0 MSc thesis
“The Performance of Companies”
The Effect of CEO Duality and Board Size on Firm Performance in Different Cultures
ABSTRACT: This study examines whether a certain corporate governance structure influences firm performance, and whether cultural dimensions derive different results for Japanese or United States firms. More specifically, this study focusses on two important governance elements that may affect firm performance, namely CEO duality and board size. In addition, I examine whether the cultural dimensions “collectivism” and “uncertainty
avoidance” yield different results regarding the two elements for either country. I find that CEO duality and board size does not affect firm performance on a short-term basis measured by Return on Assets (ROA), regardless of the cultural dimensions. Finally,
regarding the long-term accounting measure for firm performance Return on Equity (ROE), I found evidence that board size positively influences firm performance, but that based on the cultural dimensions, no evidence is found for Japanese firms. After measuring firm
performance with the use of Tobin’s Q for the long-term effect, I found that board size negatively affects firm performance. As for the cultural impact, I found that firms from Japan who have a large board, experience a positive firm performance.
Keywords: CEO duality, Board Size, Corporate Governance, Firm Performance, US, Japan
Student name: Mourad el Khalfi Student number: 10260668 Submission date: 31-05-2014
Supervisor: Dr.ir. S.P. van Triest Second reader: Dr. B. Qin
Word count: 14.888
MSc Accountancy & Control
1 Contents
1. Introduction ... 2
2. Literature review ... 4
2.1 CEO duality ... 4
2.1.1. Agency theory and CEO duality ... 5
2.1.2. Stewardship theory and CEO duality ... 7
2.1.3 Empirical results ... 8
2.2 Board size ... 10
2.2.1 Empirical results ... 12
2.3 Hofstede’s culture dimensions ... 14
2.3.1 CEO duality and culture ... 18
2.3.2 Board Size and culture ... 20
3. Methodological approach, sample, and variable descriptions ...22
3.1. Sample selection ... 22 3.2.1 Dependent variables ... 25 3.2.2 Independent variables ... 25 3.2.3 Control variables ... 26 3.2.4 Empirical model ... 27 4. Empirical results ...29 4.1 Descriptive statistics ... 29
4.2 Empirical results: Return on Assets (ROA) ... 32
4.3 Empirical results: Return on Equity (ROE) ... 33
4.4 Sensitivity analysis ... 36
5. Conclusion ...38
2 1. Introduction
Numerous accounting and banking scandals (e.g., Enron, WorldCom, Royal Ahold, Lehman Brothers) have significantly changed the landscape of affected countries’ corporate
governance system (Monks & Minow, 2004). In fact, it has affected not only the countries where these scandals have taken place, but the surrounding economies as well (e.g., Europe, Asia).
The way companies are governed determines their fate as well as that of the
economy in general. One of the roles of boards of directors is to ensure that chief executive officers (CEOs) carry out their duties in a way that serves the best interest of shareholders (Vance, 1983). Thus, Fama & Jensen (1983) argue that boards can be seen as monitoring devices that help align CEO and shareholder interests (Finkelstein & D’Aveni, 1994). It is therefore expected, that when the board performs its duties effectively, firm performance increases and shareholders wealth is enhanced correspondingly.
The important question now to be answered is Do board of director’s function effectively in monitoring the performance of management? For this study, two elements are of great importance in measuring firm performance, namely the board size and leadership structure. When talking about leadership structure, this study will focus on the phenomenon ‘CEO duality”. According to Finkelstein & D’Aveni (1994), CEO duality occurs when the same person holds both CEO and board chairperson positions in a corporation (Rechner & Dalton, 1991). The other possible leadership structure is when these positions are assigned to different persons (Boyd, 1995; Dalton et al., 2009). In literature, there are proponents of CEO duality (e.g., Baliga, Moyer, & Rao, 1996; Dahya et al., 2009; Dalton et al., 2008) who follow stewardship theory, while there also are opponents for this type of leadership structure (e.g., Dalton et al., 2008; Dey, Engel, & Liu, 2009; Faleye, 2007; Finkelstein & D’Aveni, 1994). These opponents incorporate agency theory, which is the dominant theory in literature.
As for the importance of board size, this corporate governance process is well recognized. Numerous academics found firm performance to be negatively associated with bigger boards (e.g., Lipton & Lorch, 1992; Jensen, 1993; Hermalin & Weisbach, 2003). First documented by Yermack (1996), the negative association between board size and firm performance is one of the prominent empirical regularities of the role of boards (Hermalin & Weisbach, 2003.
As aforementioned, academic literature is filled with studies focussed on agency theory and/or stewardship theory. In addition, the majority of literature stems from the United States, although there are studies performed in different countries of different settings. However, no research is known on the influence of cultural values related to CEO duality, board size and its influence on firm performance. It seems literature remains fixed in the
3 national culture, the majority being the United States. If several countries are researched (e.g., Eisenburg et al., 1998; Bonn, 2004; de Andreas et al., 2005), cultural values or aspects are left out. Therefore, this study contributes to prior literature by mainly building further on the findings of existing literature. More specifically, this study examines the impact of board size and CEO duality on firm performance and researches whether differences between countries are caused by their cultural values. This study differs from previous studies by focussing specifically on a period surrounding the financial crisis of 2008 and by taking a different setting, which in this case is the United States and Japan. In addition, by conducting this research, I will try to supplement previous research with more evidence. Furthermore, this study also examines the effect of industry, country and cultural differences on the relation between board size, CEO duality and firm-level performance.
The results from the regression model suggest that CEO duality and board size does not influence firm performance on a short-term basis, measured by Return on Assets (ROA). In addition, although cultural dimensions influence the effect of CEO duality and board size on firm performance, statistical evidence is missing. Looking at long-term performance measures (ROE), the model suggests that board size negatively influences firm
performance, while no evidence is found on the influence of cultural values. After conducting a sensitivity analysis, where firm performance is measured through Tobin’s Q, I found that board size negatively influences firm performance on the long-term. However, considering cultural values, such as collectivism and uncertainty avoidant behaviour, I found that Japanese firms show a positive relation between firm performance and board size.
The next section discusses the literature and develops the hypotheses. The third section describes the data and methodology. The fourth section presents results on the relation between board size, CEO duality and firm performance. Finally, the fifth section contains the conclusions.
4 2. Literature review
Many academics and practitioners have become interested and focused on corporate governance. Corporate governance as a means in which companies are controlled, directed and made accountable (Conyon & Peck, 1998). According to Brennan (2006) a corporate board, as a most critical and dominant internal corporate governance mechanism, not only monitors and supervises management, but also sets corporate strategies and makes significant decisions. Hence, one could argue that corporate boards have a big influence on how a firm performs. As such, Core et al (1999) and Dey (2008) discuss the impact of corporate governance on firm performance; where both researchers found that firms with weaker corporate governance structures have greater agency problems, which results in a firm performing worse.
