The International Journal of

R
VOLUME 8
Business and Finance
ESEARCH
NUMBER 2 2014

CONTENTS

New Evidence from S&P 500 Index Deletions 1

Rashiqa Kamal

The Interplay between Director Compensation and CEO Compensation 11

Dan Lin & Lu Lin

The Relationship between Brand Image and Purchase Intention: Evidence from
Award Winning Mutual Funds 27
Ya-Hui Wang & Cing-Fen Tsai

Time Series Modeling and Forecasting Inflation: Evidence from Nigeria 41

Ikechukwu Kelikume & Adedoyin Salami

Capital Structure Determinants of Publicly Listed Companies in Saudi Arabia 53

Turki SF Alzomaia

Cost Efficiency of Ghana’s Banking Industry: A Panel Data Analysis 69

Kofi Adjei-Frimpong, Christopher Gan & Baiding Hu

Effects of Service Innovation on Financial Performance of Small Audit Firms in

Taiwan 87
Yi-Fang Yang, Lee-Wen Yang & Yahn-Shir Chen

The Association between Firm Characteristics and Corporate Financial Disclosures:

Evidence from UAE Companies 101
Khaled Aljifri, Abdulkareem Alzarouni, Chew Ng & Mohammad Iqbal Tahir
The International Journal of Business and Finance Research ♦ VOLUME 8 ♦ NUMBER 2 ♦ 2014

NEW EVIDENCE FROM S&P 500 INDEX DELETIONS

Rashiqa Kamal, University of Wisconsin-Whitewater

ABSTRACT

Kamal, Lawrence, McCabe, and Prakash (2012) argue that information asymmetry exists in the financial
markets and additions to S&P 500 Index convey new information about the added firms to the uninformed
investors. They further argue that because of important changes and regulations in the financial markets,
like, Regulation Fair Disclosure, Sarbanes-Oxley Act, and Decimalization of the exchanges, in or after
the year 2000, information asymmetry has decreased. In support of their arguments, they find that for
additions, the positive abnormal returns on announcement day have decreased, and added stocks’
liquidity changes have become marginal in the post-2000 period. We extend their work and for a sample
of deletions between October 1989 and December 2011, we find that the negative abnormal returns on
the announcement day are not significantly different in the post-2000 period, but the negative returns are
reversed earlier in the post-2000 period. Contrary to our expectation, liquidity changes after deletion are
significant in the post-2000 period. However, when we divide our sample into optioned versus non-
optioned stocks and control for other factors that affect liquidity, we find that liquidity changes after
deletion are insignificant in the post-2000 period.

JEL: G12; G14

KEYWORDS: S&P 500 Deletions, Information Asymmetry, Liquidity Changes

INTRODUCTION

R esearch on additions to and deletions from the Standard and Poor’s (S&P) 500 Index has recorded
significant abnormal returns (Shleifer, 1986, Beneish and Whaley, 1996, 2002, Lynch and
Mendenhall, 1997, Dash, 2002, and Chen, Noronha and Singal 2004, 2006a, b) and changes in
liquidity (Beneish and Whaley, 1996, Erwin and Miller, 1998, and Hegde and McDermott, 2003) around
these events. Several theories have been put forward to explain the price effects around index changes.
The downward-sloping demand curve hypothesis (Shleifer, 1986) argues that index funds, which buy
stocks added to the S&P 500 to replicate the market, drive price movements associated with S&P 500
inclusion announcements. However, the information hypothesis (Jain, 1987, Dhillon and Johnson, 1991,
Denis, McConnell, Ovtchinnikov and Yu, 2003) states that inclusion in the index conveys positive
information about the stock and thus, drives up the price. Cai (2007) argues that addition to the S&P 500
Index conveys favorable information about the stock and the industry and hence, can be considered a
partial explanation for the positive price effect of additions to the S&P 500.

Recently, Kamal, Lawrence, McCabe and Prakash (2012) argue that additions to the S&P 500 provide
information about the performance and future prospects of a firm and hence, reduce the informational
asymmetry amongst investors, resulting in a significant positive abnormal return and an increase in stock
liquidity on the announcement of firm’s addition to S&P 500 (pg. 381). Kamal et al. (2012) further argue
that the information environment has changed after the year 2000 due to important regulations and
changes in the financial markets. They categorize the additions to the S&P 500 Index into two sub-
periods, namely, pre- and post-2000 periods and show that for additions to the S&P 500, abnormal returns
have reduced in the post-2000 period, whereas, liquidity of the added firms’ stock has become marginal.
In light of their arguments, it would be worthwhile to test whether deletions from S&P 500 also
experience similar changes in abnormal returns and liquidity around the announcement and effective days
in pre- and post-2000 periods. Even though there is a plethora of literature around S&P 500 Index
changes, Chen, Noronha and Singal (2004) rightly observe that most of the researchers have focused on

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R. Kamal | IJBFR ♦ Vol. 8 ♦ No. 2 ♦ 2014

additions. Hegde and McDermott (2003) argue that deletions have unique characteristics that make them
noisier events than additions to study (pg. 452). Even though the two aforementioned studies have
attempted to address deletions, as such, it is fair to say that there is still a void in the literature regarding
the study of deletions from the S&P 500. A recent study by Ivanov (2010) uses a sample of discretionary
deletions between October 1989 and December 2007 and shows that firms with analyst following, after
deletion, experience an increase in earnings forecasts and actual forecasts, which is contrary to the
predictions of the information hypothesis. If Kamal et al (2012)’s observation that the information
environment has changed after the year 2000 is accurate, then it could be possible that Ivanov (2010)’s
results are affected by this phenomenon.

