Impact of corporate governance practices on stock prices and earnings quality

Abstract

Corporate governance has gained importance in the recent years. Corporate Governance has become a yardstick for ensuring that the objectives of the different stakeholders are met fairly and completely minimizing conflicts, if any. The need for corporate governance stems from the agency problem arising out of the various ownership and control structures in different institutions. In the Indian context especially this agency problem comes both from the conflict of interest between management and shareholders (Type I agency cost) as well as that between dominant and small shareholders (Type II agency cost). Hence, the objective of the corporate governance has been arguably to undertake an overall stakeholder perspective which is believed to be achieved through the shareholder perspective. In order to meet this objective, firms have deployed both internal mechanisms such as Board of Directors, large shareholders, etc. and been subjected to external mechanisms such as market for corporate control and product market competition. The effectiveness of these mechanisms and thus the quality of corporate governance however is determined by various aspects of the legal, regulatory etc. environment. India was among the very few developing countries where institutions of governance were formally in place for many years. Corporate governance issues in India formally came to light since the inception of structural reforms and liberalization in 1991. The first formal attempt at corporate governance was made by CII Confederation of Indian Industry) in 1998 when it published the Desirable Code of Corporate Governance. The Code was the first instance where an industry association took the lead in prescribing corporate governance standards for listed companies. Several committees were set up by SEBI and MCA, including the KMBCCG (Kumar Mangalam Birla Committee) in 1999, Narayan Murthy Committee in 2002, Naresh Chandra Committee Report on Corporate Audit and Governance in 2002, Expert Committee on Company Law (J.J. Irani Committee) in 2004. The Companies Bill of 2009 was drafted and introduced in the Parliament to revise, modify and rationalize the existing Companies Act, 1956. The Companies Act was further modified in 2013. Thus, the landscape of corporate governance regulations has considerably evolved in the last decades. Further, we conducted a study to understand the impact of the various corporate governance regulations on the overall performance of the company. A review of the various studies mostly highlights the presence of mixed results. While some studies conclude that metrics such as independent directors, women directors, CEO duality, institutional ownership etc. have had little direct impact on the performance of the companies. In fact, in some studies the resulting effect of the metrics have been counterintuitive, for example a study revealed that increased CEO Duality improves the speed of decision making and reduces the transaction costs therefore being more valued by the shareholders, some studies also pointed out that having a big4 company as an auditor has no impact on earnings quality. In order to understand these studies more comprehensively, a primary analysis of the impact of different metrics on the earnings quality and the earnings response coefficient has been undertaken. For adjudging the impact on earnings quality, a regression equation of the different corporate governance metrics as the explanatory variables on the absolute values of discretionary accruals identified through the modified jones model was fitted. The resultant co-efficient and p-values denoted that presence CEO Duality significantly and positively affected the quantum of discretionary accruals. This highlights that presence of CEO Duality is viewed negatively and is associated with poorer earnings quality. Regression on the cumulative abnormal returns with the unexpected earnings and the different corporate governance metrics do not show any coherent results for interpretation due to high level of multi-collinearity and presence of high number of outliers.