2.1 CEO duality
The debate over the effect of CEO duality on firm performance has been very extensive and full of mixed evidence. Guillet et al. (2013) argue that the impact of CEO duality on firm performance has been controversial from an academic perspective. Especially two schools of thought represent conflicting interests, namely: agency theory and stewardship theory. Rechner & Dalton (1991) describe CEO duality as when the same person holds both the CEO and board chairperson positions in a corporation at the same time (Finkelstein & D’Aveni, 1994). More extensively, they define CEO duality as:
“A board leadership structure in which the CEO wears two hats; one as the CEO of the firm, the other as chairman of the board of directors” (Rechner & Dalton, 1991, p. 155)
Larcker (2011) further explained both duties belonging to these positions:
“Compared with the CEO, who is accountable for managerial work, the chairman of the board is responsible for planning strategies, picking executive directors and making decisions. A chairman is important, because it not only shapes the composition of the board but also plays a critical role in communicating corporate priorities, both internally and externally, and in managing stakeholder concerns” (Larcker, 2011, p. 129)
As numerous academics stated, both the CEO and chairperson of the board are important to an organization. The distribution of power and interaction between one another may influence performance on a firm level. On average, the board tries to retain itself from
5 engaging in the daily operational activities of management due to the fact that this may lead to conflicting interest between both parties (Abdullah, 2004; Morck et al, 1988; Yermack, 1996). Zahra & Pearce (1989) noted that:
“The board is just responsible for corporate leadership without actually stepping in daily operations, which are the responsibilities of the CEO and its senior executive” (p. 292)
The empirical results in academic literature, which examine CEO duality and its impact on firm performance, are mixed (Chaganti et al., 1985; Rechner & Dalton, 1991; Pi & Timme, 1993). One explanation for these mixed empirical findings is due to their indicators for firm performance. Several researchers used different performance indicators to research how well/bad a company performs with mixed results as an outcome. Therefore, in paragraph 2.1.1, I will discuss the disadvantages and in paragraph 2.1.2, the benefits of CEO duality will be discussed.
2.1.1. Agency theory and CEO duality
An agency problem occurs when an agent (e.g., CEO) establishes goals conflicting with that of the principal (e.g., shareholder) (Boyd, 1995). Such problems are more likely to occur when a key decision maker has little or no financial interest in the outcome of his decision (Fama & Jensen, 1983). This is the norm, when senior executives are more likely to pursue strategies which: (a) maximize personal welfare at the expense of shareholders and (b) minimize their personal risk. Corporations try to respond to such problems by delegating the task of decision management to the CEO, and decision control to the board (Boyd, 1995). However, when the CEO also serves as chairman of the board, he will acquire a wider power base and locus of control, which weakens decision control of the board in the process
(Hambrick & Finkelstein, 1987; Harrison et al., 1989; Patton & Baker, 1987; Morck et al., 1989).
Agency theorists such as Jensen & Meckling (1976) and Fama & Jensen (1983) emphasize the negative influence of CEO duality from its allowing a CEO to act freely in personal best interests. Adversely, advocates of stewardship theory signify the importance of CEO duality (Stoeberl & Sherony, 1985; Anderson & Anthony, 1986; Donaldson & Davis, 1991; Finkelstein & D’Aveni, 1994; Dahya et al., 1996; Brickley et al., 1997; Bhagat & Black, 2001).
Elsayed (2007) states that different theoretical arguments have been used either to support or to challenge CEO duality. While looking from the view of agency theorists, the opponents (e.g., Levy, 1981; Dayton, 1984) suggest that CEO duality diminishes the
6 effect on corporate performance. This notion is underlined by numerous academics (e.g., Morck et al. 1988; Tricker, 199; Yermack, 1996; Solomon, 2007), who come to conclude that when the CEO is able to decide who may, or may not, have a seat on the board brings the opportunity of the CEO to formulate regulations which are in his best interest. As a
consequence, the board loses its monitoring and controlling function, which amplifies agency problems difficult to prevent.
Furthermore, CEO duality is thought to be constraining on board independence and reduces the feasibility that the board can properly carry out its governing function (Fizel & Louie, 1990; Dobrzynski, 1991; Jensen, 1993). Fama & Jensen (1983a, 1983b) also were uncomfortable with the duality structure and argued that it would compromise the ability of the board to independently monitor the CEO. This comes forth of the fear that when adopting a duality structure, the firms’ managers’ influence in setting board agenda and controlling information flows could impede the board’s ability to perform its duties effectively. A notion subscribed by Aram & Cowen (1983), Solomon (1993) and Abdullah (2004). They predicted that this would be much more the case than within a firm, which adopted a unitary system.
Abdullah (2004) states that though literature consistently argues that separate
individuals for the post of CEO and chairman leads to a better corporate governance system, the real issue is whether this leads to be a better monitor and, thus, is capable of increasing the value of the firm. Tricker (1994) argues that if the CEO also holds the title of board chairman, he or she may be given too much power and authority. This in turn weakens the functioning of the board and increases the probability of the CEO acting on his or her own interest, instead of pursuing the interest of the firm and its shareholders. Abdullah (2004) answers this notion with the fact that a duality structure is likely to lead to the board being incapable of protecting the interest of the shareholders. Reasoning behind this is that the board will not be able to discipline management appropriately, as the management who controls the board will over-rule such initiatives. Larcker (2011) found that when CEO and chairman positions are separated, the chance to exercise opportunistic behavior by the CEO decreases.
Furthermore, there are also some other reasons why agency theorists oppose the duality structure. For instance, Finkelstein & D’Aveni (1994) claim that the association between CEO duality and board alertness is affected by several circumstances. An alert board considers duality to be less desirable when firm performs well and the CEO possesses substantial informal power. Baliga et al. (1996) discuss that the rationale behind this
apparently paradoxical position is that boards fear CEO duality will constrain their monitoring role.
Next to criticism on the duality structure, literature gives also examples of the benefits of an unitary structure. For example, Pearce & Zahra (1991) state that the board will truly be
7 able to exercise monitoring rights and control the management as they are supposed to, which in turn leads to a more powerful board when adopting a unitary system. In addition, according to Maassen (2002), when both positions are separated, the dominant power of the CEO over the board diminishes. Miller (1997) finally concludes that a non-executive
chairman promotes a higher level of corporate openness. Regarding known literature it is hence safe to say that according to agency theorists, an unitary board structure has the preference over the duality structure. Abdullah (2004) may have best expressed the downside of CEO duality, which agency theorists would affirm to, as “custodias ipso custodiet” or “who will watch the watchers” (p. 52).
2.1.2. Stewardship theory and CEO duality
Agency theory, as explained in the previous paragraph, would suggest a negative
relationship between CEO duality and firm performance. However, according to Boyd (1995), other perspectives would argue for a very different outcome. An implicit assumption of the agency model is that executives are inherently opportunistic agents who will capitalize on every chance to maximize personal welfare at the expense of shareholders (Boyd, 1995). Donaldson & Davis (1991) however, suggest that this can be counterbalanced by the fact that the CEO ‘essentially wants to do a good job, to be a good steward of the corporate assets’ (p. 51). What Donaldson & Davis (1991) were advocating was in fact stewardship theory, which proposes that CEO duality would facilitate effective action by the CEO, and consequently lead to higher firm performance. The stewardship model is consistent with other research on corporate governance (Boyd, 1995; Barney, 1990; Davis et al., 1997). Furthermore, stewardship theorists suggest that CEO duality will lead to better corporate performance, not only because of the clear leadership structure, but also the power of executives and the stewardship role can be carried out in a better fashion (Donaldson & Davis, 1991; Ong & Lee, 2000).
