CHAPTER TWO

LITERATURE REVIEW
This chapter presents reviews of theoretical perspectives and empirical literature of studies and
their findings.

2.1 Theoretical Review

2.1.1 Agency Theory
Firms are assumed to exist for the benefit of its owners who are assumed to be solely interested
in the maximization of their wealth. Managers, on the other hand, are the decision-makers in an
organization and they are implicitly assumed to automatically act in the best interests of the
owners. Agency theory recognizes that people are unlikely to ignore their own self-interest in
making decisions. The theory provides a means of establishing a contract between the principal
and the agent which will lead to optimal performance by the agent on behalf of the principal
(Crowther & Seifi, 2011).

The advent of the modern corporation created a separation between ownership and control of
wealth. Even though owners would prefer to manage their own companies and reap the
maximum utility for themselves, this is impossible because of the capital requirements of the
modern corporation. Corporations grow beyond the means of a single owner, who is incapable of
meeting the increased economic obligations of the firm. Owners become principals when they
contract with executives to manage their firms for them. Executives accept agent status because
they perceive the opportunity to maximize their own utility. Principals invest their own wealth in
companies and design governance systems in ways that maximize their utility (Berle & Means,
1932).

According to Alchian and Demsetz (1972); if every stock owner participated in each decision in
a corporation, not only would large bureaucratic costs be incurred, but many would shirk the task
of becoming well informed on the issue to be decided, since the losses associated with
unexpectedly bad decisions will be borne in large part by the many other corporate shareholders.

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More effective control of corporate activity is achieved for most purposes by transferring
decision authority to a smaller group, whose main function is to negotiate with and manage
(renegotiate with) the other inputs of the team. The corporate stockholders retain the authority to
revise the membership of the management group and over major decisions that affect the
structure of the corporation or its dissolution.

The importance of Alchian and Demsetz’s model for corporate governance lies in the fact that it
justifies the role of shareholders as profit-earning entrepreneurs by using efficiency
considerations. The shareholders are the constituency that determines what objectives should be
pursued by the firm if it is to be efficient, but they also have the necessary incentives to ensure
that these objectives are actually pursued. The implication is that firms controlled by
unconstrained managers are not efficient, because of the divergence between the objectives of
managers and those of profit-maximizing shareholders. Hence, in order to promote efficiency
and economic welfare, one would have to ensure that within the firm structure there are
sufficient constraints on managerial discretion aligning management motivation to the profit
maximization objective which in turn leads to the maximization of the firm’s market value
(Dignam & Galanis, 2009).

Jensen and Meckling (1976) state that an agency relationship is a contract under which one or
more persons (the principal(s)) engage another person (the agent) to perform some service on
their behalf which involves delegating some decision making authority to the agent. If both
parties to the relationship are utility maximizers, there is good reason to believe that the agent
will not always act in the best interests of the principal. The principal can limit divergences from
his interest by establishing appropriate incentives for the agent and by incurring monitoring costs
designed to limit the aberrant activities of the agent. Agency costs is the sum of the monitoring
expenditures by the principal, the bonding expenditures by the agent, and the residual loss.

In the theory of the firm, Jensen and Meckling state that the relationship between the
stockholders and the managers of a corporation fits the definition of a pure agency relationship.
Corporations are associated with the general problem of agency as there is separation of
ownership and control. The problem of inducing an “agent” to behave as if he were maximizing
the “principal’s” welfare is quite general.

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Fama and Jensen (1983) in their article of Separation of Ownership and Control state that the
agency problems of diffuse decision management can be reduced by separating the management
(initiation and implementation) and control (ratification and monitoring) of decisions. Without
effective control procedures, decision managers are more likely to take actions that deviate from
the interests of residual claimants. The common apex of the decision control systems of
organizations, large and small, in which decision agents do not bear a major share of the wealth
effects of their decisions is some form of board of directors. Exercise of these top-level decision
control rights by a group (the board) helps to ensure separation of decision management and
control. Separation of decision management and decision control at all levels of the organization
helps to control agency problems by limiting the power of individual agents to expropriate the
interests of residual claimants.

Fama (1980) stated that the board is viewed as a market-induced institution, the ultimate internal
monitor of the set of contracts called a firm, whose most important role is to scrutinize the
highest decision makers within the firm.

A key issue in the agency view of corporate governance is how to align the interests of the agent
with those of the principal. Other important issues include the timely minimization of any
divergences, and how to balance the need for and the cost of monitoring with the benefits that
arise from the separation of control and ownership (Marnet, 2008).

2.2.2 Stewardship Theory

Davis, Schoorman, and Donaldson (1997) define stewardship theory as situations in which
managers are not motivated by individual goals, but rather are stewards whose motives are
aligned with the objectives of their principals. In the theory, the model of man is based on a
steward whose behavior is ordered such that pro-organizational, collectivistic behaviors have
higher utility than individualistic, self-serving behaviors. Where the interests of the steward and
the principal are not aligned, the steward places higher value on cooperation and seeks to attain
the objectives of the organization. This behavior in turn will benefit principals. Stewardship
theorists assume a strong relationship between the success of the organization and the principal’s
satisfaction.

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A steward who successfully improves the performance of the organization generally satisfies
most groups, because most stakeholder groups have interests that are well served by increasing
organizational wealth. The steward realizes the trade-off between personal needs and
organizational objectives and believes that by working towards organizational, collective ends,
personal needs are met. The essential assumption underlying the stewardship theory is that the
behaviors of the executive are aligned with the interest of the principals. Thus, stewardship
theorists focus on structures that facilitate and empower rather those that monitor and control.
When both the principal and the manager choose a stewardship relationship, the result is a true
relationship that is designed to maximize the potential performance of the group.

2.2.3 Stakeholder Theory

The other popular theory of corporate governance is the Stakeholder theory. The stakeholder
theory originated from the management discipline and gradually developed to include corporate
accountability to a broad range of stakeholders (Abdullah and Valentine, 2009). Unlike the
agency theory, whereby managers are predominantly responsible for satisfying the interests of
shareholders, stakeholder theory maintains that managers in organizations are not only
responsible for the interests of shareholders but also for a network of relationships to serve which
includes the supplier’s employees and business partners (Ibid).

