FIRM PERFORMANCE, CEO TENURE AND CORPORATE GOVERNANCE REPORTING: EVIDENCE FROM INDONESIA

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1 FIRM PERFORMANCE, CEO TENURE AND CORPORATE GOVERNANCE REPORTING: EVIDENCE FROM INDONESIA Ria Nelly Sari Rita Anugerah Miranti Herly Department of Accounting, Faculty of Economics, Universitas Riau, Indonesia Abstract This study attempts to investigate the relationship between firm performance and CEO tenure on corporate governance reporting. Seventy-three large public firms from 100 largest companies in Indonesia were selected as the sample. Data for corporate governance reporting are collected from annual reports for the year Corporate governance reporting is indexed by the extent to which companies disclose the corporate governance practices in their annual report. The disclosure index reporting model developed in the current research is based on selected items using in Annual Report Award (ARA, an award given annually to Indonesian listed and non listed companies interm of relevant information disclosed), and firm performance is measured using two indicators; ROA and Tobin-Q. Results demonstrate that when firm performance is measured by ROA, firm performance is positively related to corporate governance reporting but the relationship becomes significantly negative when performance is measured by Tobin-Q. Results support that CEO tenure significantly has a negative relationship with corporate governance reporting. The interactive effects of firm performance and CEO tenure on corporate governance reporting demonstrate that only the interaction of ROA and CEO tenure effects is significantly related to corporate governance reporting. However, the interaction between CEO tenure and Tobin-Q is not associated with the level of corporate governance reporting. The discussion and implications of the findings and also suggestions for future research are discussed. Key words: Corporate governance reporting, CEO tenure, firm performance Introduction In this globalization era, transparency and accountability are necessity. One of the good corporate governance principles which currently attract public attention is the issues of transparency and disclosure. Corporate governance prinsciples of disclosure and transparency states that disclosure of timely and accurately carried out on all material things related to the company including financial condition, performance, ownership and corporate governance. In Indonesia, the awareness of companies to implement and report on corporate governance parctices is relatively low. According to Daniri (SWA sembada No. 06/XXIII 1

2 edisi Maret 2007) there are still companies that antipathy toward the practices of good corporate governance. One of the reasons is there still many companies or their surrounding companies that run an unhealthy business practices (Daniri in SWA sembada No. 06/XXIII edisi Maret 2007). In fact, the implementation of good corporate governance is a positive matter because it can be a feedback system (Gendut Suprayitno in SWA sembada No. 19/XXIV edisi 4 17 September 2008) and can create a sustainable competitive advantage (Pambudi in SWA sembada No. 19/XXIV edisi 4 17 September 2008). Moreover, if companies applied a good corporate governance practices and then follow the good corporate governance rating, the foreign investor will value more towards the companies if the companies rating were considered high (Pambudi in SWA sembada No. 19/XXIV edisi 4 17 September 2008). Over the last three decades, corporate governance became an interesting research issue for many researchers. Researchs on corporate governance had evolved not only research on the implementation of GCG in the company but also research on how far the companies disclose the corporate governance practices within the company s annual report. Corporate governance reporting is a report of crucial information related to management, monitoring, transparency and accountabilities which is presented to users of annual reports. With these kinds of information the users will be able to distinguish between the good and the bad company. Information about good corporate governance practices might help the investor to invest their capital in the industries that have a low agency cost. There are two main issues in this research; firm performance and CEO characteristics especially CEO tenure, that contribute to the corporate governance reporting. The topic of firm performance has indeed long been a concern in studies of disclosure and corporate governance practices. However, empirical evidence from previous research is mixed and 2