The purpose of this study is to extend the work of Kamal et al (2012) to deletions from the S&P 500
Index, in an attempt to fill the void in this area of research. We study deletions from the S&P 500 Index
between October 1989 to December 2011, and divide the sample period into pre- and post-2000 periods.
Researchers have found significant negative abnormal returns around the announcement day and effective
day of stocks deleted from the S&P 500 (Lynch and Mendenhall, 1997; Dash, 2002; Beneish and Whaley,
2002), and significant decrease in liquidity after announcement, of deleted stocks (Beneish and Whaley,
1996, and Hegde and McDermott, 2003). Extending the argument of Kamal et al (2012) to deletions, due
to reduced information asymmetry in the post-2000 period, we expect the negative abnormal return on the
announcement day of deletions to be significantly smaller or marginal in the post-2000 period, as
compared to the pre-2000 period. We also expect the increase in the relative bid-ask spread (or the
decrease in liquidity) after deletion to be marginal in the post-2000 period, as compared to the pre-2000
period. Using standard event-study methodology, we calculate the average abnormal returns on
announcement day for deletions and compare them across the pre- and post-2000 periods.

We find that for the sample of deletions, the average abnormal return on the announcement day is
negative and insignificant in the post-2000 period but it is not significantly different from the negative
average abnormal return in the pre-2000 period. The same is true for the cumulative abnormal returns
between the announcement day and the effective day. However, we find that in the post-2000 period the
negative cumulative abnormal returns are reversed in 20 days after the effective day, as compared to in 60
days after the effective day in the pre-2000 period. We argue that the early reversal of abnormal returns in
the post-2000 period can be attributed to reduced information asymmetry in the post-2000 period, as
found for additions to S&P 500, by Kamal et al (2102). Then we calculate and compare the average
relative bid-ask spreads before and after announcement of deletion, in the pre- and post-2000 periods.
Contrary to our expectation, we find that even though the relative spread is smaller in magnitude in the
post-2000 period, the increase in spread is significant in the post-2000 period.

Erwin and Miller (1998) and Kamal et al (2012) argue that due to informational efficiencies already
achieved by optioned stocks, optioned and non-optioned stocks behave differently on addition to the S&P
500 Index. Following them, we separate our sample of deleted stocks into optioned and non-optioned
stocks, that is stocks that were trading options at the time of announcement of deletion, and stocks that
were not trading options at the time of announcement of deletion, and compare the changes in relative
spread before and after announcement, in the pre- and post-2000 periods, by setting up a multivariate
regression. After controlling for price, volume, and return variance, as expected, we find that the changes
in spread of non-optioned stocks are insignificant in the post-2000 period. However, we are cautious in
evaluating these results because of the limited sample size for the pre-2000 period. Overall, our results
show some evidence that the information environment has changed in the post-2000 period, with respect
to deletions from the S&P 500 Index. The rest of the paper is organized in the following way: the next
section reviews the literature briefly, followed by the section on data and methodology. Results are
discussed after that, and the last section concludes.

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The International Journal of Business and Finance Research ♦ VOLUME 8 ♦ NUMBER 2 ♦ 2014

LITERATURE REVIEW

The abnormal returns followed by additions to or deletions from the S&P 500 Index have been a widely
researched phenomenon. Several authors have put forward various theories to explain these returns. One
of the explanations for the price changes around additions to and deletions from the S&P 500 index is the
price pressure effect. Evidence of temporary price pressure is presented by Harris and Gurel (1986) who
find a reversal of the initial price response, associated with additions to or deletions from the S&P 500.
Lynch and Mendenhall (1997) show that a part of the price decrease resulting from deletions, remains
permanent and that it cannot be explained by price pressure effect. Dash (2002) shows that the short-term
price reactions, associated with deletions from the index are reversed within six days. Chen, Noronha and
Singal (2004, 2006a) find a temporary price effect for deletions from the S&P 500 index and they put
forward the concept of “investor awareness” which states that increased investor awareness for added
stocks and a corresponding smaller drop in the awareness for deleted stocks can explain asymmetric price
effect around additions to and deletions from S&P 500 Index.

However, Beneish and Whaley (2002) present evidence that suggests that deleted firms do not fully
recoup their losses, thus they might have information content. Denis, McConnell, Ovtchinnikov and Yu
(2003) examine a sample of additions between 1987 and 1999 and find that these firms experience an
increase in realized earnings per share and forecasted earnings per share. As such, their findings support
the information hypothesis of the price reaction to index additions. Extending their work, Ivanov (2010)
tests whether discretionary deletions from the S&P 500 display similar information content and finds that
contrary to the predictions of the information hypothesis, the earnings forecasts and actual earnings of
deleted firms increase, on average. Recently, Kamal, Lawrence, Prakash and McCabe (2012) analyze
additions to the S&P 500 index by dividing them into pre- and post-2000 periods and find that the
positive abnormal returns around the announcement day decreased significantly in the post-2000 period.

They also find that the change in the liquidity of added stocks has become marginal in the post-2000
period. They attribute these findings to the changes in the information environment in the post-2000
period. They argue that passage of important regulations in the post-2000 period (namely, Regulation Fair
Disclosure in October 2000, Decimalization of NYSE and NASDAQ in 2001, and Sarbanes-Oxley Act in
October 2002) has decreased the information asymmetry in this period and hence, announcements of
additions to S&P 500 are not as informative as they used to be in the pre-2000 period.

Another possible explanation for the price effects is the liquidity hypothesis that states that inclusion in an
index may have valuation consequences because it increases a stock's liquidity. The supporters of this
view (like, Erwin and Miller, 1998) argue that inclusion may result in greater institutional interest in the
stock leading to an increase in public information about it. As a result, the stock will be held more widely,
will become more liquid and the bid-ask spread will fall which lowers the required rate of return on the
stock and leads to a price increase. Erwin and Miller (1998) use a sample of 109 additions over the period
1984-1989 and examine the changes in stock liquidity when the stock is added to S&P500 and find a
significant decrease in the bid-ask spread upon addition to S&P 500 for the stocks that were not trading
listed options. They also find that these liquidity effects are mitigated for those stocks that were already
trading listed options and the reduction in bid-ask spread is more prominent for the non-optioned stocks.