Stewardship theorists argue that CEO duality can improve organizational efficiency in corporate leadership, and consequently maximize shareholder value. Despite extensive studies, the findings of existing research provided no definitive evaluation of the effect of CEO duality on firm performance.
Proponents of CEO duality claim that it may be demanded when it helps improve efficiency of the firm, enhance conformity and when the need for a strong leader is required (Tricker, 1994; Finkelstein & Hambrick, 1996). Stoeberl & Sherony (1985) argue that CEO duality leads to superior firm performance, since clear leadership helps formulating and implementing strategy purposes. Finkelstein & Hambrick (1996) give the example that when a CEO is placed in a powerful position to manage firm operations, he can make decisions
8 more effectively and quicker. This is especially the case for a firm facing a crisis or when operating in highly volatile markets. Besides, Baliga et al. (1996) argue that; (a) CEO non-duality creates confusion since there are two public spokesmen and (b) it limits innovation and entrepreneurship if the CEO feels the board will second-guess his actions in advance.
Furthermore, executive managers can improve firm value when they simultaneously hold the position of chairman and CEO since agency costs decline (Anderson & Anthony, 1986; Donaldson & Davis, 1991; Davis et al., 1997; Guillet et al., 2013). Brickley et al. (1997) give the example that a CEO duality structure can mitigate the costs of information transfer between executives and the board effectively. In addition, CEO duality may cause superior firm performance by conceding CEOs to obtain complete authority over their organizations, implement consistent strategies and promote better communication on a board-level (Desai et al., 2003; Anderson & Anthony, 1986; Stoeberl & Sherony, 1985). Also, a strong
leadership is more efficient for implementing strategic decisions due to an established, clear authority among top managers (Pfeffer & Salancik, 1978). Finkelstein & D’Aveni (1994) add to that, that a unified command may help firms avoid confusion and ambiguity from multiple authorities, while Miller & Friesen (1977) further argue that a single leadership structure enables firms to respond faster to external events and thus leads to efficient decision making. This is in line with the findings of Finkelstein & Hambrick (1996). Boyd (1995) therefore concludes that arguments based on stewardship theory suggest a positive association between CEO duality and firm performance (p.340).
2.1.3 Empirical results
As table 1 shows, empirical research on the effect of CEO duality on firm
performance has offered opposing results. Berg & Smith (1978) studied Fortune 200 firms in their research. In their study, they measured firm performance in three ways, namely firm performance based on stock price growth, ROI and ROE. They used u sample size of 159, 194 and 193 firm year observations respectively. They hereby found a negative relationship between CEO duality and ROI, whereas no relation was found between CEO duality, ROE and the change in stock price. As Berg & Smith (1978) suggested in their supplemental analyses, CEO duality had a positive effect on firm performance in several industries.
Rechner & Dalton (1989) studied a sample consisted of Fortune 500 firms to provide multiple-year comparisons of shareholder returns for companies with CEO duality versus those with CEO non-duality. To do this responsibly, they identified firms that experienced a stable governance structure. This means that Rechner & Dalton (1989) investigated whether there was a duality structure or non-duality structure over the six-year sample period. This resulted in a sufficient sample size of 141 firms. They found no statistical significant
9 difference whatsoever over the entire six-year period. Also, after a sensitivity-analysis, there were no differences evident in any given year, in good years as well as bad (Rechner & Dalton, 1989). In a subsequent analysis for the same firms, Rechner & Dalton (1991) did found a negative relationship between CEO duality towards ROE, ROI and profit margin. However, they did not control for industry-effects in their study, so the extent of any puzzling of structure effects by industry effects is unknown.
Table 1: Summary and integration of previous research (CEO duality)1 Study
Performance
measure Effect size
Sample size Berg & Smith (1978) Stock price growth - 0,49 159
ROI 0,04 194
ROE - 0,18 193
Cannella & Lubatkin (1993) ROE 0,05 673
Chaganti et al. (1985) Firm failure n/a 42
Donaldson & Davis (1991) ROE 0,13 329
Stock return 0,06 321
Mallette & Fowler (1992) ROE 0,04 800
Rechner & Dalton (1989) Stock return 0,05 141
Rechner & Dalton (1991) ROE - 0,22 141
ROI - 0,27 141
Profit margin - 0,22 141
aggregated effect size: - 0,02
Note: Effect size estimates based on comparison of means, t- and F- statistics reported in individual papers. (Boyd, 1995); CEO duality = 1
Donaldson & Davis (1991) used a sample taken from a compensation survey based upon data drawn from Standard & Poor’s Compustat Services Inc. They used companies, which covered a wide range of industries and classified these in seven industry groups: consumer products, high technology, financial services, low technology, resources,
transportation/service, and utilities. Donaldson & Davis (1991) used two proxies for firm performance, namely ROE where they had a sample size of 329 firms and stock return with a consequential sample size of 321 firms. They found a positive relationship between CEO duality and ROE. Even though firms with a duality structure show a higher stockholder return, Donaldson & Davis (1991) did not find a statistically significant difference.
1
Boyd (1995) conducted a meta-analysis to help integrate the inconsistent results of previous research. Test statistics which were reported in each study were used to generate the effect size r, which is analogous to the point biserial correlation. Effect sizes were then aggregated across studies, weighted by sample size. Eleven individual tests of the duality-performance relationship were included, and yielded an aggregate effect size of - 0,02 (p. 302).
10 Furthermore, Cannella & Lubatkin (1993) found a weak positive relationship between CEO duality and firm performance, which was proxied as the level of ROE for 673 firms. They used a series of logistic regression equations to test their three interactive hypotheses. Finally, Chaganti et al. (1985) described firm performance in their research as firm failure and looked for a relationship between CEO (non)-duality and firm failure for a sample size of 42 firms. This study showed that for the proxy of firm performance (firm failure); no evidence was found in the US retailing industry.
Abdullah (2004) investigated all companies listed on the Main Board of the Kuala Lumpur Stock Exchange for the period between 1994 and 1996. Hereby, he tested whether CEO duality and board independence had an effect on firm performance, which was
measured as ROE, ROA and Earnings per share (EPS). The general results of the study show that there was no association between board independence, or CEO duality on firm performance. These results were in line with the studies of Annuar & Shamsher (1994) and Fosberg (1989). Abdullah (2004) brings forward that the reason behind these results might be due to the fact that the used financial ratios only capture short-term performance of firms.