According to stakeholder theory decisions made regarding the company affect and affected by
different parties in addition to stockholders of the company. Hence, the managers should on the
one hand manage the company to benefit its stakeholders in order to ensure their rights and their
participation in decision making and on the other hand the management must act as the
stockholder’s agent to ensure the survival of the firm to safeguard the long term stakes of each
group (Fontain et al., 2006).

Stakeholders are persons or groups with legitimate interests in procedural and/or substantive
aspects of corporate activity. Stakeholder theory intends to explain and to guide the structure and
operation of the established corporation. The ultimate managerial implication of the stakeholder
theory is that managers should acknowledge the validity of diverse stakeholder interests and
should attempt to respond to them within a mutually supportive framework, because that is a
moral requirement for the legitimacy of the management function (Donaldson & Preston, 1995).

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Wang and Dewhirst (1992) state that stakeholder theory can best explain how members of
governing boards think about the interests of corporate constituencies and thus how
organizations are actually managed.

2.1.4 Resource Dependency Theory

Resource dependency theory focuses on the role that directors play in providing or securing
essential resources to an organization through their linkages to the external environment.
Directors bring resources to the firm, such as information, skills, access to key constituents such
as suppliers, buyers, public policy makers, social groups as well as legitimacy (Abdullah &
Valentine, 2009).

Pfeffer and Salancik (2003) state that organizations are constrained and affected by their
environments and they act to attempt to manage resource dependencies. Pfeffer (1972) asserts
that boards enable firms to minimize dependence or gain resources. Pfeffer (1972) finds that
board size relates to the firm’s environmental needs and those with greater interdependence
require a higher ratio of outsider directors. He concludes “that board size and composition are
not random or independent factors, but are, rather, rational organizational responses to the
conditions of the external environment” Pfeffer and Salancik’s (1978) asserts that boards can
manage environmental dependencies and should reflect environmental needs. Pfeffer and
Salancik (1978) suggest that directors bring four benefits to organizations: (a) information in the
form of advice and counsel, (b) access to channels of information between the firm and
environmental contingencies, (c) preferential access to resources, and (d) legitimacy (cited in
Hillman, Withers, & Collins, 2009)

2.2 Concept of Corporate Governance

Corporate governance mechanisms are designed to align the interest of owners and managers,
constrained the opportunistic behaviors of managers and protect shareholder interests, generally
to solve agency problem. Enhancing corporate governance mechanisms should result in
improved financial performance (Manini & Abdillahi, 2015). Corporate governance mechanisms
are means or control structures used by the principals to align the interests of principals and
agents and to monitor and control agents. The purpose of these governance mechanisms is to
limit the scope and frequency of agency costs and to ensure that agents act in accordance with
the best interests of their principals (Gebba, 2015).

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Sound corporate governance encourages the efficient use of resources and provides for
accountability for those resources by managers. Institutions that practice good corporate
governance are more likely to achieve institutional objectives and goals. Good corporate
governance should thus be of prime concern to owners and other stakeholders of the institutions.
In fact, good corporate governance helps promote the general welfare of the society and should
be of interest to the general public and governments. Corporate Governance broadly refers to the
mechanisms, processes and relations by which corporations are controlled and directed.

A governance structure identifies the distribution of rights and responsibilities among different
participants in the corporation (such as the board of directors, managers, shareholders, creditors,
auditors, regulators, and other stakeholders) and includes the rules and procedures for making
decisions in corporate affairs. Corporate governance includes the processes through which
corporations' objectives are set and pursued in the context of the social, regulatory and market
environment. Governance mechanisms include monitoring the actions, policies and decisions of
corporations and their agents. Corporate governance practices are affected by attempts to align
the interests of stakeholders. One must note that the key elements of an effective governance
structure are ownership (this involves both institutional and managerial), board size, board
composition and its structure, CEO characteristics and board members’ remuneration, auditing,
information, and the market for corporate control (Keasey et al 1997 as cited on Vishwakarma,
2015).

Governance is concerned with the manner in which rules and regulations are applied and
followed, the relationships that these rules and regulations determine or create and the nature of
those relationships (Otieku, 2010). Corporate Governance, therefore, refers to the manner in
which the power of a corporation is exercised in the corporation’s total portfolio of assets and
resources with the objective of maintaining and increasing shareholder value and satisfaction of
other stakeholders in the context of its corporate mission (Chenuos, Mohamed, and Bitok, 2014).
It is concerned with creating a balance between economic and social goals and between
individual and communal goals while encouraging efficient use of resources, accountability in
the use of power and as far as possible to align the interests of individuals, corporations and
society.

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2.3. Corporate Governance and Firms’ Financial Performance
Adopting better corporate governance mechanisms such as an enhanced board and audit
committee improves monitoring of management and reduces information asymmetry problems
(Aldamen et al., 2011). There is a significant literature that links size, gender diversity, and other
characteristics of the board of directors and audit committees to improved firm performance
(Klein, 1998; Aldamen et al, 2011). Corporate governance mechanisms have been identified as
an essential tools needed in managing any corporation including banks. There are different
mechanisms that reduce agency cost whereby corporate governance can be measured in an
organization. In the corporate governance literature board characteristics (board size, board
gender diversity and educational qualification and experience) and audit committee size were
used as corporate governance mechanisms. International organizations such as Organization for
Economic Cooperation and Development (OECD) and International Corporate Governance
Network (ICGN) have developed corporate governance principles which stressed on the role of
boards.

According to Bathula (2008), corporate governance principles focus on the importance of

corporate governance for long-term economic performance and strengthening of international
financial system. A strong board can play a decisive role in improving firm financial
performance. The important role of boards is to act as an internal governance mechanisms and
monitoring of management (Shleifer and Vishny, 1997). An effective board is likely to help the
firm achieve better performance by effectively under taking their monitoring duties (Bathula,
2008). Board of directors is an important corporate governance mechanism (Aljifriand Moustafa,
2007). Boards of directors are the agent of the shareholders and their primary task is to monitor
and control firm management on behalf of shareholders to reduce agency problem.