Beneish and Whaley (1996) study a sample of 103 additions between 1989 and 1994 and find that
spread decreases after announcement. Hegde and McDermott (2003) use a sample of 74 (27) firms over
the period 1993-1998 and find a sustained increase (decrease) in the liquidity of added (deleted) stocks.
The explanation for the change in liquidity is supported by sound theoretical arguments. According to
Shleifer (1986), addition of stocks to S&P 500 may result in closer scrutiny of firm by analysts and
investors leading to greater institutional interests, large trading volumes and lower bid-ask spreads. Hegde
and McDermott (2003) argue that change in the composition of equity ownership may increase the

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R. Kamal | IJBFR ♦ Vol. 8 ♦ No. 2 ♦ 2014

proportion of liquidity-motivated traders and greater competition amongst informed traders leading to
improvement in the liquidity of added stock.

DATA AND METHODOLOGY

The S&P 500 index started pre-announcing index changes beginning in October 1989; hence, in this
paper, the sample period covers deletions from October 1989 to December 2011. We examine the
abnormal returns around announcement (AD) and effective days (ED) for the entire period and then split
up the period into pre- and post-2000 years. Following Kamal et al (2012), we define deletions occurring
up to September 2000 as the pre-2000 period and deletions occurring after that period as the post-2000
period. We exclude deletions announced in October 2000 when Regulation Fair Disclosure was
implemented. Some of the reasons that S&P removes a company from the 500 Index are the filing of
Chapter 11 by the company or approval of an alternative recapitalization plan by the shareholders of the
company that changes the company’s debt/equity mix or cessation of the company in its current form due
to reasons like mergers, acquisitions, and takeovers. Chen et al (2004) argue that due to requirement of
post-announcement data, the sample will be biased because firms that cease to exist after the
announcement will not be included in the sample.

Hence, we follow the methodology of Chen et al (2004) to create a “survivorship bias” free sample, and
after excluding deletions that resulted from mergers, acquisitions, spinoffs, bankruptcies, liquidation
proceedings, and leveraged buyouts, our sample consists of 120 deletions. Fifty-one of these are
announced in the pre-2000 period and 69 are announced in the post-2000 period. Daily returns required
to calculate the abnormal returns are obtained from Center for Research in Security Prices (CRSP). Firms
for which returns were not available for 245 days prior to announcement date were dropped because these
returns were used to compute the beta for calculation of risk-adjusted returns. After imposing these data
requirement restrictions, and one outlier, the final sample consists of total 115 deletions, out of which 51
were announced in the pre-2000 period and 64 were announced in the post-2000 period. For liquidity
tests, to test for a change in the bid-ask spread when a stock is deleted from S&P 500 we obtain daily bid
and ask closing quotes during the period 30 trading days before and 30 trading days after the
announcement of deletion for each stock. We eliminate all firms with data less than 58 days. Daily stock
spread data, stock price, return and trading volume data are obtained from the CRSP database. After
excluding the firms with unavailable data there are 42 firms in our pre-2000 sample and 48 firms in the
post-2000 sample, for liquidity tests. Information of option trading is obtained from “CBOE Equity
Option Volume Archive”, http://www.cboe.com/data/AvgDailyVolArchive1998.aspx, and since this
information is available only for the year 1998 and forward, our pre-2000 sample is reduced to only 15
deletions. Out of these 15 deletions, eight stocks trade options at the time of deletion announcement, and
seven do not trade options. In the post-2000 sample, at the time stocks were deleted from the S&P 500
index, 42 were trading listed options while 6 were not.

This paper basically follows the methodology of Kamal et al (2012). To calculate the average abnormal
returns (AARs) and the cumulative abnormal returns (CARs), we use the standard event-study
methodology, with the announcement date of deletion as the event date. To compare liquidity changes
around announcement date of deletions, in the pre- and post-2000 period, we calculate the absolute spread
as the difference between the ask and bid prices. The relative spread is the absolute spread divided by the
mean of the ask and bid prices. Similar to Erwin and Miller (1998) and Kamal et al (2012), we test for
changes in bid-ask spread while controlling for share price, trading volume and return variance. Return
variance on day t is estimated using the variance of the stock’s return over the five-day period
immediately preceding day t. The following multivariate model is estimated:

𝑆𝑝𝑟𝑒𝑎𝑑𝑖𝑡 = 𝜆0 + 𝜆1 𝑇𝑖𝑚𝑒𝐷𝑢𝑚𝑚𝑦𝑖𝑡 + 𝜆2 𝑃𝑟𝑖𝑐𝑒𝑖𝑡 + 𝜆3 𝑉𝑜𝑙𝑢𝑚𝑒𝑖𝑡 + 𝜆4 𝑉𝑎𝑟𝑖𝑎𝑛𝑐𝑒𝑖𝑡 + 𝜀𝑖𝑡 (1)

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The International Journal of Business and Finance Research ♦ VOLUME 8 ♦ NUMBER 2 ♦ 2014

where Spreadit, Priceit, Volumeit, and Varianceit, are the relative bid-ask spread, the closing share price,
the trading volume and an estimate of return variance, respectively. TimeDummyit is a dummy variable
which equals 1(0) in the 30 trading days before (after) announcement day for firm i on day t. Table 1
presents the summary statistics for 42 (48) firms deleted from the S&P 500 Index in the pre (post)-2000
period, 30 trading days before, and 30 trading days after the announcement of deletion. The table reports
the mean, median and standard deviation for the relative spread, the closing share price, the adjusted
volume, and the return variance.