3 inconclusive. In spite of the importance of performance on disclosure, little research has examined know how and when firm performance can affects disclosure. Research on good corporate governance practices, especially the research that relates good corporate governance practice and firm performance has been widely done in developed countries. For example, the research conducted by Lang and Lundholm (1993) and Miller (2002) found the fact about the increase of substantial in information disclosure in Annual Report in line with the increase of income. In other word, the level of disclosure had increased along with earnings raising period. Klapper and Love (2002) also found that there was a positive relation between corporate governance and firm performance that was measured with ROA and Tobin s Q. Beside, Che Haat et al. (2008) found that corporate governance mechanisms have a significant influenced on firm market performance (Tobin s Q). However, some research found that there was no relation between corporate governance with the company performance (for example Labelle, 2002 and Raffournier, 1995). In Indonesia, the issue of good corporate governance and its relation to firm performance has been investigated by several researchers (eg. Darmawati et al. 2005). Darmawati et al. (2005) found that the practice of good corporate governance was not significantly influenced towards the firm market performance as measured by Tobin s Q, but significantly influenced the firm s operating performance (as measured by ROE). Based on the above discussion, it can be convinced that the implementation of good corporate governance is certainly an important element. However, in the business world, the role of Chief Executive Officer (CEO) is equally important. As a business leader, the CEO has very vital role as a piooner, supervisor, empowering and role model. With the role he played, the CEO will be able to determine the development of a company (SWA no. 4 /XXIV/21 Feb-5 March 2008:4). 3

4 CEO characteristic is an importance aspect of corporate governance and corporate governance reporting (Shen 2003). The difference stages of CEO tenure would influence either CEO leadership development or control of managerial opportunism. However, further research on performance and CEO tenure in relation to corporate governance practices and reporting still has not been explored in depth. This study has attempted to examine the effect of firm performance and CEO tenure on the the level of corporate governance reporting and also to investigate interaction effect of CEO tenure and corporate performance on corporate governance reporting. This study used panel data from 73 companies with three years of observation ( ). The data was analyzes using regression model with random effect approach. The results is expected to increase our understanding of the role of CEO and firm performance on the level corporate governance disclosure. The remainder of this paper is structured as follows. In the nex section, we review the literature on corporate governance reporting and discussion on hypothesis development which involves the relationship between firm performance and corporate governance reporting as well as the relationship between CEO tenure and corporate governance reporting. Also we discuss the the effect of interaction between firm performance and CEO tenure on corporate governance reporting. The third section explains the methodology used to satisfy the objective of the study. The fourth section reports the results of the study, leading to a conclusion, implications and limitations of the study. Literature review and hypotheses development Corporate governance reporting An annual report is a comprehensive report on a company s activities throughout the preceding year. Annual reports are intended to give shareholders and other interested people 4

5 information about the company's activities and financial performance. An annual report is an important medium for management to demonstrate their responsibility in managing the company. In annual report management will inform the practices of corporate governance that have been implemented. The information disclosed in annual reports can be grouped into two categories, namely mandatory disclosure and voluntary disclosure. Mandatory disclosure is the information that must be disclosed by the company as required by law. Whereas voluntary disclosure is the disclosure of information that is made voluntarily by the firm or it can be said as the disclosure of information which exceeds what is required by law. Voluntary disclosure is a source of information that can help shareholders or investors to obtain information about the various decisions taken by the company. Voluntary disclosure is also helping the market to reflect the fundamental values of company. Theoretical framework used in the prior research on voluntary disclosure is usually rely on agency theory that explains the conflict between the Agent (management) and Principal (owner) that due to conflict of interest (Jensen & Meckling 1976). Conflict of interest that caused by the possibility that the agent do not act in accordance with the interest of principal can be minimized by using corporate governance mechanism (such as independent board of directors, members of committees within the board and share ownership). However with the existence of these monitoring mechanisms will lead to the existence of agency cost (Jensen & Meckling, 1976). Related to agency problems, corporate governance is a concept that is based on agency theory, is expected to serve as a tool to give confidence to investors that they will receive a return on the funds they have invested. Corporate governance relates to how investors believe that managers will not steal or embezzle or invest their funds to unprofitable projects. Corporate governance is also related to how investor can control or monitor the 5