In Modern Corporation’s board of directors are charged with the task of monitoring the activities
of top management to ensure that the managers act in the best interests of shareholders (Jensen
and Meckling, 1976). From the agency theory point of view boards have play decisive role in
alleviating agency problems that arising from the separation of ownership and control of firms

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(O’Connell and Cramer, 2010). In doing so the board of directors need to be effectively
supervise the activities of top management.

The effectiveness of the board is influenced by factors such as board composition and quality,
size of board, board diversity, board committee effectiveness such as audit committee and
information asymmetries ultimately this affects the board oversight performance (Uadiale, 2010).
When the board is effective it is expected to drive the company towards better financial
achievement (Andres and Vallelado, 2008). When financial markets are not well developed as an
efficient external control mechanism and when the shareholders are not well protected due to
weak legal system and poor law enforcement the role of the board of director becomes highly
significant as an internal control mechanism (Gonz´alez and Garay, 2003). Boards of director are
the heart of corporate governance. However, the effectiveness of the board of directors as
shareholders’ monitoring mechanism can only be efficient if bounded with appropriate size,
composition and sub-committee (Lawal, 2012).

2.2.3.1 Board Size

Board size represents number of directors on a board. Boards having too many directors could be
unproductive with ineffective communication that results directors free riding problem (Alam &
Akhter, 2017). According to Kiel and Nicholson (2003) board size is crucial to achieving the
board effectiveness and improved firm performance. According to Lawal (2012), board size
affects the quality of deliberation among members and ability of board to arrive at an optimal
corporate decision. Therefore, identifying the appropriate board size is essential because size can
be detrimental to corporate governance effectiveness beyond optimal level. However,
determining an ideal size of the board has been an ongoing and controversial debate in corporate
governance literature (Lawal, 2012).

Al-Manaseer et al. (2012) also argues that boards with too many members lead to problems of
coordination in decision making. Small board size was favored to promote critical, genuine and
intellectual deliberation and involvement among members which presumably might led to
effective corporate decision making, monitoring and improved performance (Lawal, 2012).
Larger boards can be less participative, less cohesive, and less able to reach consensus.

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Coordination, communication and decision-making problems increasingly impede company
performance when the number of directors increases (Yermack, 1996 as cited by Uadiale, 2010).

In contrast Klein (2002) suggested that larger boards able to promote effective monitoring due to
their ability to distribute the work load over a greater number of observers. Thus, board size can
influence the financial performance of firms.

2.2.3.2 Board Gender Diversity

Gender diversity is part of the broader concept of board diversity. Boards are concerned with
having right composition to provide diverse perspectives. Greater female representation on
boards provides some additional skills and perspectives that may not be possible with all-male
boards (Boyle and Jane, 2011). Board diversity promotes more effective monitoring and
problem-solving. He suggests that female board members will bring diverse viewpoints to the
boardroom and will provoke lively boardroom discussions. Gender diversity in the boards is
supported by different theoretical perspectives. Agency theory is mainly concerned about
monitoring role of directors. Representation from diverse groups will provide a balanced board
so that no individual or group of individuals can dominate the decision-making of the board
(Erhardt et al., 2003). The management may be less able to manipulate a more heterogeneous
board to achieve their personal interests. Gender diversity is associated with effectiveness in the
oversight function of boards of directors. The oversight function may be more effective if there is
gender diversity in board which allows for a broader range of opinions to be considered.

According to Erhardt et al. (2003), diversity of the board of directors and the subsequent conflict
that is considered to commonly occur with diverse group dynamics is likely to have a positive
impact on the controlling function and could be one of several tools used to minimize potential
agency issues. From stakeholders' theory, diversity also provides representation for different
stakeholders of the firm for equity and fairness (Keasey et al., 1997). From resource dependency
perspective, the board is a strategic resource, which provides a linkage to various external
resources (Walt and Ingley, 2003). This is facilitated by board diversity. On the other hand, Rose
(2007) revealed insignificant association between number of women directors on the board and
firm performance. However, many scholars now believe that an increase in board diversity leads
to better boards and governance on the ground that diversity allows boards to tap on broader

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talent pools for the role of directors (Bathula, 2008). However, as he stated in corporate world
women representation on boards is very limited.

2.2.3.3. Educational Qualification

Director's educational qualifications are central to effectively interpret and utilize the information
generated by the management of particular types of business enterprise. Educational qualification
is potentially important since the ability to seek and interpret appropriate information is essential
for the efficient operation of the modern corporation and the effective control or guidance of
management by boards of directors. Educational qualification affects the oversight and
monitoring role of boards of directors (Gantenbein and Volonte, 2011). Board of directors is
vested with the responsibility of ensuring that the shareholders’ money is not wasted,
shareholders have a serious interest in ensuring that the board is staffed with well-educated and
experienced directors (Gantenbein and Volonte, 2011). The human capital provided by its board
of directors is vital given the corporate board is one of the mechanisms for overseeing the firm
and it can arguably provide the knowledge needed to function in the new environment. Personal
profile factors of directors such as education and experience is important for board efficiency.

2.2.3.4. Frequency of board meeting

Meeting frequency refers to how much time Board meet on a year. For board to effectively
perform its oversight function and monitor management performance, the board must hold a
regular meeting. Measuring the intensity and effectiveness of corporate monitoring and
discharging is the frequency of board meetings (Jensen M., 1993). Empirical findings on the
effect of frequent board meetings and corporate performance show mixed results. Some studies
concluded more meeting frequency has a negative impact on the performance of firms. Meeting
Frequency has a significant negative impact on ROA and an increasing in meeting frequency will
reduce the ROA (Ms.S.DanoshanaandMs.T.Ravivathani, 2013). Moreover, Akpan (2015) found
that board meetings negatively and significantly relate with company performance. Another
study conducted on public listed companies in Malaysia using five years’ data 2003 to 2007 of
328 companies, shows that the higher the number of meetings the worse the firm performance
(Amran, 2011).

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Whereas, Karamanou et al (2005) found a positive association between frequency board meeting
and management earnings forecasts, using a sample of 157 firms in Zimbabwe from 2001-2003;
Mangena and Tauringana (2008) report a positive relationship between board meeting frequency
and corporate performance. Similarly, in a study of the sample of 169 listed corporations from
2002-2007 in South African, a statistical significant and positive association between the
frequency of board meeting and corporate performance exist (Ntim and Osei, June 2011). This
implies that the board of directors in South Africa that meet more frequently tend to generate
higher financial performance. Moreover, Ntim and Osei (2011) found a statistically significant
and positive association between the frequency of corporate board meetings and corporate
performance, implying that South Africa boards that meet more frequently tend to generate
higher financial performance.