Table 1: Summary Statistics for 90 Firms Deleted from the S&P 500 Index between October 1989 and
December 2011

Pre-2000 period (42 firms) Post-2000 period (48 firms)

Mean Median Stdev Mean Median Stdev
30 days before deletion Relative 0.030 0.025 0.022 0.005 0.002 0.010
Spread
Price 20.18 13.38 23.83 15.88 11.65 14.93
Volume 585,239 124,000 1,707,550 6,324,206 2,391,900 22,775,069
Return 0.001 0.0004 0.001 0.004 0.001 0.15
variance
30 days after deletion Relative 0.032 0.024 0.026 0.006 0.002 0.010
Spread
Price 17.86 13.13 23.27 13.86 10.50 13.58
Volume 741,862 244,000 1,727,751 9,630,464 3,287,450 26,453,010
Return 0.001 0.001 0.002 0.009 0.001 0.037
variance
This table shows the mean, median and the standard deviation for the relative bid/ask spread, the closing share price, adjusted volume, and the
return variance for 42(48) firms deleted in the pre(post)-2000 period, 30 trading days before and 30 trading days after the announcement of
deletion. The relative spread is the absolute spread (difference between ask and bid prices) divided by the mean of the ask and bid prices. Return
variance on day t is estimated using the variance of the stock’s return over the five-day period immediately preceding day t.

RESULTS AND DISCUSSION

Panel A of Table 2 shows that for the entire sample of 115 deletions from October 1989 to December
2011, the announcement day average abnormal return is -3.26% and it is significant at the 1% level. This
result is consistent with previous research (like, Chen et al, 2004, find significant abnormal returns equal
to -7.82% for 16 deletions between March 1990 and April 1995). Panel B of Table 2, reports the
announcement day average abnormal return for the pre-2000 period sample as significant -4.34%, and the
post-2000 sample has an insignificant return of -2.40%. However, these returns are not significantly
different (t-stat=1.16). This shows that our results for deletions do not support the results for additions to
S&P 500 as presented by Kamal et al (2012), and we find that the negative abnormal returns around the
announcement days of deletions are not significantly different in the pre- and post-2000 periods.

Table 2: Announcement Day Average Abnormal Return For Deletions from the S&P 500 Index

Panel A: For all deleted firms 1989-2011 (115 firms)

AAR t-stat
-3.26%*** 3.59
Panel B: Comparison of Pre- versus Post-2000
Pre-2000 (51 firms) Post-2000 (64 firms) Comparison of Pre- versus Post-2000
AAR t-stat AAR t-stat t-stat
-4.34%*** 7.23 -2.40% 1.54 1.16
This table presents the announcement day average abnormal return (AAR) for firms deleted from the S&P 500 during October 1989-December
2011, in Panel A, and in the pre- and post-2000 period, in Panel B. Deletions occurring up to September 2000 are defined as the pre-2000 period
and deletions occurring after that period as the post-2000 period. AARs are calculated using the standard event-study methodology. ***, **, and
* indicate significance at the 1, 5 and 10 percent levels respectively.

Next, we examine the permanence of the negative abnormal returns. Table 3 presents the cumulative
abnormal return for deletions between the announcement day and the effective day, and 20 and 60 days

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R. Kamal | IJBFR ♦ Vol. 8 ♦ No. 2 ♦ 2014

after the effective day. Previous research has shown that the negative announcement day average
abnormal returns around deletions from the S&P 500 are not permanent and that the effect is reversed
shortly (Chen et al, 2004, find that for 46 deletions between 1996 and 2001, the stocks recover their losses
60 days after the effective day). For this analysis, our sample is reduced to 106 firms because we need
data after 60 days from the effective day. Panel A of Table 3 shows the cumulative abnormal return for
the entire sample period and overall our results support the findings in the current literature. We find that
the negative cumulative abnormal returns are reversed within 20 days (0.22%) after the effective day but
it is significantly reversed only after 60 days (0.27%) of the effective day. Panel B of Table 3 presents the
cumulative abnormal return for the deletions in the pre- and post-2000 period.

The results show that the cumulative abnormal return between announcement day and effective day is
negative and significant in both pre- and post-2000 periods, but they are not significantly different from
each other. The interesting result here is that the negative abnormal returns are reversed earlier in the
post-2000 period. Panel B of Table 3 shows that the cumulative abnormal return between announcement
day and 20 days after effective day is significant -0.20%, and in the post-2000 period, it is significant
0.58%. These returns are significantly different from each other. Furthermore, the cumulative abnormal
returns between the announcement day and 60 days after the effective day are insignificant in the pre-
2000 period but positive and significant in the post-2000 period. This result suggests that in the post-2000
period, the negative returns around deletions do not last as long as in the pre-2000 period. This result
indicates that probably the announcement of deletion does not convey much new information in the post-
2000 period, or information asymmetry has decreased in the post-2000 period.

Table 3: Cumulative Abnormal Return for Deletions from the S&P 500 Index

Panel A: For all deleted firms 1989-2011 (106 firms)

CAR t-stat
AD -3.99%*** 3.69
AD to ED -2.54%*** 3.63
AD to ED+20 0.22% 1.42
AD to ED+60 0.27%*** 3.24
Panel B: Comparison of Pre- versus Post-2000
Pre-2000 (49 firms) Post-2000 (57 firms) Comparison of Pre- versus
Post-2000
CAR t-stat CAR t-stat t-stat
AD -4.21%*** 7.23 -3.79%** 1.94 0.20
AD to ED -2.20%*** 6.15 -2.83%*** 2.23 0.48
AD to ED+20 -0.20%*** 2.15 0.58%*** 2.15 2.73***
AD to ED+60 0.03% 0.53 0.47%*** 3.36 2.90***
This table presents the cumulative abnormal return (CAR) for firms deleted from the S&P 500 during October 1989-December 2011, in Panel A,
and in the pre- and post-2000 period, in Panel B. Deletions occurring up to September 2000 are defined as the pre-2000 period and deletions
occurring after that period as the post-2000 period. CARs are calculated using the standard event-study methodology. ***, **, and * indicate
significance at the 1, 5 and 10 percent levels respectively.