6 managers. However, management will seek to minimize agency cost, because higher costs would reduce the compensation that can be accepted by management. So to reduce monitoring costs, management will voluntarily disclose information in annual reports (Depoers, 2000). Disclosure and reporting on corporate governance practices is an important element because it shows the level of monitoring mechanism. Therefore, disclosure of information will minimize company s overall monitoring costs. Previous researchs have raised the issue of reporting and have been trying to find out the relationship between this variable with some other variables such as firm performance (for example Lang & Lundholm 1993; Miller 2002; and Che Haat et al., 2008), transparency of information (Che Haat et al., 2008) and the cost of capital towards type of disclosure (Botosan & Plumlee, 2000). Prior researched have proven that there was a relation between corporate performance with the level of disclosure. Research conducted by Lang and Lundholm (1993) found that most of the companies that the quality of information disclosure increases from year to year are the companies that have positive annual earnings. Based on this findings, it can be concluded that the level of disclosure increased during the period of increased earnings. Other researchers, Che Haat et al. (2008), examines the influence of good corporate governance reporting on the performance of public companies in Malaysia using transparency (ie disclosure level and timeliness) as a mediating variable. The results of this study indicate that corporate governance mechanisms have a significant effect on firm performance. However, the level of disclosure does not affect the company's market performance (Tobin s Q) and do not mediate the relationship between corporate governance with firm performance. In relation to the disclosure of information, Botosan and Plumlee (2000) has conducted a research on effects of cost of equity capital on three types of disclosure (annual 6

7 report, quarterly and other published reports and investor relations). Botosan (2000) found that the cost of equity capital has a negative relationship with annual report disclosure level, had a positive relationship with quarterly report disclosure level and has no effect on investor relations. Firm performance and corporate governance reporting. The performance of a company can be seen from the financial statament presented by the company. Disclosure of financial information will provide useful information for users of financial statements. Disclosure as one aspect of GCG is expected to be a good base to see the firm performance. Company with a good performance will support the management to make a quality disclosure. Most of the literature in the previous study provides evidence that performance is a factor considered by management in relation to disclosure of information. Research conducted by Lang and Lundholm (1993) found that most of the companies that experienced an increase in the quality of disclosure of information from year to year are the companies that have positive annual earnings and its also increase every year. Similarly, Miller (2002) also found that a subtantial increase in disclosure level is concurrent with increase in earnings. Based on these findings, it can be concluded that the level of disclosure increased during the period of increased earnings. However Labelle (2002) did not find a consistent significant relationship between the quality of corporate governance disclosure with the company performance. Similar with Labelle (2002), Raffournier (1995) also found that profitability (net income over net worth) was not a significant variable in measuring the level of voluntary disclosure. The insignificant relationship between firm performance with the quality of disclosure maybe was influenced by the type of corporate performance measurement used and also depends on the information disclosed. 7

8 Although evidence from previous research is inconclusive, but generally with the existence of good corporate governance practices the management will be motivated to disclose more detailed information about the company (including information on practices of good corporate governance). For strategic purposes, management may choose to disclose positive information only, and tend to keep the information about the decline in company performance. In a period of bad performance, managers tend to disclose less fearing information that corporate governance practices are perceive to be lacking (Miller, 2002). Because the bad performance was caused by the poor of corporate governance mechanism itself, this may lead managers to provide less disclosure on their corporate governance attributes. From the discussion above it can be concluded that the company's performance and reporting the practices of GCG has a closed relationship. In other words, the level of disclosure increased during periods of increased firm performance. Previous researchs have measured firm performance by some proxy such as Return On Assets (ROA) and Tobin's Q (Klapper & Love, 2002) and Return On Equity (ROE) and Tobin Q (Darmawati, et al, 2005) From the above discussion, the following hypotheses are proposed: H 1 : H 1a : H 1b : Firm performance is positively related to corporate governance reporting ROA is posively related to corporate governance reporting Tobin Q is posively related to corporate governance reporting CEO tenure and corporate governance reporting CEO tenure is a critically important constructs for research relating to the organization and executive leadership (Simsek, 2007). CEO tenure is always associated with quality of leadership and power (Shen, 2003). Past research on leadership suggests that, to meet the demands for their new jobs, CEOs spend a lot of time on learning while in the process of 8