2.3.6 Audit Committee Size

An audit committee is an operating committee of the board of directors charged with oversight of
financial reporting and disclosure. Committee members are drawn from members of the
company's board of directors, with a Chairperson selected from among the committee members.
Its role includes choice and monitoring of accounting principles and policies, overseeing
appointment, dismissal of external auditors, monitoring internal control process, discussing risk
management policies and practice with management and overseeing the performance of internal
audit function.

Ferede (2012) found that large number of audit committee has a negative and significant effect
on financial performance. He added that Limiting audit committee size to reasonable number
improves audit committee effectiveness. Thus, it is expected that there is a Negative relationship
between size of audit committee and financial performance, Aldamen et al. (2011) reveals that
smaller audit committees with more experience and better educational qualifications are more
likely to be associated with positive firm performance. In Ethiopia banking industry. Kyereboah-
Coleman (2007) reported a significant positive relation between size of the audit committee and
firm performance (ROA and Tobin’s q) using the overall sample. Kyereboah Coleman (2007)
describe that size of the audit committee could be an indication of the seriousness attached to

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issues of transparency by the organization. However, only using Ghanaian sample the size of the
audit committee showed a negative effect on performance.

He explained as free-ridership and difficulty in consensus building in large groups leads to low
performance. In addition, Lin et al (2006) found significant positive association between audit
committee size and occurrence of earnings restatement. It was explained that a certain minimum
number of audit committee members may be relevant to the quality of financial reporting.
According to Jensen and Meckling (1976) the audit committee plays a significant role in the
monitoring process carried out by the directors of the firm and auditing is used by firms to
reduce agency costs. In addition to that they revealed that most essential board decisions
originate at the committee level, and this includes the audit committee. Audit committees thus,
represent another internal governance mechanism whose impact is to improve the quality of
financial management of a company and hence its performance.

2.2.3.7 Board composition

Board composition has been highly debated in the realms of economics, organizational science
literatures, and finance on the empirical and the theoretical levels. It has also been debated that
effective ways of monitoring can assist the boards in making executives effectively take care of
the shareholder's interests rather than their own (Ramdani & Van, 2009). According to agency
theory, a larger proportion of independent directors generally provide better firm performance. In
general, it has been concluded by Ramdani and Van (2009) that the proportion of independent
directors has an effect on firm performance.

Boards mostly compose of executive and non-executive directors. Executive directors refer to
dependent directors and non-Executive directors to independent directors (Shah et a, 2011). At
least one third of independent directors are preferred in board, for effective working of board and
for unbiased monitoring. Dependent directors are also important because they have insider
knowledge of the organization which is not available to outside directors, but they can misuse
this knowledge by transferring wealth of other stockholders to themselves (Beasly, 1996).

Previous studies examining the relationship between board composition and firm performance
have been inconsistent. For example, some researchers (such as Forsberg, 1989; Hermalin &
Weisbach, 1991; Zahra & Pearce, 1989) found that there is no significant relationship. On the

12
other hand, other studies found that firms with board of directors dominated by outsiders are able
to perform better (Adams & Mehran, 1995; John & Senbet, 1998).

2.2. Empirical Studies

This section presents the summary of the empirical studies; the detail review is presented
subsequently;

 Board of directors’ size and firms’ performance

Many researchers argue that firms’ performance differs according to the size of board of
directors. When the number of directors on the board is large, firms would get more access to
various resources in comparison to the case when board size is small. The larger board of
directors, the more experienced and knowledgeable people will be available which will lead to
more careful learning, decision making process and ultimately better firm performance. Larger
board of directors is harmful to firms’ performance (Switzer & Tang, 2009). Arora (2012)
examined the impact of board directors’ size on the performance of 150 pharmaceutical
companies for the period from 2001 to 2010, the study found that board directors’ size has a
positive impact on firms’ performance. Anderson, Mansi, & Reeb (2004) believe that board
directors’ size plays a vital role in improving firms’ performance as it enables the companies to
control and oversee managers. For instance, Yermack (1996) found that there is a negative
association between firms’ performance and number of board directors. The study was based on
a sample of 452 companies in U.S industrial corporations over the period from 1984 to 1991.
However, Jackling & Johl (2009) found that number board of directors has a positive impact on
Indian firms’ performance. Similarly, there is a positive correlation between board size and
firms’ performance (Johl, Kaur, & Cooper, 2015).in the same line, Alabdullah et al. (2016) argue
that board directors’ size positively impacts firms’ performance by reducing the financial
leverage level. Citation & Chatterjee (2011) argue that board directors’ size negatively impacts
firms’ performance measured by market-based measures. It is believed that board directors’ size
is a vital influential over firms’ performance. Thus, this study expects board directors’ size to
have a positive impact on firms’ performance.

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  Board Gender Diversity
Studies of Stephen, Djan, Bawuah, Halidu, and Kuutol (2015); and Akpan and Amran (2014)
have outcomes of a negative and significant effect of board gender diversity on RoA. Whereas
Olani and Berhanu (2015); Rao and Kidane (2016); Kilic (2015); Ekadah and Mboya (2011);
Liang, Xu, & Jiraporn (2013) in their study indicate that there is a negative and insignificant
effect of board gender diversity on banks performance. On the studies of Belhaj and Mateus
(2016) it is found a positive and significant result. Whereas Yenesew (2012) in his study indicate
that there is a positive and insignificant effect of board gender diversity on banks performance.

 Number of Board Meetings

The results of Olani and Berhanu (2015); Assefa and Megbaru (2014); Liang, Xu, & Jiraporn
(2013); Salim, Arjomandi, & Seufert (2016); and Firehiwot 2015 shows significant and positive
effect. Whereas, the study of Andres and Vallelado (2008) and Abdurazak (2017) indicates
results of insignificant and positive effect. The results of Malik, Wan, Ahmad, Naseem, &
Rehman (2014) states that a negative and significant effect of number of board meetings on bank
performance.

