Corporate governance and firm performance: empirical evidence from Pakistan

• DOI: https://doi.org/10.1108/CG-07-2020-0286
• Published date: 17 August 2021
• Date: 17 August 2021
• Pages: 42-66
• Subject Matter: Strategy,Corporate governance
• Author: Muhammad Farooq,Amna Noor,Shoukat Ali

Corporate governance and f‌irm

performance: empirical evidence

from Pakistan

Muhammad Farooq, Amna Noor and Shoukat Ali

Abstract

Purpose –The purpose of this researchis to look into the governance–performance relationshipin the

contextof critical firm characteristics, suchas firm size.

Design/methodology/approach –Based on total assets, sample firms were classified as small or large.

The governance index, which is based on 29 governance provi sions covering the audit committee, board

committee, ownership and compensation structure of the respect ive firm, measures governance quality

among sample firms. A higher governance index indicates a high er level of governance quality and vice versa.

Accounting and market value measures are used to determine firm profit ability. The authors used the t

wo-stage least square (2SLS) method of estimation of the model to eliminate t he simultaneous equation bias.

Findings –Corporate governance (CG) appears to have a positive impact on accounting return and

market indices (Tobin’s Q), but it has little impact on return on equity. In terms of firm size, larger

companies profited more from better governance implementation than smaller firms that lacked these

principles, thus improving CG. The findings indicate that small businesses should improve their

governancemechanisms to reap the benefits of CG in termsof increased profitability.

Research limitations/implications –There are certain drawbacks to this research. First, the authors

omitted qualitative aspects of CG from the CG index, such as the board’s decision-making process,

directors’ perceptions of the board’s position and directors’ age and qualifications. Such a qualitative

componentwill improve the governance index in thefuture while building the governanceindex. Second,

as the current study only looks at the nonfinancial sector, caution should be exercisedbefore applying

the findingsto the entire population.

Practical implications –The findings show that companies that follow good governance standards

have better accounting and market efficiency than those that do not. As a result, good governance

practices can help firms in developing countries improve their performance. Academic researchers,

regulators, investors, lenders and practitioners can find the findings useful in establishing a true

relationshipbetween firm performance and CG practicesin Pakistan.

Originality/value –The relationship between governance and profitability in the context of firm size is

examined in this research.Firms with varying resources and ability to implementCG codes have varying

effects on profitability. Tothe authors’ knowledge, there was a gap in the literature that addressed this

topic in the localcontext.

Keywords Corporate governance, Nonf‌inancial f‌irms, Firm performance, Firm Size,

Pakistan Stock Exchange, Nonf‌inancial listed f‌irms

Paper type Research paper

1. Introduction

This study aims to investigate the governance–performance relationship in the context of

firm size. Firm size is an essential determinant of a company’s relationship with its internal

and external operating environment (Babalola and Abiodum, 2013). The increasing

influence of multinationals and conglomerates has revealed what role size plays in today’s

Received 8 July 2020

Revised 5 December 2020

5 February 2021

9 March 2021

4 May 2021

1 July 2021

Accepted 26 July 2021

Funding: There is no funding

available for the said project.

Conflict of interest: The authors

declare that they have no

conflict of interest.

Data availability: The data sets

generated during and analyzed

during the current study are

available from the corresponding

author on reasonable request.

Authors contributions:Allauthors

contributed to the study’s

conception and design.

Muhammad Farooq performed

material preparation, data

collection and analysis.

Muhammad Farooq wrote the

first draft of the manuscript, and

all authors commented on

previous versions of the

document. All authors read and

approved the final manuscript.

Competing interest: The authors

declare that they have no

competing interests.

Informed consent: Informed

consent was obtained from all

individual participants included

in the study.

PAGE 42 jCORPORATE GOVERNANCE jVOL. 22 NO. 1 2022, pp. 42-66, ©Emerald Publishing Limited, ISSN 1472-0701 DOI 10.1108/CG-07-2020-0286

corporate environment. Big firms have more competitive power because of their more

significant market share and higher capital, allowing them to remain profitable in theface of

competition (Bayyurt, 2007). According to Papadogonas (2007), large firms benefit from

economies of scale by negotiating a better interest rate and receiving a better rebate

because of large purchases, resultingin higher profits than smaller firms.

Corporate governance (CG) playsa vital role in an organization’s success because it paves

the way to achieve social and financial objectives (Ehsan, 2019). According to the

Organization for Economic Co-operation and Development (OECD) principles of CG, 2004,

it is a mechanism for establishing the organization’s goals and objectives andthe means to

achieve these goals and objectives. Comprehensively, CG defined mechanisms, policies,

rules and regulations framed by regulatory bodies to protect the interests of minority capital

providers and all stakeholders while also achieving the organization’s goal. The actual

implementation of CG among firms aids these firms in particular, and the country attracts

foreign investment (Bhatt and Bhatt,2017).

For a long time, researchers have been studying the relationship between CG and firm

value. Researchers agree that acceptableCG practices are valued increasingly (Johl et al.,

2016). Good CG adds value to a company by closing the information gap between the

resource handler and the ultimate owner and keeping both parties’ interests on the same

page (Audousset-Coulier et al., 2016). The implementation of the Sarbanes–Oxley Act in

2002 increases the effectiveness of CG in reducing agency costs and creating firm value.

Existing literature does not demonstrate a relationship between governance and firm

performance in one direction and is therefore inconclusive about the direction of this

relationship (Hermalin and Weisbach, 1991). Some researchersbelieve that effective CG drives

firm performance (Gompers et al.,2003;Bebchuk et al., 2009), whereas others find a mixed or

no relationship between the two (Yermack, 1996). However, Gompers et al. (2003) and Cornett

et al. (2009) believe that this relationship is endogenous and more researchis needed.

According to the researchers, good CG firms outperform other firms in two ways, first, by

making better use of financial and human resources. As the mitigated agency requires less

cash, these firms pay out higher dividends, resulting in a higher stock price and firm value.

Second, better-governed firms do not require a higher return on equity (ROE) because the

cost of monitoring management is lower for shareholders than for competitors (Shleifer and

Vishny, 1997). Because of their excellent market reputation, well-governed firms can obtain

external funds at lower rates (Nazir and Afza, 2018). Some researchers question the direct

relationship between CG and firm profitability, claiming that the benefit may be outweighed

by the cost of implementing an effective CG mechanism.

Interestingly, because each firm has different resources and agency cost, the degree of CG

implementation varies. Firms that implement CG more effectively benefit from its performance

more than firms that do not. Large firms have more resources and higher agency cost (Sajid

et al.,2012

) than small firms. As a result, they are better positioned to implement governance

codes and reap the benefits than smaller firms. Furthermore, large firms are actively monitored

by the external debt market and have a greater check by regulators, making them more

conscious of their performance. As CG is an effective channel for managing resources and

increasing firm performance. As a result, large corporations should be more cautious about CG

implementation to continue satisfying shareholders and stakeholders. This disparity in firm

resources and agency cost begs the question :Is there a difference in governance quality

between large and small firms?” If so, how will this difference in governance quality affect the

firm’s profitability? The level of CG implementation varies between large and small firms, which

have a different impact on profitability. This research aims to find an answer to this question in

the context of Pakistan Stock Exchange (PSX)-listed companies.

The primary goal of this study is to examine the governance–performance relationship in the

presence of a critical firm characteristic, namely firm size, concerning PSX-listed firms from

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