9 taking charge (Shen, 2003). Shen (2003) explained that CEOs spent a lot of time to achive their success of their work and the ability of CEOs will increase from time to time. In the first years of serving in the company, the new CEOs get the opportunity to demonstrate their performance. This is because at the beginning of their existence in the company, they still intensely be monitored by the board of commissioner and the shareholders. The most important thing, process undertaken by the CEO in performing his duties in the full attention by all parties associated with the company, internal or external parties (shareholders and stakeholders). Before the CEO can proves the quality of his leadership in fulfill the expectation of various parties ranging from board of directors, shareholders and the rest of powerful stakeholders, the position as CEO was definitely cannot be considered safe for sure (Shen 2003). According to Gabarro (1987), new CEOs normally need one or two years to acquire needed task knowledge before they can take major actions to reshape their organizations. It takes additional time for these actions to show substantial impacts on their firms' competitive positions in the market and financial returns. Without the backing of their boards, new CEOs are vulnerable to challenges by forces from inside and outside the firm and may lose their jobs before they can fully demonstrate their leadership potential (Fredrickson et al. 1988). Thus, the newly appointed CEO of the company will seek to reveal (disclose) more about corporate governance practices. In other words, CEOs with shorter tenure will perform control towards the important informations as their contribution to the corporate. When a CEO successfully meet the expectations of boards and shareholders, he will not only gain significant power in the company, but also the CEO will get another opportunity to build strength, and when the leadership of CEO has proven to be good, then the level of confidence of the board of commissioners will be increased so that the boards become more flexible and reduce the level of vigilance in monitoring the performance of the CEO (Coles et al., 2001). 9

10 Lack of monitoring from board of commissioners to the CEO (due to increased confidence in the board of commissioners to the CEO) causes an increase in CEO power significantly (Shen, 2003). Then, CEOs with longer tenure will reduce the disclosures about corporate governance practices because they felt they had power and were less monitored by the board of commissioners. This leads to the following hypothesis: H 2 : CEO tenure has negative relationship with the corporate governance reporting. Firm performance, CEO tenure and corporate governance reporting According to Shen (2003) the development of leadership and power of CEOs have influence on corporate governance. CEOs with long tenure will tend to reveal more information about corporate governance practices as the firm's performance increased (Shen 2003). CEOs with long tenure will report corporate governance practices better than previous years to realize the reflection of a good performance as the output of good strategic planning and appropriate monitoring mechanisms, which have been applied during his tenure. On the other hand, when CEOs have just held positions as CEOs, the CEOs need to establish their existence and maintain their position. When the company shows poor performance, the new CEO will disclose more information of corporate governance practices to convince the board of commissioners, stakeholders and shareholders that the monitoring mechanism are already in place. Also, the new CEO disclose more information in order to avoid the perception that the CEOs are pursuing their personal interest. Therefore, new CEOs may have a tendency to disclose more information compared to longer tenured CEOs especially when performance is low. Based on the above discussion, the following hypotheses are proposed: H 3 : The relationship between firm performance and corporate governance reporting is moderated by CEO tenure. 10

11 H 3a : The relationship between firm operating performance (ROA) and corporate governance reporting is moderated by CEO tenure H 3b : The relationship between firm market performance (Tobin'Q) and corporate governance corporate governance reporting is moderated by CEO tenure Research methodology Data collection Data of this study were collected from Annual Report and related resources available. The sample comprises a selection of the top 100 largest Public Companies rated by SWA Nine firms from the financial and insurance industry were omitted because these companies have special requirement in term of disclosure. 12 firms listed in the year 2006 and 2007 were also dropped from the sample and 6 firms were deleted due to incomplete data. This yielded a sample of 219 firm-year observations from 73 firms during Measurements Dependent variable in this study is corporate governance reporting. In this study, corporate governance reporting was measured by assessment criteria used in Annual Report Award Based on the ARA s criteria corporate governance reporting is evaluated by searching company s annual reports for the information of 152 possible attribute broadly divided into the following four categories: the information of the board of commissioners and directors, company profiles, management discussion and analysis on company performace and good corporate governance. 1 Annual Report Awards (ARA) is organized by the Ministry of Finance (Bapepem-The Capital Monitoring Agency and the Directorate General of Taxation), Ministry of State Own Enterprises, Bank of Indonesia, National Committee on Governance and Indonesian Institute of Accountants to promote Indonesia to the highest standard in corporate reporting of Indonesia Listed and Nonlisted Company 11