 Audit committee size and firms’ performance

Audit committee is one of the important factors that play a vital role in boosting firms’
performance, it provides a sufficient protection against fraud and makes sure that these
protections are in accordance with the best practices. Audit committee members must be
qualified holders and have the experience in the field of auditing (Aldamen, Duncan, Kelly,
McNamara, & Nagel, 2012). Small audit committee size that consists of well-experienced
members and financial expertise associates positively with firms’ performance (Aldamen et al.,
2012). Detthamrong et al. (2017) investigated the impact of corporate governance on firms’
performance of 493 non-financial companies in Thailand. It was found that audit committee size
has an impact on firms’ performance. Beasley (1996) argued that audit committee role makes

14
sure of meeting the quality of financial reporting. However, audit committee presence does not
affect the financial statement fraud. Aldamen et al. (2012) advocated that there is a negative
association between audit committee and firms’ performance. Based on the discussion above the
study anticipates a negative impact of audit committee size on firms’ performance in tourism
sector.

 Board independence and firms’ performance

Board of directors include a number of executives who might be non-independent or independent
directors. The board provides essential work as it monitors the management team of the firm. A
large number of independent directors are preferable for investors. It is also called outside
director (Muniandy & Hillier, 2015). Many studies were conducted to investigate the association
between board independence and firms’ performance; Switzer & Tang (2009) investigated the
impact of degree of board independence on the performance of 245 Small-Cap Firms U.S for the
period from 2000 to 2004; it was found that degree of board independence positively correlates
with firms’ performance. Citation & Chatterjee (2011) aimed to explore the relationship between
board directors’ independence and Indian firms, the sample covered public, private, undertaking,
standalone firms, and subsidiaries foreign firms. It was found that board independence
insignificantly impacts all types of companies. Agrawal & Knoeber (1996) found that there is a
positive association between firms’ value and board directors. Jackling & Johl (2009) believe
that firms’ performance is positively impacted by board independence. There is a low positive
association between board composition and financial performance (Spring & Rhoades, 2017).
Johl et al., (2015) advocate that board independence have no impact on firms’ performance.
Arora (2012) believes that board directors’ composition negatively affects firms’ performance.
On the other hand, Alabdullah et al. (2016) advocate

15
Empirical studies in Detail
Mahan and Marimuthu, (2015) on their study on the relationship between corporate governance
on selected Indian companies. On this study the researcher employed one dependent variable
(ROA) and five independent variable i.e board size, CEO duality, remuneration to board of
directors, independent directors and board ownership. The researcher uses SPSS, correlation,
regression and means to analyze the collected data. The finding indicates that size of board,
remuneration to directors and composition of independent directors in the board do not have any
sort of impact on the financial performance of firms listed in the Bombay Stock exchange, the
two corporate governance variables of board ownership and duality are exerting significant
impact on financial performance ,presence of promoters in the board is the single corporate
governance variable which shall significantly enhance financial performance of a firm.

Nazar, Rahim(2015) analyze the impact corporate board size and corporate performances of Sri
Lankan listed companies by employing a cross sectional analysis of 109 firms listed in Colombo
Stock Exchange(CSE) for the financial year ending 2013 and multivariate analyses are used to
test the hypotheses. The independent ,dependent and control variables used in this study were
board size, ROA and ROE and board independence, CEO duality, leverage, firm size and
dividend yield respectively. The results show that board size is significantly negatively
associated with ROA and insignificantly negatively linked with ROE. Control variables of board
independent, CEO duality and leverage are negatively related with ROA and ROE.

Bussoli, Gigante, and Tritto (2015) investigated the impact of corporate governance on bank
performance and loan quality. 48 sample banks in Italy for a period of three years were analyzed
using multivariate OLS regression model. Return on asset, return on equity and non-performing
loan ratio are the dependent variables; board size, presence of women directors, number of board
committees are the independent variables. Results indicate that there is statistically insignificant
negative relationship between the number of committees and bank performance. There is

16
statistically insignificant positive relationship between the board size and bank performance.
There is a statistically insignificant positive relation between women directors and bank
performance. Bank size used as a control variable has a significant negative relation with return
on asset.

Bathula (2008) studied the association between board characteristics and firm performance.
Board characteristics which were considered in the research include board size, director
ownership, chief executive officer duality, gender diversity, educational qualification of board
members and number of board meetings. Additionally, firm age and firm size was used as
control variables. Firm performance was measured by return on assets. To test the hypothesis a
sample of 156 firms over a four year period data from 2004 to 2007 was used. The sample
includes all firms listed on New Zealand stock exchange. Empirical analysis was undertaken
using Generalized Least Squares analyses. The findings of the study showed that board
characteristics such as board size, chief executive officer duality and gender diversity were
positively related with firm performance, whereas director ownership, board meetings and the
number of board members with PhD level education was found to be negatively related. Firm
age and firm size does not have significant influence.

HifzaI.and Aqeel M.(2014), provide the evidence on the impact of corporate governance on
Pakistan banking sector .Performance of banking sector is measured through liquidity,
profitability, growth, asset quality, operational efficiency, privatization, investor's protection,
disclosure; cost of equity; capital adequacy indicator and expense management and the none of
the corporate governance mechanism were indicated on the study . This study has been
conducted over commercial banks of Pakistan. The empirical results show that there is strong
association of corporate governance and determinants of banking sector performance. Results of
this study show that banks with good corporate governance show better performance as
compared to banks having less corporate governance.

Abdullah Kaid et aI., (2012) examined the relationship between board characteristics and the
firm performance of non-financial listed Kuwaiti firms. To achieve the objectives of the study,
the data were collected from a sample of 136 companies for the financial year 2009. Variables
such as CEO duality, COE tenure, audit committee size, board size and board composition were

17
considered as predictors of the firm performance that was measured employing the return on
assets (ROA). By contrast, the effects of CEO tenure and leverage on firm performance were
found to be negative and significant at the chosen level of significance. To test the hypotheses of
the study, multiple linear regression analysis using SPSS 18.0 was utilized. Using the firm size
and leverage as a control variable, the findings of the study support the positive effects of CEO
duality and audit committee size on ROA.

