant as patents. On the other hand, CG mechanisms can have a stronger direct effect on the amount of R&D expenditures. On its turn, this amount can affect the strength of the
relation between a mechanisms and the output of innovation (patents). The arguments presented below must be seen as follow up to the possible direct effect, as explained above.
The R&D expenditures of a firm are used in multiple ways. Most importantly they represent the spending on research and development, and can indicate the proposition of the firm towards innovation (Bracker & Krishnan, 2011). Secondly these costs are used, next to advertising and maintenance costs, to meet earnings expectations (Carcello et al., 2006). When financial reports or accounting statements predict lower earnings, some costs must be reduced (Brown & Caylor, 2006). This creates a negative relation between the legal pressures and R&D expenditure. This hinders the level of innovation of the firm. This provides the following hypothesis:
H1B: The relation between legal pressures and innovation is negatively mediated by R&D expenditures.
Board practice
As suggested earlier the link regarding R&D expenditure and board practice is expected to be stronger than the link between board practices and innovation (amount of patents). The board has a more direct influence on R&D costs than they have on the amount of patents the firm produces. Daellenbach et al. (1999) prove that firms performing below industry average also invest in R&D at rates lower than their rivals. The causal nature of this relation is unclear. The sample presented in this thesis originates from the best performing firms in their sectors and thus are expected to have relatively high R&D spending, providing us with the following hypothesis:
H1B, H2B & H3B
Independent Variables:
(Legal) Audit costs Non- Audit Costs (Board)
Independent Board members Board Membership
Board Functions/ Activities (Owner) Board Compensation* Shareholder Rights (*Linked to Shareholders) Mediating Variable: R&D expenditure (Innovation Input) Dependent Variable: Patents (Innovation Output) H2A H3A Control Variables: Industry Type Investments Tobin’s Q H2B H3B H2B H1A Ownership structure
Firms that spend a lot on R&D are focussed on long term value creation and focus on internal innovations (Daellenbach et al., 1999). The costs or investments a firm has can diminish the earnings and returns for investors. Because the compensation of board members can be dependent on the return shareholders receive, it can be argued that higher earnings are in the interest of all (Hoskisson et al., 1993). This can reduce the interest in long term investments and costs like R&D. Especially in a situation with controlling shareholders that have a preference on short term value creation. Meaning, a negative relation can exist between ownership structure and innovation through R&D. This provides the last hypothesis:
H3B: The relation between ownership structure and innovation is negatively mediated by R&D expenditures.
The conceptual model below was constructed following the formulated hypotheses.
3. Data and method
This section provides an overview of the empirical method of this thesis. The collection of the data and the selected variables are explained. Furthermore, the model specification is presented and explained.
3.1 Data collection
The data required to research the impact of bundles of corporate governance on innovation is obtained from several secondary sources. Most data was obtained via Datastream, available through the Pierson Révész library of the University of Amsterdam. Data was used for the years 2008 to 2012. Since Datastream reports data for FT 500 companies, this was the sample chosen for this study. To further apply the sample to this specific study, the companies marked as active in the technology and pharmaceutical sectors were selected, while others were deleted from the sample. This resulted in a sample of 103 companies based in Europe, the United States, and Asia, which are the interest of this study. Additional data, to resolve missing cases, was obtained from companies’ corporate website. Via the tab labeled as ‘investor relations’, companies provide the public with financial data as well as data on corporate governance. For US based companies, Form 10-K (annual report) was of special interest because listed, as well as private companies, provide financial information to the filing of this form.
Data on patent application however is not provided through the website. To fill in missing cases on patent application, the website of the Unites States Patent and Trademark Office (USPTO) was accessed. They provide a search function to obtain information on patent application in the US. To search for patent applications of Chinese companies, the Global Patent Search Network (GPSN) was used. The same goes for information on European company patent
2008 to 2012 was gathered per company. The results of this search were cross examined with those of Patentscope to test for accuracy. Patentscope is a service of World Intellectual Property Office that enables the public to search for international and national patent collections.
3.2 Sample
The self- constructed dataset contains data of 103 selected companies, based in the United States, Europe and Asia, active in the pharmaceutical and technology sectors. For the pharmaceutical sector this entails companies that produce drugs, medical equipment or are involved in the research and development of these products and services. The technology sector includes companies that produce hard- and software for media devices (mobile phones, tablets, laptops, computers etc.), and produce these devices themselves or are active in the semi-manufactured product branch. Providers of fixed line communications are also included in this sector, because of the broadening interest of these companies in aligning markets. Some companies were excluded from the sample because of non-availability of the relevant data for this research.