12 Following prior studies (such as Cooke, 1992; Hannifa & Cooke, 2002; Setiawan, 2009), we formed an unweighted index. The index is simply a count of items disclosed in the annual report. A simple disclosure index was employed instead of a weighted disclosure index because prior studies employing both types of indexes have reported identical results (Chow & Wong-Boren, 1987; Naser & Nuseibeh, 2003; Wallace & Naser, 1995). Firm performance This study used two indicators to measure firm performance. First indicator is based on company s financial returns and second indicator is based on company s competitive position in the market. This study uses return on assets (ROA) and Tobin-Q (Shen 2003; Hillegeist 2003, Bhagat & Bolton 2007; Nourayi & Daracoca, 2008; Che Haat et al., 2008). Return on Assets is measured by net income over total assets at the end of the year and Tobin-Q is measured by the total debts, preferred stock and market value over book value of assets. CEO tenure CEO Tenure is measured by the number of year CEO had held the position for the year ended (Michel & Hambrick 1992; Bushman et al. 2004; Coles et al 2001). Since the distribution of data is negatively skewed, the suitable transformation procedure as suggested by Pallant (2001) is using the squared root method. Control Variable Previous studies have documented that several variables (as discussed below) have an effect on transparency and disclosure or firm performance. First, the firm size as a control variable has been included. Larger firms face a greater information demand from financial analysts (Lang & Lundholm, 1993), and there is a positive association between firm size and 12

13 disclosure (Fitriany, 2001; Gunawan, 2000; Hadi & Sabeni, 2002; Hossain et al, 1994). Company size is measured by the natural log of the annual total assets of the company, to control for a possible size effect. Second, firm age is included because, firm age would greatly affect rules, procedure and information to disclose. Firm age was measured by the logarithmic of the number of years from the date of firm s incorporation (Pallant, 2001). Lastly, leverage is measured by total liability over total assets (Banhart & Rosenstein, 1998; Depoers, 2000; Hutchinson & Gul, 2004; Raffournier, 1995). A high level of firm s leverage might cause the firm to disclose more information about their governance in order to reduce risk and monitoring problem. Analysis and Results Statistical analysis The hypotheses stated earlier were testing using panel data regression techniques. The use of cross-sectional and time-series data in this study permits the use of panel data regression techniues. Panel data provides a more accurate inference of model parameters because of more degrees of freedom, less multicollinearity among explonatory variables (Hsiao, 2005) and controls for the impact of omitted unobservable variables due to self or sample selection and firm-spcific heterogeneity (Nikolaev & Van Lent, 2005). Descriptive statistics Table shows the distribution of CEO tenure, firm performance (proxied by ROA and Tobin Q), the company s age, total assets and leverage. The mean of firm s age is 35 years and the mean of CEO ternure is 6.6 years. The highest total assets owned by sample companies is trillion and the lowest total assets owned by sample companies is 143 billion. On average sample has total assets of 11 trillion, ROA of and Tobin Q of

14 Corporate governance reporting have an average of as much as or 49.54% of the total reporting items with the highest index reporting was 127 items and the lowest reporting index was 33 items. This finding indicates that there is still lack of disclosure of corporate governance practices in the sample companies. Tabel 1 Descriptive Statistics (n=219) Variable Mean Maximum Minimum Deviation Standard C Total Assets 11,057,837,888, ,375,422,986, ,432,000, E+13 Leverage CEO Tenure ROA TobinQ CGScore Results The data analysis is to test whether firm performance and CEO tenure are significant predictors of corporate governance reporting. In brief, H1 states that firm performance lead to higher level of corporate governance reporting, H2 states that CEO tenure has a negative relationship with corporate governance reporting, while H3 states that interaction between CEO tenure and firm performance will affect the level of corporate governance reporting. Hypotheses were tested using regression model with random effect approach. Tabel 2 demonstrate the regression results for the relationship between firm performance and CEO tenure on corporate governance reporting. The regression produced an adjusted R 2 of The results show that none of the control variables (firm age, firm size and leverage) has significant relationship with the level of corporate governance reporting. Tabel 2 shows that 14