Overall, from the results presented in Tables 2 and 3, we do not find that the abnormal returns around the
announcement of deletions from the S&P 500 have changed much in the pre- and post-2000 period. Even
though our results do not show significant difference in the two sub-periods, for completeness’ sake,
following Kamal et al (2012), we also estimate a multivariate regression with the announcement day
average abnormal return as the dependent variable and a dummy variable for the pre-2000 period, a
dummy variable for technology firms, a dummy variable for the exchange on which the stock is listed, a
dummy variable for bull market, log of the relative size, and shadow cost, as independent variables (pg.
391). We did not find any significance in this regression; hence, the results are not reported here.

Another way that we want to test whether the information content of deletions’ announcement has
changed in the post-2000 period is to examine the change in liquidity of the deleted stocks before and
after announcement, in the pre- and post-2000 period. Table 4 presents the results of this examination. We

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calculate the relative bid-ask spread for the 30 days before and 30 days after the announcement of
deletion for the entire sample, and for the pre- and post-2000 sample periods. Column 1 of Table 4 shows
that for the entire sample, the relative bid-ask spread for deleted stocks significantly increases in the
period after the announcement of the deletion. Columns 2 and 3 of Table 4 report the relative bid-ask
spread in the pre- and post-2000 periods, respectively. We find that the relative spread increases (hence,
liquidity decreases) in both the sub-samples but the spread increases significantly in the post-2000 period.
This finding is contrary to our expectation that if information asymmetry has reduced in the post-2000
period, there should be insignificant increase in the spread of deleted stocks in the post-2000 period.

Table 4: Relative Bid-Ask Spread before and after Announcement of Deletion from S&P 500 Index

Complete Sample (1989-2011) Pre-200 period Post-2000 period

Spread before index deletion 0.0168 0.0303 0.0049

Standard Deviation 0.0208 0.0217 0.0100

Spread after index deletion 0.0181 0.0317 0.0061
Standard Deviation 0.0228 0.0257 0.0098
T-stat for equality 2.23 1.48 3.13
p-value 0.03 0.14 0.002
Number of stocks 90 42 48
This table presents the average relative bid-ask spreads before and after deletions from the S&P 500 index. Relative spread is the absolute
spread divided by the mean of the ask and bid prices. Average spread is the difference between ask and bid prices. The spreads prior to deletion
are calculated over the 30 trading days before announcement date of deletion and the spreads in the post deletion period are calculated over 30
trading days after the announcement date of deletion. Column 1 presents the relative bid-ask spread for the entire sample, and columns 2 and 3
present the spreads in the pre- and post-2000 periods, respectively.

Research has shown that spread can also be affected by other factors, so next, we estimate regression
equation (1) described in the previous section.

𝑆𝑝𝑟𝑒𝑎𝑑𝑖𝑡 = 𝜆0 + 𝜆1 𝑇𝑖𝑚𝑒𝐷𝑢𝑚𝑚𝑦𝑖𝑡 + 𝜆2 𝑃𝑟𝑖𝑐𝑒𝑖𝑡 + 𝜆3 𝑉𝑜𝑙𝑢𝑚𝑒𝑖𝑡 + 𝜆4 𝑉𝑎𝑟𝑖𝑎𝑛𝑐𝑒𝑖𝑡 + 𝜀𝑖𝑡 (1)

where Spreadit, Priceit, Volumeit, and Varianceit, are the relative bid-ask spread, the closing share price,
the trading volume and an estimate of return variance, respectively. TimeDummyit is a dummy variable
which equals 1(0) in the 30 trading days before (after) announcement day for firm i on day t. Results are
presented in Table 5. The univariate results in Table 4 are also supported by the multivariate results
presented in Table 5. TimeDummy is a dummy variable that is equal to 1 (0) in the 30 days trading day
before (after) announcement of deletion from the S&P 500 Index. According to our hypothesis, we expect
this time dummy variable to be negative (indicating an increase in spread after announcement of deletion)
and insignificant in the post-2000 period. In Table 5, we find that the in the post-2000 period, the increase
in the spread after deletion is significant at the 10% level, whereas, it is insignificant in the pre-2000
period. This is contrary to our expectation.

Table 5: Multivariate Regression for Relative Spread of Deletions from the S&P 500 Index

Pre-2000 period Post-2000 period

Intercept 0.032*** 0.008***
Time Dummy 0.0004 -0.0007*
Price -0.0002*** -0.0002***
Volume -0.000*** 0.000
Variance 2.935*** 0.037***
Adjusted R2 0.1390 0.0742
This table presents the estimates for the following multivariate model: Spreadit=λ0+λ1TimeDummyit+λ2Priceit+λ3Volumeit+λ4Varianceit+εit where
Spreadit, Priceit, Volumeit, and Varianceit, are the relative bid/ask spread, the closing share price, the trading volume and an estimate of return
variance, respectively. TimeDummyit is a dummy variable which equals 1(0) in the 30 trading days before (after) announcement day for stock i on
day t. Return variance on day t is estimated using the variance of the stock’s return over the five-day period immediately preceding day t. ***,
**, and * indicate significance at the 1, 5 and 10 percent levels respectively.