When looking at the empirical results and extensive literature where agency theory prevails, agency theory will be considered critical in understanding the relationship between CEO duality and firm performance. Hence, I expect that CEO duality will be negatively related to firm performance. This leads to the following hypothesis:
Hypothesis 1: CEO duality is negatively related to firm performance. 2.2 Board size
The two most important functions held by the board of directors are those of advising and monitoring (Raheja, 2005; Adams & Ferreira, 2007). Fama & Jensen (1983) add that the advisory function involves the provision of expert advice to the CEO and access to critical information and resources. Cheng et al. (2008) argue that the importance of board size in the corporate governance process is well recognized.
Prior literature focusses on board size as an important aspect of corporate
governance which impacts firm performance. Common in literature, also regarding board size and its effect on firm performance, one can find proponents and opponents (e.g., Jensen, 1993; Lehn et al. 2004).
Proponents of small boards, which are usually agency theorists, argue that when a board consists of too many directors, agency problems increases since it is tougher to control for these agency costs in large boards. At the same time, more expenses have to be allocated on control activities in large boards (Hermalin & Weisbach, 2003; Larcker, 2011).
11 Guest (2009) states that there are disadvantages of large boards, which are
expressed through coordination costs and free rider problems. With respect to coordination costs, Jensen (1993) argues that smaller boards are generally more effective than larger boards, since it is harder for larger boards to arrange meetings, reach consensus, and react rapidly. Secondly, Lipton & Lorsch (1992), notice that board cohesiveness is undermined because board members will be less inclined to share a common purpose, communicate clearly and reach unanimity that builds on the directors’ divergent viewpoints (Guest, 2009). With respect to free rider problems, Lipton & Lorsch (1992) argue that this problem increases because, the cost to any individual director of not exercising diligence falls in proportion to board size.
As board size increases beyond a certain point, these inefficiencies outweigh the initial advantages. These advantages spring forth from having more directors to draw on, leading to a lower level of corporate performance (Jensen, 1993; Lipton & Lorsch, 1992; Guest, 2009). For instance, Jensen (1993) argues that smaller boards are preferred, due to organizational and/or technological change that eventually leads to downsizing and reduction of costs. Jensen (1993) argues that coordination and communication problems may occur because of the difficulty to arrange meetings and reach consensus. This in turn leads to an inefficient decision-making process. Lipton & Lorsch (1992) add to that the fact it is difficult for board members, due to different viewpoints and strategic goals, to share a common purpose and have a good communication process
Despite the fact that there is a lot of critique on large boards for their inefficiency, large boards still hold some advantages. Lehn et al. (2004) for instance, note that the advantage of larger board size and an increasing number of non-executive directors is the greater collective information possessed by the board, which is also valuable for monitoring functions. Baysinger & Butler (1985) also conclude that companies perform better if boards include more outside directors. Other researchers (Weisbach, 1988; Byrd & Hickman, 1992; Brickley et al., 1994) also concluded this fact. Coles, Daniel & Naveen (2008) found that the impact of board size on firm value has a positive effect regarding large firms. Hence, they concluded that large board size might be an optimal value-maximizing outcome for such firms. Dalton et al. (1999) confirm this notion by stating that large boards have the power and resources to collect more information for the use of controlling and monitoring the firm. This would eventually lead to better performance on a firm level.
A number of empirical papers also found that board size is expected to be greater when the need for information and, as a result, board advice is high (Lehn, Sukesh, & Zhao, 2004; Boone et al., 2007; Coles, Daniel, & Naveen, 2008; Guest, 2008; Linck, Netter, & Yang, 2008). This need for information is high for example for firms operating in volatile
12 markets where the board sets strategies and needs to act swiftly to determine the course of a firm. (Lehn, Sukesh, & Zhao, 2004; Guest, 2008).
Yermack’s (1996) study further shows that there is a negative association between board size and firm performance. In other words, he found no evidence of when the number of board members increase, firm value decreases. Furthermore, evidence shows that large boards are less likely to dismiss poor-performing CEOs, shareholders respond negatively to increasing board size announcements and large boards are less likely to award CEO compensations, which correlate with shareholder value (Yermack, 1996). In addition,
Eisenberg et al. (1998) found evidence that the inverse relation between board size and firm performance also is applicable for small firms.
Now that there is extensive and mixed literature on the effect of board size on firm performance, one could wonder what the number of directors a board should be comprised of in order for a firm to perform effectively. There is no specific number of directors, which will cause a board to function effectively, but Jensen (1993) argues that the optimum number of directors sitting on a board should be around seven or eight. While Lipton & Lorsch (1992) note that, the number being around eight or nine is more optimal.
2.2.1 Empirical results
There has been mixed empirical evidence by different researchers, performed in different settings and countries, although the majority of research known stems from the United States. Literature shows that there is mixed empirical evidence about whether board size has a negative or positive effect on firm value. For instance, Bonn, Yokishiwa & Phan (2004) found that there is a negative relation between board size and firm performance in Japanese firms. This relation was not found for their Australian counterparts regarding firms with smaller boards.
Yermack (1996) furthermore, found a negatively significant relation between board size and firm performance using measurements such as Tobin’s Q, ROA and ROE. Conyon & Peck (1998) found the same results for firms operating in Denmark. Eisenburg et al. (1998) used profitability as a performance measure for firms operating in Finland and found negative but significant relation between board size and firm performance.
Dalton et al. (1998) found a positively significant relationship in their meta-analysis of 131 studies. However, Dalton et al. (1998) point out that a possible limitation of their study can be that the direction of the demonstrated relationship between board size and firm performance could be misspecified. Furthermore, they state that retrospective meta-analysis relying on bivariate relationships cannot demonstrate causality. One note of remark
13 Study Year Country Performance measure Results
Yermack 1996 USA Firm value (Tobin's Q)
ROA/ROE
Conyon & Peck 1998 Denmark Tobin's Q "-" not significant ROE "-" significant Eisenburg et al. 1998 Finland Profitability "-" significant Bamhart & Rosenstein 1998 USA Tobin's Q "-" significant in 3/4
estimations
Dalton et al. 1998 Meta analysis of 131
studies
"+" significant relationship between board size and firm
performance
Bonn 2004 Japan Firm value "-" significant for large boards
(Japan)
Australia Smaller boards no influence on
firm performance (Australia)
de Andres et al. 2005 10 OECD
countries Tobin's Q "-" significant Profitability "+" not significant
Guest 2009 UK Profitability
Tobin's Q Share returns
O'Connel & Cramer 2010 Ireland ROA
RET Financials Q
"-" significant
"-" significant with all performance metrics
"-" significant with all performance metrics
negative relationship between board size and firm performance, the meta-analysis of 131 studies shows a positively significant relationship. The study of Dalton et al. (1998) is not a case off its own, which portrays a positive association between board size and organizational performance. For instance, Pearce & Zahra (1992) and Kiel & Nicholson (2013) found that larger boards are better because they have a large range of expertise to help make better decisions, have people with diverse backgrounds, who bring knowledge and intellect to the board.