15 Tabel 2 Regression Results Variable Coefficient Std. Error t-statistic Prob. Constant LogAge LnAssets Leverage ROA TOBINQ SqrTen ROAxTen TOBQxTen R 2 0,8574 Adj. R 2 0,8519 Durbin-Watson Stat. 2,3758 N 219 firm operating performance (measured by ROA) has a significant positive relationship with corporate governance reporting (ß= , t= , p<0.05). The significant positive relation between firm operating performance and corporate governance reporting is consistent with theory suggesting that operating performance is associated with the level of disclosure. Contrary to hypothesis 1b, when firm performance is represented by market performance (measured by Tobin Q), result shows that Tobin Q has a significant negative relationship with corporate governance reporting. Hence, H1 which predicted that there was a positive relationship between firm performance and corporate governance reporting is only partially supported. The results of data analysis provided support for H2. This research proved the existence of a negative relationship between CEO tenure and the level of corporate governance reporting (ß= , t= , p<0.05). Hence, H2 which predicted that shorter tenured CEO would have more incentive to disclose corporate governance practiced as compared to longer tenured CEO is supported. 15

16 The interactive effect of performance and CEO tenure on corporate governance reporting demonstrates that only the interaction of Tobin Q and CEO tenure effects is significantly related to corporate governace reporting (ß= , t= , p<0.05). However, the interaction between ROA and CEO tenure is not associated with corporate governance reporting. Hence, H3 which predicted that there was an interaction between CEO tenure and firm performance on corporate governance reporting is only partially supported. Discussion and Conclusion This study attempts to examine the effects of firm performance and CEO tenure on corporate governance reporting. A panel data set comprising 219 firm-year observation from 73 firm was constructed for the period of In order to measure corporate governance reporting, this study has used ARA criteria. Results of random effect coefficient estimation show under accounting based performance, ROA is positively related to corporate governance reporting. This supports the findings of past studies which also record a positive relationship between ROA and disclosure (Lang & Lundholm, 1993; Miller, 2002). This study failed to provide support to the hyphotesis that state the positive relationship between Tobin Q and corporate governance reporting. Tobin Q is significantly related to corporate governance reporting but in the opposite direction as hypothesized. However, this support the findings of past studies which also did not record a positive relationship between Tobin Q and disclosure (Raffournier, 1995; Labelle, 2002, Mohd Sanusi et al., 2009). This finding indicates that in the period of bad market performance, managers tend to disclose more information about their corporate governance practices. Managers prefer to provide extra information to the stakeholders either to offer a reasons for the poor performance or to justify their future strategic position (Moh. Sanusi et al., 2009). This study provide support to the hyphotesis that state the negative relationship between CEO tenure and corporate governance 16

17 reporting. In the early stage of the tenure, most managers need time to adapt to the changes and to understand the operation and the people in the firm. As new CEOs in the company, they need to disclose more of the corporate governance practices. This should be done in order to enhance the confidence of the stakeholders in them, and thus, secure their job or promotion (Shen, 2003). Therefore, shorter CEO tenure will need to disclose more information about monitoring and firm s strategic planning. An examination of the interaction effect revealed that CEO tenure interacts with firm market performance (Tobin Q) on corporate reporting (H3b). This might be one of the reasons for the negative relationship between firm market performance and corporate governance reporting is due to the difference in the CEO tenure. When the company s performance is low, shorter tenured CEOs disclose more of their corporate governance practices. On the other hand, firms with longer CEO tenure disclose more of their corporate practices when the firm performance is good. The generalizations made from the findings are subject to several limitations. The measurement of corporate governance reporting has been subjected to a long debate. Since this study does not differentiate good and poor company and this differentiation will have different effect to firm disclosure and transparency (Che Haat et al., 2008), future research would have to extend this study by splitting the good and bad companies and also by dividing the industry sectors. Some previous studies found a few other variables that also can affect the level of disclosure, such as national culture and intitutional environment (Emanuel et al., 2010). Future studies may consider these variables so that enriches the understanding of corporate governance reporting. Besides, since this study is constrained to Indonesia, future study may also be design to compare the finding of this study with finding that relate to corporate governance reporting in other countries. Despite these limitation, the findings reported in this paper and future research would help improve our understanding of the factor that relate to the level of corporate governance reporting and firm performance. 17

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