Erwin and Miller (1998) show that changes in liquidity after addition to the S&P 500 index can also be
affected by option trading status of the stock at the time of announcement because they find that optioned

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R. Kamal | IJBFR ♦ Vol. 8 ♦ No. 2 ♦ 2014

stocks show no change in liquidity while the non-optioned stocks show a significant increase in liquidity
after addition. They argue that this happens because optioned stocks have already achieved informational
efficiencies, while non-optioned stocks have not. Kamal et al (2012) argue that in the post-2000 period, if
information asymmetry decreases then non-optioned stocks should show diminished or no liquidity
changes. This argument should be true for deletions as well. We also extend our analysis and examine
liquidity changes of optioned versus non-optioned stocks in the pre- and post-2000 period. Results are
presented in Tables 6 and 7. However, we need to point out a limitation of these results. Since the data on
option trading is obtained from Chicago Board of Option Exchange’s options archives page and it reports
this information only for the year 1998 and forward, the number of deleted firms in the pre-2000 period
(15 firms) is small as compared to in the post-2000 period (48 firms). The results should be viewed in
light of this limitation. In Table 6, the results indicate that in the pre- and post-2000 periods, the spread
for optioned stocks increases significantly, or the liquidity decreases, after the announcement of deletion.
For non-optioned stocks, again contrary to expectation, the spread increases significantly after the
announcement of deletion from the index.

Table 6: Relative Bid-Ask Spread before and after Announcement of Deletion for Optioned and Non-
Optioned Stocks

Pre-2000 period Post-2000 period

Optioned Non-optioned Optioned Non-optioned
Spread before index deletion 0.0325 0.0316 0.0059 0.0033
Standard Deviation 0.0214 0.0346 0.0106 0.0053
Spread after index deletion 0.0391 0.0300 0.0061 0.0046
Standard Deviation 0.0315 0.0331 0.0105 0.0061
T-stat for equality 2.68 -0.74 2.32 2.81
p-value 0.008 0.46 0.02 0.005
Number of stocks 8 7 42 6
This table presents the average relative bid-ask spreads before and after deletion from the S&P 500 index, for optioned and non-optioned stocks,
in the pre- and post-2000 periods. Relative spread is the absolute spread divided by the mean of the ask and bid prices. Average spread is the
difference between ask and bid prices. The spreads prior to deletion are calculated over the 30 trading days before announcement date of
deletion and the spreads in the post deletion period are calculated over 30 trading days after the announcement date of deletion.

In Table 7, we estimate the multivariate regression equation (1) for optioned and non-optioned stocks in
the pre- and post-2000 periods. As can be seen in Table 7, the liquidity change after deletion for non-
optioned stocks in the post-2000 period is insignificant (the time dummy variable is insignificant). This is
in accordance with our expectation.

Table 7: Multivariate Regression for Relative Spread of Deletions for Optioned and Non-Optioned Stocks

Pre-2000 period Post-2000 period

Optioned Non-optioned Optioned Non-optioned
Intercept 0.0594*** 0.0278*** 0.0075*** 0.0050***
Time Dummy -0.0044*** 0.0053*** -0.0004 -0.0005
Price -0.0022*** -0.0003*** -0.0002*** -0.0001***
Volume -0.0000*** 0.0000*** -0.0000 -0.0000
Variance 1.3578*** 1.9154*** 0.0381*** 0.5100***
Adjusted R2 0.335 0.239 0.061 0.1427
This table presents the estimates for the following multivariate model, for optioned and non-optioned stocks:
Spreadit=λ0+λ1TimeDummyit+λ2Priceit+λ3Volumeit+λ4Varianceit+εit where Spreadit, Priceit, Volumeit, and Varianceit, are the relative bid/ask
spread, the closing share price, the trading volume and an estimate of return variance, respectively. TimeDummyit is a dummy variable which
equals 1(0) in the 30 trading days before (after) announcement day for stock i on day t. Return variance on day t is estimated using the variance
of the stock’s return over the five-day period immediately preceding day t. ***, **, and * indicate significance at the 1, 5 and 10 percent levels
respectively.

CONCLUDING COMMENTS

This paper revisits the abnormal returns and liquidity changes around deletions from the S&P 500 Index,
in light of new research that argues that the information environment in the financial markets has changed

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The International Journal of Business and Finance Research ♦ VOLUME 8 ♦ NUMBER 2 ♦ 2014

after the year 2000, because of major regulations passed in and after year 2000. By examining and
comparing deletions in the pre- and post-2000 periods, we find some effect of decreased information
asymmetry in the post-2000 period on deletions. Our results indicate that the average abnormal returns
on the announcement day of the deletion are not significantly different in the post-2000 period, from in
the pre-2000 period. However, we do find evidence that the negative abnormal returns after deletion from
the S&P 500 Index are reversed earlier in the post-2000 period from the pre-2000 period.

This could probably be because of reduced information asymmetry in the post-2000 period. We also find
that contrary to our expectations, the average relative bid-ask spread after the announcement of deletion
increases significantly (that is, liquidity after announcement of deletion decreases) in the post-2000
period. If there is reduced information asymmetry in the post-2000 period, we should see only a marginal
increase in the spread in the post-2000 period. However, when we examine optioned versus non-optioned
stocks and control for other factors that affect the relative spread, namely, closing price, trading volume,
and return variance, we find insignificant increase in the spread after announcement of deletion, in the
post- 2000 period, for non-optioned stocks. This is consistent with our expectations. As is true for past
studies on deletions from the S&P 500 Index, the small sample size is obviously a limitation of this study.