Furthermore, de Andres et al. (2005) found a positively significant relationship for firms that were measured by profitability as the performance metric. The study was
conducted in 10 OECD countries. Finally, O’Connell & Cramer (2010) and Guest (2009) all found negatively significant relationships between board size and firm performance
measured as profitability, Tobin’s Q, ROA, ROE and share returns.
Table 2: Literature review: board size – company performance relationship (Gavrea & Stegerean, 2012)
Also, there is mixed evidence about the number of directors on a board that yield the best firm performance. Bennedsen, Kongsted & Nielsen (2004) found a negative relation between board size and firm performance in a setting of Danish firms if the number of
14 directors exceeds seven. While Mak & Yuanto (2003) found that firms from Singapore and Malaysia performed best if the board consists of a maximum of five members. This partially proves Yermack’s (1996) study where he found that firm value deteriorates when the board is made up in between five to ten directors.
Finally, there are strong contrasts observable regarding the composition of the board of directors when looking across countries. Gavrea & Stegerean (2012) note in their study that Japanese firms are known for the large number of board members. These can reach up to more than 50 board members with few external directors to monitor management activities and the strategic direction of the firm. Data gathered from German firms shows an average board size of 10.6 members. Gavrea & Stegerean (2012) base this numbers on firm reports from 2010. On the opposite side is Romania with an average of 4.9 members in the board of directors.
Since the known empirical literature shows to be mixed and does not provide clear and cohesive results, I will follow the leading agency theory in formulating my next
hypothesis. Hereby, I will take in consideration the previous studies that show a negative link between board size and firm performance. This leads to the following hypothesis:
Hypothesis 2: Board size is negatively related to firm performance
2.3 Hofstede’s culture dimensions
Murphey et al. (2013) state that culture may help explain firm performance despite a
remarkable range of definitions for the concept. Tosi & Greckhamer (2004) define culture as ‘a patterned way of thinking, feeling, and reacting that is reflected in traditional ideas and values that differentiate members of one human group from other human groups’ (p. 657). Schein (1990) states that culture represents a pattern of evolved assumptions instilled in members as the way to perceive organizational life. Hostede (2001) further states that how people expect companies to be managed may be shaped by a deep routed culture.
Furthermore, literature shows that differences in national cultures emerges from a broad set of forces. Hofstede (1980), Pedersen & Thomson (1997) and Tose & Greckhamer (2004) state that these forces are a result of a nation’s history, geography, recources, climate and other factors. Kanungo & Jaeger (1990) add that managing an organization also requires an understanding of both the internal and external environment, in order to shape the
organization to fit employees.
Tosi & Greckhamer (2004) gave a good example on how geography could have playd a role in the differences between US and Japan regadring the individualism dimension. They state that when the Europeans arrived in America, they found unlimited recourses and land,
15 which caused them to widely separate from other people and work necessary for survival could be done by a single family. Hence fostering individualism. The Japanese however, with little land and natural recourses had to form more structured communities, with cooperation with the wet agricultural methods for growing rice as the perfect example. Table 3 shows the results of cultural dimensions from the Hofstede index for the United States compared to Japan.
Hofstede (2001) stated that culture could be divided into six cultural dimensions. Of
these dimensions, a few will be elaborated on as they show the biggest differences between US and Japan and are of importance regarding firm performance.
Uncertainty Avoidance
characterized societies tend to prefer rules, and to operate inpredictable situations, as opposed to situations where the appropriate behaviour is not specified in advance (Hofstede. 1980a, 2001). The concept of uncertainty avoidance has been defined by Hofstede (2001), which he states as: “how individuals in society accepted uncertainty in their life” (p. 145). Later, de Lugue & Javidan (2004) further developed this concept and defined it as “the extent to which individuals within a society or an organization strive to avoid uncertainty by relying on social norms, rituals and practices” (p. 607).
The tolerance for uncertainty avoidance is subject to differences between countries, societies and cultures (Hofstede, 2001, de Lugue & Javidan 2004). Tosi & Greckhamer (2004) argue that societies characterized by uncertainty avoidance, the people are uncomfortable with high risk and ambuigity. In other cultures however, there is a greater tendency to take risks.
A difference in uncertainty avoidance is observable between countries. Table 3 clearly shows that firms operating in Japan score high on uncertainty avoidance as opposed
16 to the United States. This observation is carried by literature. For example, according to Brislin (1993) nations low in uncertainty such as the United States, there is a fewer acceptances of rules and less conformity to the wishes of authority figures observable. Furthermore, these societies are more willing to take risks and can tolerate ambiguity and handle unpredictable situations (Schuler & Rogovsky, 1998).
The adverse is observable for firms operating in high uncertainty avoidant nations such as Germany, and as table 3 shows, Japan. This desire to minimize uncertainty will be reflected in the level of performance risk that is present in the governance structure that a firm adopts (Tosi & Greckhamer, 2004). In these societies, Schuler & Rogovsky (1998) state that people feel uncomfortable in unstructured or risky situations. House et al. (2004) further state that these people will try to decrease the probability of unpredictable future events.
Power Distance
is the degree to which differences in power and status are acceptedin a culture (Hofstede 1980a, 2001). This theory initially explained the unequal distribution of authority between powerful and less powerful individuals within a society (Mulder et al., 1973). Hofstede (2001) later developed it further and Carl et al. (2004) explained the notion of power distance as “a measurement of the degree to which people within an organization or society can expect and agree to unequal sharing of power” (p. 517).
In high-level power distance cultures, power is seen as providing stability to society (Schwartz, 1999). According to Carl et al. (2004), in cultures characterized by high levels of power distance and class distinctions, individuals do not expect to be able to climb the hierarchy. Tosi & Greckhamer (2004) note that some nations accept high differences in power and authority between members of social classes or occupational levels, which underlines this statement. They give the example that the French score high in power distance, while Israelis and Swedes score the opposite. Adler’s (1997) and Cole‘s (1989) studies show that in Israel and Sweden, worker groups demand and have a great deal of power over work assignments and conditions, while French managers tend not to interact socially with subordinates and do not expect to negotiate work assignments (Laurent, 1986).
Individualism-Collectivism
relates to whether individual or collective action is thepreferred way to deal with issues (Tosi & Greckhamer, 2004). Gelfand et al. (2004) characterize ‘individualism-collectivism’ as whether individual or collective behaviour is encouraged and/or preferred by society. Hofstede (2001) states that in cultures oriented towards individualism, people tend to emphasize their individual needs, concerns, and interests over those of their group or organization. In individualistic cultures, individual initiative is encouraged (Tosi & Greckhamer, 2004). In these cultures, people perceive themselves as independent and believe that they are hired in an organization due to their special skills and abilities, rather than their network or social background (Gelfand et al.,
17 2004). This is generally the case in countries such as the United States, the United Kingdom and Canada.