3.2 Dependent & Mediating Variables
This section provides an explanation of the different variables that are used in the tests. First the dependent variable will be discussed. Subsequently the independent-, moderating- and control variables will be discussed.
3.2.1 Patents as dependent variable
The dependent variables in this research are patents and R&D expenditures. In many studies reviewed in the second section, innovation is measured by the amount of patents (applications included) a company has (Henry, Bin Ali & Torkar, 2013). The amount of patens is seen as the
output when measuring innovation. Controlling for industry type is important because certain types of industries make more use of patents. The results of patents do not have to occur within one year, which is why this study takes the average over a five year period (2008 to 2012).
3.2.2 R&D expenditure as dependent and mediating variable
Another way of measuring innovation is by looking at the resources the firm allocates to achieve innovation. R&D expenditure forms the input side of innovation. Data on R&D expenditures was obtained via Datastream. This measure is chosen because it reflects directors’ decisions to allocate resources to innovation; it can thus be influenced by corporate governance aspects (Hoskisson et al., 1993). In this thesis R&D expenditures are also studied as a mediating variable because of the more direct effect of CG mechanisms on the decision to make expenses. Controlling for other investments is important because these possibly form other input of innovation. This is dependent on choices the audit committee of a firm makes and on the different legal pressures of the geographical area.
Both dependent variables will be tested separately for each model, in order to determine if findings differ for the innovation measure used. These variables were obtained from Datastream. A lagged effect is expected for the influence of CG mechanisms on the level of innovation of a firm. Therefore data from 2008 till 2012 was used for the amount of patents and the average spending on R&D.
3.2.3 Independent variable
This study uses multiple independent variables to test the effect of bundles of corporate governance on innovation. The first bundle, legal pressures, entails audit costs and non- audit
compensation. The last bundle is aimed at measuring the board practice and includes independent board members, board activities and board membership..
The choice for these variables follows García‐Castro et al. (2013), from an institutional perspective to an organizational perspective, developing the main argumentation for the choice of these variables. Starting with legal pressures, the different institutional forms provide different pressures on companies following the differing contexts. Hard- (e.g., US Sarbanes- Oxley Act) and soft law (e.g., UK Combined Code) institutions have an efficient market for corporate control and have no problem with meeting the requirements of board of directors’ information disclosure. On the other hand, roles of CEO and chairman are mostly exercised by the same person that influences the independence of the board. This is an example of the complementarity of the bundles, and shows that all the bundles must be examined together.
Focusing on the legal pressures, audit costs represent the expenditures a company needs to make to fulfil legal demands concerning transparency and the accurate reporting of financial information. In an increasing global world, these legal requirements for reporting information become more and more aligned to gain an advantage on comparing companies across different contexts. In this study, audit costs represent the legal pressures of the institutional context on companies. The balancing act between what they need to report on the legal account and what is expected that they report increases the legal costs measured through the audit costs. Complementing these expenditures are the non- audit costs. These are the costs companies make for services from auditors different than accounting and control. On the one hand, this increases the insights of the auditors in the business, and would be beneficial for a higher level of control and understanding. On another note this could decreases the perception of the shareholders on the independence of the auditors (Quick & Warming‐Rasmussen, 2009). A high level of non- audit costs could indicate a lower independence of the auditors making inappropriate accounting more
realistic. It also shows that companies make more costs on other than legal requirements when they want to increase the transparency, making a good case for a high level of corporate governance.
Measuring audit costs provides insights into the amount of sales, assets, market value and overall size of the firm. When the sales increase, the audit costs increase with it, as well with the increase of assets. An initial test of the variance inflation factor (vif) showed the high correlation between these variables and supports the decision to only measure audit- and non- audit costs.
Ownership structure provides us with insight into the alignment between owners and managers of a company. It can be measured through the board’s compensation (e.g., long term compensation versus CEO compensation aligned with shareholder interest) and the amount of
shareholder rights. Board compensation is dependent on the institutional context in which the
company is active. In countries with an outsider focus, the compensation is linked to shareholder interests, which gives the shareholders a greater influence on the decision making of the company (Aguilera et al., 2008). In these kinds of contexts the shareholders generally enjoy more rights to influence the firms’ strategy. When compensation is focused on long term returns (e.g., maximal compensation reached over five year period) the board has a greater opportunity to focus on the growth of the company instead of on fast results. It also creates higher commitment and involvement, as well as job security, through which employees can follow new and riskier business opportunities without directly being punished for not reaching their goals (Chemmanur & Tian, 2013).
Board practices entail the effectiveness and the commitment of the board towards following best practice corporate governance principles. Corporate governance principles assure stakeholders of the best intentions of the company and create transparency towards the public. It