REFERENCES

Beneish, M. D. and R. E. Whaley (1996) “An anatomy of the 'S&P 500 game': the effects of changing the
rules,” Journal of Finance 51 (5), 1909-1930

Beneish, M. D. and R. E. Whaley (2002) “S&P 500 index replacements: A new game in town,” The
Journal of Portfolio Management 29 (1), 51-60

Cai, J (2007) “What’s in the news? Information content of S&P 500 additions,” Financial Management
36 (3), 113-124

Chen, H., G. Noronha, and V. Singal (2004) “The price response to S&P 500 index additions and
deletions: evidence of asymmetry and a new explanation,” Journal of Finance 59(4), 1901-1930

Chen, H., G. Noronha, and V. Singal (2006a) “S&P 500 Index Changes and Investor Awareness,”
Journal of Investment Management 4 (2), 23-37

Chen, H., G. Noronha, and V. Singal (2006b) “Index Changes and Losses to Index Fund Investors,”
Financial Analysts Journal 62 (4), 31-47

Dash, S. (2002) “Price Changes Associated with S&P 500 Deletions: Time Variation and Effect of Size
and Share Prices,” Standard & Poor’s, July 9

Denis, D. K., J. J. McConnell, A. V. Ovtchinnikov, and Y. Yu. ( 2003) “S&P 500 Index Additions and
Earnings Expectations,” Journal of Finance 58 (5), 1821-1840

Dhillon, U.S. and H. G. Johnson (1991) “Changes in the Standard and Poor’s 500 list,” Journal of
Business 64 (1), 75-85

Erwin, G.R. and J.M. Miller (1998) “The Liquidity Effects Associated with Additions of A Stock to the
S&P 500 Index: Evidence From Bid/Ask Spreads,” Financial Review 33 (1), 131-146

Harris, L.E. and E. Gurel (1986) “Price and Volume Effects Associated with Changes in the S&P 500
List: New Evidence for the Existence of Price Pressures,” Journal of Finance 41 (4), 815-829

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R. Kamal | IJBFR ♦ Vol. 8 ♦ No. 2 ♦ 2014

Hegde, S. P. and J. B. McDermott (2003) “The Liquidity Effects Of Revisions to the S&P 500 Index: An
Empirical Analysis,” Journal of Financial Markets 6 (3), 413-459

Ivanov, S. (2010) “Discretionary Deletions from the S&P 500 Index: Evidence on Forecasted and
Realized Earnings,” The International Journal of Business and Finance Research 4 (4), 1-9

Jain, P.C. (1987) “The Effect on Stock Price of Inclusion in and Exclusion from the S&P 500,” Financial
Analysts Journal 43 (1), 58-65

Kamal, R., E. Lawrence, G. McCabe, and A. Prakash (2012) “Additions to S&P 500 Index: Not So
Informative Any More”, Managerial Finance 38 (4), 380-402

Lynch, A. W. and R. R. Mendenhall (1997) “New Evidence on Stock Price Effects Associated With
Changes in the S&P 500 Index,” Journal of Business 70 (3), 351-383

Shleifer, A. (1986) “Do Demand Curves for Stocks Slope Down?,” Journal of Finance 41 (3), 579-590

BIOGRAPHY

Dr. Rashiqa Kamal is an Assistant Professor in the Department of Finance and Business Law at the
University of Wisconsin-Whitewater. She can be contacted at: Department of Finance and Business Law,
College of Business and Economics, University of Wisconsin-Whitewater, 800 W. Main St., Whitewater,
WI 53190. E-mail: [email protected]

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The International Journal of Business and Finance Research ♦ VOLUME 8 ♦ NUMBER 2 ♦ 2014

THE INTERPLAY BETWEEN DIRECTOR

COMPENSATION AND CEO COMPENSATION
Dan Lin, Takming University of Science and Technology
Lu Lin, Takming University of Science and Technology

ABSTRACT

This paper empirically examines the determinants of director compensation and CEO compensation and
investigates whether director compensation has an effect on CEO compensation. Based on 713 firms (or
2,852 firm-years) between 2007 and 2010, we find that CEO tenure is related to the ability of the CEO in
influencing the board’s pay determination process. However, sitting on the board does not strengthen the
CEO’s power over the board during the pay negotiation process. More importantly, we find evidence of a
“mutual back scratching” relationship between CEO and the board of directors. Excess director
compensation and CEO compensation are positively related. The results thus support Jensen’s (1993)
argument that as the CEO is involved in the selection of directors, the monitoring role of the board of
directors becomes less effective.

JEL: J33, M52

KEYWORDS: Director Compensation, CEO Compensation, Board of Directors

INTRODUCTION

D ue to the conflicts of interests between outside shareholders and managers in the modern
corporate structure, the board of directors has the fundamental role of monitoring managers to
ensure that managers act in the interest of shareholders. However, as the CEO is often involved in
the selection of directors, Jensen (1993) argues that the board directors may not be an effective monitor.
The board of directors may become more aligned with the CEO, thereby compromising the independence
of the board. Brick et al. (2006) further suggest that when the board of directors is highly compensated,
they are less likely to conduct critical monitoring of the CEO, referred to as “mutual back scratching”.
According to Hermalin and Weisbach (1998), the CEO may also use barriers to monitoring, including
large boards, inside directors, CEO duality, CEO tenure, and CEO membership in nominating committee,
in an attempt to maximize his compensation. Therefore, one objective of this study is to examine whether
director compensation has an effect on CEO compensation by utilizing the excess director compensation
variable, which is the residual from the director compensation model.

After the financial crisis of 2008, the “fat cat problem” highlighted the executive compensation issue.
Recently there have been increasing concerns about the escalation in executive compensation (Dong and
Ozkan, 2008). In particular, the substantial rises in executive pay have far exceeded the increases in
underlying firm performance (Gregg et al., 2005). The review of CEO compensation by Frydman and
Jenter (2010) shows that there was a dramatic increase in compensation levels from the mid‐1970s to the
early 2000s in the US. Especially in the 1990s, the annual growth rates were more than 10% by the end of
the decade. The increase in executive compensation is also evident in firms of all sizes while larger firms
have experienced greater growth. The high level of CEO pay in the U.S. has therefore brought about
considerable debate and a lot of attention from academia and policy makers regarding executive
compensation, in particular, the pay-setting process and the effectiveness of the compensation contracts.

The compensation packages of the top executives are set by the board of directors. After the financial
crisis, the boards of collapsed firms are asked to hold full responsibility because they have not conducted

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D. Lin and L. Lin | IJBFR ♦ Vol. 8 ♦ No. 2 ♦ 2014

appropriate supervision over top executives. In this regard, this study incorporates the characteristics of
the board of directors and the effect of director compensation, in addition to CEO characteristics, when
examining the determinants of CEO compensation.