Africa from Reza

Abdulazeez, Ndibe and Mercy (2016) studied the impact of corporate governance on the
performance of Nigerian banks. 15 sample banks for a period of 7 years were part of the study.
The study used regression analysis using panel data, for the independent variables of board size,
board composition (number of non-executive directors), CEO duality, audit committee and for
the dependent variable of return on assets. The regression results show that board composition is
negatively and insignificantly related to the performance of banks. Audit committee has positive
but insignificant relationship with performance. Board size is positive and significant at 5 per
cent on bank performance. The result indicates that increase in board size would increase the
performance of the banks.

Pun (2015) on his study on the effect of board committees on corporate financial performance
among companies listed on the Ghana Stock Exchange (GSE) and he found board committees
had no statistical significant effect on the corporate financial performance of listed firms.
Specifically, nomination committee regressed negatively on corporate financial performance but
was statistically insignificant, audit committee have no effect whiles remuneration committee
predicted positively but also not statistically significant on corporate financial performance .The
quantitative research approach was adopted to study the prognostic effect of board committee on
corporate financial performance for companies consistently listed on the GSE from 2006-2010.
Data was sourced from annual reports of listed companies and a static panel regression model
was employed to analyze the presence of various committees on corporate financial
performance.

Manini and Abdillahi (2015) examined the impact of corporate governance mechanisms on
banks’ profitability of forty-two sample banks in Kenya for a period of one year. Multiple
regression analysis was used to test the relationship between the independent variables of audit

18
committee size, board gender diversity, board size and the dependent variable of return on asset.
The regression results show that there is no statistically significant relationship between board
gender diversity, audit committee and bank profitability. There is statistically significant
negative linear relationship between board size and banks’ performance and a statistically
insignificant negative linear relationship between board gender diversity and financial
performance.

According to Xavier, Shukla, Oduor, Mbabazize (2015) the study on the effect of corporate
governance on Financial Performance of commercial banks in Rwanda. The study has four
objectives which determined how board size, CEO duality, institutional ownership, board
composition affect financial performance of commercial banks in Rwanda. The researcher used a
descriptive research design in analyzing the effect of corporate governance and financial
performance of commercial banks in Rwanda, this study made use of primary and secondary
data. The study collect primary data concerning corporate governance through open ended and
closed questions that has been distributed to the sample size and data drawn from the annual
reports of the banks under review. The study has been based on the four independent variables
which are CEO duality, board composition, board size as well as institutional ownership.
Financial Performance was measured by the Return on Assets and return on equity of each
commercial bank. The finding of the study shows that board size and CEO duality have no effect
on performance of commercial banks in Rwanda, Board composition had a negative effect and it
was found that institutional ownership was not a significant factor in explaining profitability

Mohammed, (2011) on his study on the topic of the impact of corporate governance on the
performance of banks in Nigeria by using both primary and secondary data and concludes that
corporate governance significantly contributes to positive performance in the banking sector. The
secondary data obtained from the annual financial statement of the banks for a period of five
accounting year used in analyzing the financial ratios for the study and questionnaires were
distributed to the staff of the selected banks. The primary data was analyzed through inferential
statistical the chi-square analysis method. The secondary data collected from the audited annual
reports of the banks were subjected to descriptive statistical analysis through data tabulation. The
non-probability sampling technique was used for this study. The ratios employed in this study
includes Return on capital, Current ratio, Debt ratio, Dividend cover and Retention ratio.

19
Ethiopia

Reza (2018) examine the impact of corporate governance mechanisms on bank performance
measured by return on assets. Eight year data for the period 2010-2017 was used to study ten
private Ethiopian commercial banks. Corporate governance variables considered includes board
size, board gender diversity, and industry related qualification of board members, board
ownership, number of board meetings, and number of board committees, capital adequacy ratio,
legal reserve, liquidity position and management efficiency. Control variables of bank size and
leverage were considered. Findings of the study indicate that board size has negative but
statistically insignificant effect on return on asset. Industry related qualification, board
ownership, number of board meetings, and number of board committees have positive but
statistically insignificant effect on return on asset. Board gender diversity, capital adequacy ratio,
legal reserve, and management efficiency have negative and statistically significant effects on
the dependent variable. Whereas liquidity ratio has a positive and statistically significant effect
on return on asset

Firehiwot (2015) examined the effect of corporate governance in firms' financial performance
using ten years data from the year 2005 to 2014 with a sample of nine Ethiopian state and private
commercial banks. Dependent variable of return on asset and independent variables of board
size, board member gender diversity, board members educational qualification, board members
industry specific experience, size of audit committee, and frequency of board meeting were used.
Bank size and age are the control variables. Results reveal that board size and audit size has a
negative and statistically significant association with return on asset. There is an insignificant
and positive association between women directors and industry specific experience of directors
on performance. Board members educational qualification and frequency of meeting has a
positive and statistically significant influence on return on asset. Bank size had statistically
insignificant negative effect on bank performance.

Bonsa (2015) investigated the impact of corporate governance mechanisms on firms' financial
performance of Insurers in Ethiopia using ten year data from the year 2005 to 2014 with a
sample of nine insurance companies. Financial performance indicators such as return on asset
were used. Corporate governance mechanisms considered included board size, chief executive
compensation, educational qualification of directors ,presence of female directors, frequency of

20
board meeting, other business management experience of directors, industry specific experience
of directors and the study also controls the effect of premium growth of Insurers. The study
controls the effect of Growth premium. Results show that board size and presence female
directors don’t have statically significant impacts on Insurers’ performance. In addition Contrary
to theoretical prediction frequency of board meeting does not have significant effects on Insurers
performance. So, stakeholders should give consideration to chief executive compensation,
educational qualification of directors, other business management experience of directors, and
industry specific experience of directors when they set governance policy for industry as general
and for the company specifically. On the other hand chief executive compensation, educational
qualification of directors, other business management experience of directors, and industry
specific experience of directors has positive and significant effects on financial performance of
Insurers’ proxy by ROA.