In Asian economies, such as Japan and Taiwan, the opposite is observable. Oysterman (2006) states that members of collective societies, perceive themselves as pieces of a puzzle. A puzzle of the society and organization in which they are a part. Brislin (1993), states that in a collectivistic society, an individual is expected to interact with his or her group members. He further states that it is next to impossible to perceive a person as an individual, rather than one whose identity comes from groups with which that person is associated. They see long-term relations and loyalty towards others as more important than fulfilling their own personal needs (Gelfland et al., 2004; Oyserman, 2006). Gelfland et al. (2004) also argue that people from a collectivistic culture are willing to make personal sacrifices regarding their goals and desires to fulfil obligations towards others in their organization.
Tosi & Greckhamer (2004) argue that certain work behaviours may also be affected. Grabrenya et al. (1985) give the example that in an individualistic society like the United States, people tend to shirk on tasks when assigned to a group, as opposed to individualistic tasks. A tendency, which they did not find in a collectivistic country like Taiwan.
The
Masculinity-Femininity
dimension of a culture, according to Hofstede (1998a, b;1998; 2001), refers to the degree to which values associated with stereotypes of masculinity (such as aggressiveness and dominance) and femininity (such as compassion, empathy, and emotional openness) are emphasized. Cultures characterized as highly masculine, such as Germany, Japan, and the United States tend to have certain jobs almost entirely assigned to women and others to men. In addition, a stronger emphasis lies on achievement, growth, and challenging jobs (Hofstede, 2001). Furthermore, in these cultures people are more assertive and show less concern for individual needs and feelings, are more concerned for job performance, and show less interest in the quality of the work-environment. However, according to Tosi & Greckhamer (2004), in countries defined by femininity, working conditions, job satisfaction, and employee participation is pointed out. Examples of such countries are Sweden and Norway.
Although Hofstede mentions multiple dimensions, which characterizes a societies, or even countries culture, for this research I will only take into consideration the dimensions uncertainty avoidance and collectivism. Since these dimensions show the greatest
differences between the United States and Japan. Furthermore, these dimensions can also be clearly linked towards the corporate governance structure of a firm. Although the other dimensions also show important country characteristics, they are harder to relate to firm characteristics in showing the impact between CEO duality, board size and its effects on firm performance.
18 2.3.1 CEO duality and culture
Before discussing the hypotheses, it is best to know whether there is a clear distinction in the practice of CEO duality between the United States and Japan. Literature, for example, shows that CEO duality is practiced more in the US (82.0%) than in Japanese firms (10.9%) (Dalton & Kesner, 1987). However, in this study the effect of cultural dimensions was not incorporated.
Uncertainty Avoidance. Looking from the viewpoint of uncertainty avoidance, I expect the following relationship between CEO duality and firm performance (Graph 1).
Graph 1: Expected relationship under Uncertainty Avoidance
This expectation stems from the fact that many agency theorists oppose the CEO duality structure, since agency problems can occur (e.g., Morck et al. 1988; Tricker, 1994; Yermack, 1996; Solomon, 2007). They for example argue that the duality structure diminishes the monitoring role of directors over the executive manager, which in turn may cause a negative effect on corporate performance. Furthermore, Tricker (1994) argues that in a duality
structure, the CEO may be given too much power and authority. The CEO can for instance appoint board members, which brings the opportunity to formulate regulations, which are in the CEO’s best interest. This in turn weakens the functioning of the board and increases the probability of the CEO acting on his or her own interest, instead of pursuing the interest of the firm and its shareholders (Tricker, 1994).
At 92% (Table 3), we clearly observe that Japan is one of the most uncertainty avoiding countries on earth. This is also noticeable in corporate Japan, where a lot of time and effort is put into feasibility studies and all the risk factors must be worked out before any project can start. Managers also ask for all the detailed facts and figures before taking any
Uncertainty Avoidance
US
Japan
CEO non-dua l i ty CEO dua l i ty
Fi rm P er fo rm an ce
19 decisions.2 At the other side of the spectrum one can find the US with its uncertainty
avoidance of 46%. According to Schuler & Rogovsky (1996), societies such as the US are more willing to take risks and can tolerate ambiguity and handle unpredictable situations.
Since Japan is so uncertainty avoiding, and cultures defined by uncertainty avoidance feel uncomfortable in unstructured or risky situations (Schuler & Rogovsky, 1998), I expect that the negative relationship between CEO duality and firm performance will be more negative in corporate Japan, opposed to US firms. Reasoning behind this expectation is the fact that authority is not clearly defined or allocated in a CEO duality structure. In a CEO non-duality structure there is a clear distinction between the agent and the principal. This leads to the fact that it diminishes the risk that the board of directors will have in not being able to monitor the executive manager correctly, which may cause a negative effect on corporate performance (Levy, 1981; Dayton, 1984).Hence, this leads to the following hypothesis:
Hypothesis 3a: The relationship between CEO duality and firm performance is more negative for Japanese firms based on uncertainty avoidance
Individualism – Collectivism. Looking from the view of Individualism - Collectivism, I expect the following relationship between CEO duality and firm performance (Graph 2).
Graph 2: Expected relationship under Individualism - Collectivism
As already mentioned, ‘individualism – collectivism’ relates to whether individual or collective action is the preferred way to deal with issues. I expect, since Japanese culture scores low on individualism (46%), the relationship between CEO duality and firm performance will be more negative than firms operating in the US. Oysterman (2006) for example, states that members of collective societies perceive themselves as pieces of a puzzle. Brislin (1993)
2 http://geert-hofstede.com/japan.html
Individualism - Collectivism
US
Japan
CEO non-duality CEO duality
Fi
rm
Pe
rf
or
ma
nc
e
20 further states that in these societies it is next to impossible to perceive a person as an
individual, rather than one whose identity comes from groups with which that person is associated.
Stewardship theorists suggest that CEO duality will lead to better corporate performance due to a clear leadership structure, helps improve firm efficiency, and in the CEO making important decisions more effectively and quicker, since the power is centred around one person (Anderson & Anthony, 1986; Donaldson & Davis, 1991; Davis et al., 1997; Guillet et al., 2013). Since Japan has a culture characterized by collectivism, where according to Oysterman (2006) individuals are all part of a puzzle the relationship between CEO duality and firm performance will be more negative than for US firms. According to Fama & Jensen (1983a, 1983b) CEO duality leads to compromising the ability of the board to independently monitor the CEO. They argue that the firms’ managers’ influence in setting board agenda and controlling information flows could impede the board’s ability to perform its duties well. This will be more the case in firms characterized by individualistic cultures. Hence, this leads to the following hypothesis:
Hypothesis 3b: The relationship between CEO duality and firm performance is more negative for Japanese firms based on collectivism
2.3.2 Board Size and culture
As for the effect of board size on firm performance, I expect the following negative relation for both “Individualism – Collectivism” and “Uncertainty Avoidance“(Graph 3).