Hailab (2014) examined the effect of corporate governance in firms' financial performance using
ten years data from the year 2008 to 2012 with a sample of ten Ethiopian insurance companies.
Dependent variable of return on equity and independent Variables such as board size, board
composition, firm size, board gender diversity and leverage were used. Firm size and leverage
are the control variables. Results reveal that board gender diversity, firm size and leverage
positively influence the financial performance of selected insurance firms in Ethiopia and they
are significant based on return on equity (ROE); whereas board size and board composition have
statistically insignificant impact on financial performance, but board size influence negatively
and board composition influence positively the financial performance of selected insurance firms
in Ethiopia

Demis (2013) has undertaken a study to evaluate the financial performance of non-life insurance
industry in Ethiopia by using CARAMEL frame work. The researcher selected 10 insurance
companies from the total of 15 based on their year of establishment. Secondary data collected
from the individual insurance companies and from the National Bank of Ethiopia from the fiscal
year of 2008 to 2012 was used for the completion of the study. ROA has been used as the
dependent variable explained by capital adequacy, assets quality, re-insurance, actuarial issues,
management efficiency, earning and profitability and liquidity. Multiple linear regressions were
applied. From the multiple linear regressions, it was found that assets quality and combined ratio

21
have negative relationship whereas capital adequacy and retention ratio have positive
relationship with performance (ROA) of insurance industry in Ethiopia.

Kibrysfaw (2013) examined the impact of corporate governance mechanism on performance of

Ethiopian commercial banks. The study included 9 state and private commercial banks in
Ethiopia covering the period 2005-2012. The independent variables of the study are board size,
board composition of independent non-executive directors, availability of audit committee, board
ownership, capital adequacy ratio, legal reserve, liquidity ratio, depositors’ impact, ownership
structure. Control variables of bank size, and income diversification and dependent variable of
return on asset were analyzed using panel data framework. Results indicate that availability of
audit committee on the board had positive impact on banks performance and it is statistically
significant at 10% significant level. Board composition showed negative relationship and it is
significant at 5% level. Board size and board ownership on bank performance was insignificant
and negative. Capital adequacy ratio is negative and statistically significant at 10% to return on
asset. The impact of reserve ratio on bank performance is negative and significant. Bank liquidity
which is measured in terms of liquid asset to total asset does not have any significant effect and
the parameter is negative. Bank size had statistically significant positive effect on bank
performance

Yenesew (2012) investigated the impact of corporate governance mechanisms on firms' financial
performance using five year data from the year 2007 to 2011 with a sample of eight Ethiopian
state and private commercial banks. Financial performance indicators such as return on asset,
return on equity and net Interest margin were used. Corporate governance mechanisms
considered included board size, board gender diversity, board members educational qualification,
board members business management and industry specific experience, and audit committee
size. The study controls the effect of size, leverage and growth of banks. Results show that board
size has a negative and insignificant relation with return on asset. The relationship between board

22
gender diversity and return on asset is positive and insignificant. Board members educational
qualification has a positive and significant effect on return on asset. Business management and
industry specific experience both have positive effect on return on asset but with insignificant
and significant levels respectively. Audit committee size has a negative and significant effect on
the return on asset. Bank size has negative and insignificant effect on the return on asset.
Leverage has positive and significant effect on return on asset.

2.6 Research Gap

Corporate Governance is important in all organizations regardless of their industry, size or level
of growth. Good Corporate Governance has a positive economic impact on the Institution in
question as it saves the organization from various losses such as those occasioned by frauds,
corruption and similar irregularities. Besides it also spurs entrepreneurial innovation enabling the
organization to better seize the economic opportunities that come its way.

The main Corporate Governance themes that are currently receiving attention are adequately
separating management from the board to ensure that the board is directing and supervising
management, including separating the chairperson and chief executive roles; ensuring that the
board has an effective mix of independent and non-independent directors; and establishing the
independence of the auditor and therefore the integrity of financial reporting, including
establishing an audit committee of the board.

Good Corporate Governance aims at increasing profitability and efficiency of organizations and
their enhanced ability to create wealth for shareholders, increased employment opportunities
with better terms for workers and benefits to stakeholders. Thus, the main tasks of Corporate
Governance refer to: assuring corporate efficiency and mitigating arising conflicts providing for
transparency and legitimacy of corporate activity, lowering risk for investments and providing
high returns for investors and delivering framework for managerial accountability.

The studies cited in the literature mostly concentrate on the developed countries whose strategic
approach and Corporate Governance systems are not similar to that of Ethiopia. In Ethiopia,
study done on insurance corporate governances are very few in numbers as cited in the literature

23
above. Bonsa (2015), Hailab, (2014) and Demis, (2013) Studied to investigate the corporate
governance mechanism and their impact on performance of insurers in Ethiopia.

Generally, earlier studies have been made huge contributions to the corporate governance and
financial performance; they were attention towards the developed countries. However,
developing countries received little attention in various literatures on issue, consequently, a
design feature that works well in one country/industry may not work in another. policy and
strategy of any country or industry depends on a number of factors that are unique and contextual
to that country or industry. Given the policy objective, the strategy, programs depend on the
institutional arrangements of formulating and implementing macro and micro economic structure
of the economy as well as the intensity of involving on international economic and financial
activities. The policy and administrative strategy designed for each country or industry has to be
determined carefully in light of the conditions, objectives and nature of that country or industry.

2.7 Conceptual Framework

Corporate Governance Mechanisms Financial Performance

Independent Variables Dependent Variables

1. Board size
2. Board Gender Diversity
3. Educational Qualification
4. Number of Board
meeting
ROA
5. Audit Committee size
ROE
6. Board Independence

Control Variables
1. Firm Size
2. Leverage

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 CHAPTER THREE

RESEARCH DESIGN AND METHODOLOGY

3.1. Introduction
The purpose of this chapter is to present the research methodology adopted in the study. It has
sub-sections presenting the research design, population and sampling technique used, study
variables and their measurements, data sources and collection methods, data analysis method and
model specification.