Graph 3: Expected relationship between Board Size x Firm Performance
Japan US Board Size
Fi
rm
Pe
rf
or
ma
nc
e
21 According to agency theorists (e.g., Hermalin & Weisbach, 2003; Larcker, 2011), when a board consists of too many directors, agency problems increases since it is tougher to control for these costs in large boards. Simultaneously, more expenses have to be allocated to control activities in large boards. Furthermore, according to Lipton & Lorsch (1992), board cohesiveness is undermined, because board members will be less inclined to share a common purpose, communicate clearly, reach consensus, and reach unanimity that builds on the directors’ divergent viewpoints. This in turn would affect the relationship between board size and firm performance negatively. However, I expect that this effect will be less apparent for Japanese firms, as opposed to US firms. A possible explanation therefore could be that since Japan scores low on ‘Individualism’ (Table 3), Japanese directors are more inclined to work in groups and interact within their group members (Brislin, 1993). Japanese directors are also more willing to make personal sacrifices regarding their goals and desires to fulfil obligations towards the organization (Gelfland et al., 2004). I expect that this mentality helps Japanese firms in moderating the negative relationship between a large board and its effect on firm performance.
Additionally, I expect that since Japan scores high on uncertainty avoiding behaviour (92), Japanese firms would prefer large boards. Reasoning behind this are given by Lehn et al. (2004), who state that the advantage of larger boards and an increasing number of non-executive directors is the greater collective information possessed by the board, which is also valuable for monitoring functions. As mentioned under paragraph 2.3.1, corporate Japan puts a lot of time and effort into feasibility and risk studies, before any project can start.3
Therefore, larger boards are preferable. Furthermore, Dalton et al. (1999) note that large boards have the power and resources to collect more information for the use of controlling and monitoring the firm. This would eventually lead to better performance on a firm level. Now, since Japanese firms can be characterized as more risk avoidant than US firms, I expect Japanese firms to have larger boards, which in turn moderates the negative
relationship between board size and firm performance as opposed to firms operating in the US. Hence I expect the following relationship for both the “Uncertainty Avoidance” dimension and “Individualism – Collectivism” dimension:
Hypothesis 4: The relationship between board size and firm performance is more negative for US firms
22 3. Methodological approach, sample, and variable descriptions
In this section, the sample selection, dependent and explanatory variables that are used in testing the hypotheses are discussed. The main variables that are being tested in this study are CEO duality, board size and firm performance. The following paragraphs also specify the control variables and conclude with estimations for these variables.
3.1. Sample selection
In order to provide an answer to the proposed research questions, this study will consist of a quantitative approach. Hereby I will examine the correlation between CEO duality, the number of directors on a board (board size) and firm performance and the influence of culture here in. The analyses are based on data of publicly traded firms operating in the United States and Japan. The firms were selected from S&P 500 for the US and Nikkei 225 for Japan. The reasoning is that since information disclosed by companies in both countries are more transparent and of high quality, the data is perceived as more trustworthy.
I obtained all the data necessary for running a regression from DataStream. In order to conduct this study I choose to look at companies operating in 2004 until 2011 since this gives the biggest sample where consistent data is available. There are several advantages associated with this data set. The first advantage is that the data set post-dates the
implementation of SOX by a few years so that the transition period is excluded. Second, the availability of a long time series of subsequent performance for these sample firms helps strengthen the regression. This period also coincides with the worldwide financial crisis of 2008, which enables me to capture this effect as well.
Overall, this results in an initial sample of 6.516 firm-year observations (724 firms) in total (Table 5, Panel A). I collected data on Board Size, board structure, CEO as chairman, total assets, net operating income, total operating expenses, net sales, total liabilities, total debt, shareholders equity, total shareholders’ equity, return on equity, general industry classification and industry group. I also collected data on in which specific industry a firm operates. The following industries are observed: oil & gas, basic materials, industrials, consumer goods, health care, consumer services, telecommunications, and technology (Table 5, Panel B).
Since the industries ‘financials’ and ‘utilities’ are comprised of firms where the majority operates in the United States and due to the small sample, these industries will be dropped from the sample selection. Reasoning behind this is to diminish the effect of a possible bias. The industries, which will be used in my research, will therefore consist of the following eight
23 types: oil & gas, basic materials, industrials, consumer goods, health care, consumer
services, telecommunications, and technology.
Missing data reduces the sample by 2.516 firm-year observations (182 firms), which results in a sample of 3.284 firm-year observations (542 firms) (Table 5, Panel A).
Panel C (Table 5) shows that the majority of firms employ a CEO duality structure. Looking closer (Table 5, Panel C), this resembles the Heidrick & Struggles (1980) study where just less than 66% of United States firms CEO’s also serve as chairperson of the board. This division can also be seen in the Dalton & Kesner (1987) study where just 10.9% of the Japanese firms employ a CEO duality structure against 82% for US firms. However, in contrast to Dalton & Kesner’s (1987) study, one can see in table 6 that this distinction
between CEO (non)duality has become smaller over the years. This would indicate that the differences between countries have become smaller.
One could argue than since Japan scores high on collectivism (Table 3) on the Hofstede Index, CEO duality is therefore less employed. One could also relate this to Brislin’s (1993) study where he states that it is next to impossible to view a person as an individual, rather than one whose identity comes from groups that that person is associated.
Finally, panel D (Table 5) shows the division of how many members a board consists of. Striking is that although numerous studies show that ideal number of board members state that this lies between six or nine (Lipton & Lorsch, 1992; Jensen, 1993; Guest, 2009), the majority of the sample (91.2%) has a board size consisting of between six and fifteen directors.
When looking closer (Table 5, Panel D), one can see clearly that both for Japan and the US, the majority of the firms have a board size which lies between zero – 15 directors. This is slightly higher for the US (97.24%) than for Japanese firms (78.86%). However, Japanese firms have more boards, which exceed 16 directors, or more (17.60%) compared to the US (2.22%). Again, one could argue that this is attributable to the collectivistic mind-set, which characterizes Japanese culture as aforementioned (Brisling, 1993; Hofstede, 2001; Gelfland et al., 2004; Oysterman, 2006).
24
Table 5: Sample observations
Sample
Total sample
US
Japan
Total sample
US
Japan
Panel A: number of sample observations
Firms: 2004 - 2011
5.800
4.000
1.792
724
500
224
Missing data
(2516)
(1790)
(718)
(182)
(134)
(48)
Sample
3.284
2.210
1.074
542
366
176
Panel B: Industry observations
Oil & Gas
239
229
10
-
-
-Basic Materials
305
152
153
-
-
-Industrials
843
443
400
-
-
-Consumer Goods
608
364
244
-
-
-Health Care
316
249
67
-
-
-Consumer Services
513
428
85
-
-
-Telecommunications
64
33
31
-
-
-Technology
396
312
84
-
-
-Panel C: CEO duality observations
%
CEO duality
1.921
1.464
457
58%
66%
43%
CEO non-duality
1.363
746
617
42%
34%
57%
Total
3.284
2.210
1.074
Panel D: Board Size observations
%
Board < 5
50
12
38
1,5%
0,54%
3,54%
Board 6 - 10
1.496
1.029
467
45,6%
46,56%
43,48%
Board 11 - 15
1.500
1.120
380
45,7%
50,68%
35,38%
Board 16 - 20
154
44
110
4,7%
1,99%
10,24%
Board 21 - 25
39
0
39
1,2%
0,00%
3,63%
Board 26 - 30
34
1
33
1,0%
0,05%
3,07%
Board > 30
11
4
7
0,3%
0,18%
0,65%
Total
3.284
2.210
1.074
25 Since the study of Dalton & Kesner (1987) shows a big difference with the sample in panel C (table 5), table 6 shows the course of CEO duality over the years for both Japanese and US firms. Table 6 shows that Japanese and United States companies are moving away from the CEO duality structure. This progress is also observably stronger in Japanese firms than in firms based in the US.
3.2.1 Dependent variables
Like numerous studies have shown, firm performance can be measured by different
indicators (Cannella & Lubatkin, 1993; Donaldson & Davis, 1991; Rechner & Dalton, 1991). Weiner & Mahoney (1981) underline this fact and noted that ‘the number of corporate performance measures that could serve as dependent variables is almost infinite’ (p. 456). Therefore, just like Cochran & Wood (1984), I choose to use multiple indices of performance.
First, the study includes a firm’s short-term profitability in the form of return on assets (ROA), measured by net income scaled by total assets, because the profitability positively impacts a firms’ general performance (Guillet et al., 2013). Second, according to Cochran & Wood (1984) dependent variables fall in two broad categories: investor returns and
accounting returns. Just like Daily & Dalton (1992) I rely on return on equity (ROE) since this variable represents both categories. All performance data were derived from DataStream sources.
3.2.2 Independent variables
CEO duality is the situation where the board chair and the CEO or Managing Director holds the same position. Just as Core et al. (1999) mention, activist shareholders have argued for the separation of the board chair and CEO, where a number of empirical studies suggest that agency problems are higher when the CEO is also the board chair (Yermack, 1996). CEO duality (CEOD) variable is a dummy variable, which is equal to be one (1) if the post is hold by the same person as the CEO and board chair, zero otherwise (0) (Berg & Smith, 1978; Rechner & Dalton, 1991; Boyd, 1995).
The size of the board of directors is argued (Jensen, 1993; Yermack 1996) to be associated with less effective board monitoring, based on the argument that larger boards
Table 6: CEO duality across time
CEO duality
2004
2005
2006
2007
2008
2009
2010
2011
Japan
31,6%
48,8%
46,7%
39,5%
42,9%
42,7%
40,5%
40,2%
26 are less effective and more susceptible to the influence of the CEO (Core et al., 1999). Just as Rashid (2013) I will define board size as the natural logarithm of total number of directors in the board.
3.2.3 Control variables
A number of control variables, such as liquidity, firm size, debt ratio, and industry are used in this study. According to Rashid (2013), liquidity may influence firm efficiency and
performance. Although, according to Majumdar & Chhibber (1999) excess liquidity may reflect superior skills, it may influence firm efficiency negatively as excess liquidity may lead to firm assets tied up in non-revenue generating assets. Liquidity is measured as current ratio. Firm size is also a powerful variable which influences firm efficiency and performance. For instance, positive effects of large firms are the fact that they have a greater capacity in generating internal funds (Short & Keasey, 1999) and they have a greater variety of
capabilities (Majumdar & Chhibber, 1999). Downside of large firms is the fact that they may have problems of coordination, which can negatively affect firm efficiency and performance (Williamson, 1967). I will therefore consider the natural logarithm of total assets as firm size.
It is also argued by Jensen & Meckling (1976) that the choice of debt (corporate capital structure) plays a role in disciplining the firm. Hence, debt ratio is used as a
disciplining effect on firm performance. Debt ratio is calculated as total debt divided by total assets.
Elsayed (2007) states that controlling for industry effects is important for several reasons. For instance, Bhambri & Sonnengeld (1988) argue that firms are found to respond differently to given external pressures. Controlling for industry effects can therefore help identify unobserved heterogeneity at the industry level according to Klapper & Love (2004). Donaldson & Davis (1991) give the example of product and market competition. Secondly, Elsayed & Paton (2005) argue that corporate ethical behaviour may have a differential impact on financial performance across industries. Finally, studies show that the relationship between CEO duality and firm performance varies across industries (Boyd, 1995; Brickley et al., 1997). Also I will include market-to-book value, sales growth and market capitalization ratio as additional control variables. Regarding the aforementioned, I will control for industry effects by including a dummy variable.
27 3.2.4 Empirical model
In view of the above discussion, I will use the following regression equations to test the hypotheses of this study.
In these tests I will measure the relation between CEO duality, board size and the subsequent accounting operating performance. The specific regressions used in order to give an answer to the hypotheses as stated before are:
ROA=αi+β1CEODi,t+β2BDSIZEi,t+β3INDi,t+β4DRi,t+β5LIQi,t+β6SIZEi,t+β7DJPi,t+(β8DJP*CEODi,t)+(β9
DJP*BDSIZEi,t)+β10MTBVi,t+β11SGRi,t+β12MKRi,t+Ɛi,t
where the performance measure is the return on assets (ROA), calculated as the net income divided by total assets. Just like Guillet et al. (2013) have stated, this performance measure is regarded as a short-term profitability metric. I choose this performance measure, because according to Rappaport (1986), ROA profitability positively impacts a firm’s general
performance.
Since ROA is a short-term performance measure, I want to overcome eventual bias. That is why I will incorporate a performance measure which covers the long-term effect on firm performance. Hence the accounting performance measure return on equity (ROE) is an excellent tool to cover this dilemma. All of the variables mentioned in the regression are explained in table 7.
ROE=αi+β1CEODi,t+β2BDSIZEi,t+β3INDi,t+β4DRi,t+β5LIQi,t+β6SIZEi,t+β7DJPi,t+(β8DJP*CEODi,t)+(β9
28
Table 7: Variable definitions
Variable Definition Measurement
CEOD CEO duality Dummy variable equal to 1 if firms' CEO is also chairman of the board, otherwise 0
BDSIZE Board Size
Natural logarithm of board size representing the total number of directors of a firm
IND Industry
A specific industry in which a company operates ROA Return on Asset
Return on Assets is calculated as the net income/total assets ROE Return on Equity
Return on equity is calculated as Net income/Shareholders Equity
DR Debt Ratio
Debt Ratio is measured by total debt scaled by total assets
LIQ Liquidity
Liquidity is measured as current ratio
DJP Dummy Japan Dummy variable equal to 1 if firm is located in the Japan, otherwise 0 DJP*CEOD Dummy Japan * CEO duality Dummy variable equal to 1 if firm located in the Japan, multiplied by
CEO duality dummy variable which is equal to 1 in case of duality structure
DJP*BDSIZE Dummy Japan * Board Size Dummy variable equal to 1 if firm located in the Japan, multiplied by the natural logarithm of board size representing the total number of directors of a firm
MTBV Market-to-book value This is defined as the market value of the ordinary (common) equity divided by the balance sheet value of the ordinary (common) equity in the company
SGR Sales Growth Ratio (Current year’s sales - last year’s sales)/ by last year’s sales
MKR Market Capitalization Ratio (Current year’s market capitalization - last year’s market capitalization)/ by last year’s market capitalization * 100