3.2. Research Design

The primary aim of this study is to examine the impact of corporate governance mechanisms on
firm's financial performance. To achieve this objective explanatory type of research design with
a mixed approach, more of quantitative, was employed. The explanatory type of research design
helps to identify and evaluate the causal relationships between the different variables under
consideration (Marczyk et al., 2005). So that, in this study the explanatory research design was
employed to examine the relationship of the stated variables. Mixed methods research provides
better (stronger) inferences. Therefore, by using a mixed approach it is able to capitalize the
strength of quantitative and qualitative approach and remove any biases that exist in any single
research method (Creswell, 2003). A panel data study design which combines the attributes of
cross-sectional (inter-firm) and time series data (inter-period) was used. The advantage of panel
data analysis is that more reliable estimates of the parameters in the model can be obtained
(Gujarati, 2004).

25
3.3. Population and Sample selection
The sample selected for this research was selected companies listed by National Bank of
Ethiopia (NBE). In Ethiopia there are 16 private and one government insurance companies
registered. This study sought to investigate the effects of Corporate Governance on the financial
performance of selected insurance firms in Ethiopia. The data of the study is collected for the
period covering 2010 to 2018; hence, purposive sampling technique is used to select the
insurances that have relevant data for the selected time frame. 10 insurers, hence, are the selected
sample of study as they fulfill the requirement of the time frame selected having being
operational and data available for full fiscal years since 2010. The ten-year period is selected to
capture at least two-term tenure of board directors. The sample of insurances are Awash
Insurance, United Insurance, Cooperative Bank of Oromia, Dashen Bank, Lion International
Bank, Nib International Bank, Oromia International Bank, United Bank, Wegagen Bank, and
Zemen Bank.

Source

3.4. Source of Data and Data Collection Method

The study has employed secondary data by reviewing of annual reports, financial statements, and
other relevant documents of the selected insurance firms, documents of the regulatory bodies and
other pertinent offices have been used as the sources of secondary data collection. These data is
obtained from National Bank of Ethiopia. The secondary data provides a reliable source of the
information needed by researchers to investigate the phenomenon and seek efficient ways for
problem solving situations (Sekaran, 2003). The data required for this study was collected from
the annual reports of the companies as in the end of 2012. Specifically, they were collected from
the annual reports particularly from the portion expounding on corporate information and
statement of corporate governance as well as from the director's profile. Regarding the data
related to the firm performance, they were collected from financial statements like balance sheet,
income statement, and cash flow statement provided in the annual reports.

3.5. Method of Data Analysis

In this study to analyze the collected data both descriptive, correlation and multiple panel linear
regression data analysis method were employed. The descriptive statistics was used to
quantitatively describe the important features of the variables using mean, maximum, minimum

26
and standard deviations. The correlation analysis was used to identify the relationship between
the independent, dependent and control variables using Pearson correlation analysis. The
correlation analysis shows only the degree of association between variables and does not permit
the researcher to make causal inferences regarding the relationship between variables (Marczyk
et al., 2005). Therefore, multiple panel linear regression analysis was also used to test the
hypothesis and to explain the relationship between corporate governance variables and financial
performance measures by controlling the influence of some selected variables. STATA 11,
software was used for analysis and the results were presented through tables.

3.6. Description of variables and measurements

In this study, the variables were selected based on alternative theories and previous empirical
studies related to corporate governance and firm performance. In accordance with the theory and
empirical studies, the independent, dependent and control variables of the study as proxies will
be identified in order to investigate the impact of corporate governance mechanisms on firms’
financial performance. Operational definitions of the constructs have been included.

Agency theory, stakeholder theory, resource dependency theory, transaction cost theory are used
as base to select the variables. Moreover, empirical studies reviewed have used the variables as
proxies for governance mechanism. Mahan and Marimuthu, (2015); Hailab (2014); Demis
(2013); Ben et al. (2015); Mohammed, (2011); Abdulazeez, Ndibe and Mercy (2016); HifzaI.and
Aqeel M. (2014); Mahan and Marimuthu, (2015); Xavier, Shukla, Oduor, Mbabazize (2015) are
to site few of the reviewed empirical literature that have used the variables as proxies for
corporate governance.

Dependent Variable

In this study, the dependent variable is variable that is used to measure the financial performance
of insurance firms. The frequently used profitability measure was used Return on assets (ROA)
and return on equity (ROE).

27
Return on Assets (ROA) - measures the overall efficiency of management. It gives an idea as to
how efficient management is at using its assets to generate earnings. It is measured as;

Profit After Tax

Return on asset (ROA) ¿
Total asset

Return on Equity (ROE) - measures a firm’s financial performance by revealing how much
profit a company generates with the money shareholders have invested. It shows how well the
shareholders’ funds are managed and used to generate return.

Independent variables
In this study, the independent variables are variables that are used as a determinant of corporate
governance of the sample Ethiopian insurance firms. The independent variables of the study are
board size, board gender diversity, and educational qualification, Number of board meeting,
audit committee size, board independence, leverage and firm size. The definition and
measurements of the variables are as follows:

Board size

It can be defined as the number of directors sitting on the board. It is a measure of the total
number of members serving as board of director. According to agency theory limiting board size
to a particular level is generally believed to be improving financial performance. The reason is
that the benefit of larger boards is outweighed by the poor communication and decision making
when the board size is too large.

Board gender diversity

Board gender diversity is measured as the percentage of number of female directors divided by
the total number of board members.

Educational Qualification

28
It is measured by the proportion of board members who had college degree or higher to the total
number of board members. Educational qualification is an important determinant of board
effectiveness.

Number of Board Meeting

Meeting frequency refers to how many time Board members meet within a year.

Audit committee size

Audit committees are sub-committee of the board of the company. It is a very important
corporate governance mechanism with the objective of enhancing the credibility and integrity of
financial information produced by the company and to increase public confidence in the financial
statements. Measured as the count of the total number of board sub-committees within the banks.

Board Composition

Board composition is the proportion of independent directors to the total number of directors.
Boards mostly compose of executive and non-executive directors. Executive directors refer to
dependent directors and non-Executive directors to independent directors (Shah et aI. 2011).
Independent directors are directors who have no personal affiliations or business dealings with
the firm but in Ethiopian context independent directors are directors those have owns the share of
the particular company and not the member of the management team.

Control Variable

In this study two control variables, namely, bank size and firm leverage included to account its
potential influence on banks' financial performance in order to know the selected explanatory
variables effect on bank’ financial performance.

Firm size:-The natural logarithm of total assets at year-end.

Leverage: - The ratio of total liabilities to total assets.

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30