In short summary, the objective of this study is twofold. First, we analyze the determinants of director
compensation. Based on the director compensation model, we derive the residuals (i.e., “excess director
compensation”). Secondly, we examine whether excess director compensation and a set of CEO and
director characteristics (such as CEO tenure, CEO shareholdings and board size) are related to CEO
compensation.

While the determinants of CEO compensation and the pay-for-performance relationship (Jensen and
Murphy, 1990; Main et al., 1996; Brick et al., 2006; Ozkan, 2007) have been extensively researched, the
compensation structure of the board of directors as a governance mechanism has received less attention
(Cordeiro et al., 2000; Gregg et al., 2005), in particular, the interplay between director compensation and
CEO compensation (Brick et al., 2006). Accordingly, this study makes an important contribution by
linking director compensation with CEO compensation and examines whether there is a “mutual back
scratching” relationship between CEO and the board of directors. That is, whether the CEO receives
higher compensation when the directors are paid more. Specifically, we include an “excess director
compensation” variable in the CEO compensation model. If there is a positive relationship between
excess director compensation and CEO compensation, then a “mutual back scratching” relationship
between the board of directors and the CEO exists. If a negative relationship is observed, it means that the
directors are effective monitors of the top management.

In addition, this study contributes to the literature by adopting multiple measures when analyzing director
compensation. This allows us to examine the director compensation from different perspectives. Unlike
CEO compensation, as there is more than one person sitting on the board of directors, the board of
director compensation may be measured by the total director compensation for the entire board, the
average director compensation, and the compensation of the highest paid director. Most of previous
studies rely on one single measure (for example, Becher et al., 2005; Fernandes, 2008) or differentiate
compensation by cash and stock compensation only (for example, Cordeiro et al., 2000; Brick et al.,
2006). These studies may suffer from the weaknesses inherent in a particular measure. For example, total
director compensation for the entire board may be influenced by the size of the board. The average
director compensation ignores the dispersion within each firm and may be distorted by extreme values.
Using the compensation of the highest paid director may sometimes be measuring the compensation of
the CEO. Therefore, it is important to consider different measures.

Based on 713 firms (or 2,852 firm-years) between 2007 and 2010, we find support for the “mutual back
scratching” relationship between the CEO and the directors. Specifically, excess director compensation
and CEO compensation are positively related. The evidence thus suggests that the directors are not good
monitors of the CEO. The results also support Jensen’s argument. As directors are selected by the CEO,
the effectiveness of directors’ monitoring of the top management is weakened.

The remainder of this paper is organized into five sections. In Section 2, we review the prior empirical
literature on director and CEO compensation and develop the hypotheses tested in this study. In Section 3,
we describe the data, methodology and sample characteristics. In Section 4, we present the results on
director compensation and CEO compensation. A conclusion is provided in Section 5.

LITERATURE REVIEW AND HYPOTHESIS DEVELOPMENT

In modern economies, most companies are characterized by the separation of ownership and control
where the ownership is held by diverse shareholders and the control is in the hands of top executives. As a

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result, shareholders are not able to monitor managers’ actions directly. According to the agency theory,
these companies are likely to suffer from agency problems. That is, managers as the agents may not
always act in the interest of shareholders (i.e., the principals), thereby giving rise to the conflicts of
interests.

The governance structure of the firms, as argued by the agency theorists, can mitigate the potential agency
problem between managers and shareholders arising from the separation of ownership and control, and
therefore, influence the way firms set executive compensation packages (Murphy, 2009). In fact, the
board of directors who is responsible for providing advice to the management and assisting with strategy
development plays a key governance role in monitoring top management (Fama and Jensen, 1983). The
board of directors also has an essential role in setting CEO compensation (Finkelstein and Hambrick,
1988; Boyd, 1994; Barkema and Gomez-Mejia, 1998; Carpenter and Sanders, 2002; Chhaochharia and
Grinstein, 2009). Therefore, one objective of this study is to examine whether the board of directors has
influences over CEO compensation.

An early paper by Finkelstein and Hambrick (1988) provides a synthesis on CEO compensation and
suggests that there are two main set of factors that affect CEO compensation: first, the market factors,
including managerial labor market, marginal products of CEOs, CEO discretion, firm size, firm
performance, and human capital; secondly, the power and preferences of the board and CEO. Consistent
with this view, Ozkan (2007) finds that corporate governance mechanisms have a significant effect on the
level of CEO compensation. Specifically, measures of board and ownership structures explain a
significant amount of cross-sectional variation in CEO total compensation.

Barkema and Gomez-Mejia (1998) propose a general research framework on the relationship between pay
and performance. They argue that criteria, such as the market, peer compensation, individual
characteristics, a firm’s governance structure (including ownership structure, board of directors,
remuneration committee, and market for corporate control), and contingencies (such as a firm’s strategy,
R&D level, market growth, industry concentration and regulation, and national culture), can enhance our
understanding of the determinants of executive pay. Moreover, the managerial power theory argues that
excessive CEO pay is due to the greater power of executives over directors that allows the former to set
their own pay and extract rents (Bebchuk et al, 2002; Bebchuk and Fried, 2004). An implication of the
theory is that enhancing the independence of the board can improve corporate governance and prevent
managers from extracting rents in the form of higher pay (Guthrie et al., 2012).

Therefore, the first objective of this study is to examine the determinants of director compensation. Then,
we investigate if CEO characteristics and director characteristics, including excess director compensation,
have influences over CEO compensation. Specifically, this study adds to the literature on executive
compensation by investigating the effect of director compensation on CEO compensation and testing if
there is a “mutual back scratching” relationship between the CEO and the board of directors. The
hypotheses of this study are developed below.

Director Compensation

Following Hill and Phan (1991), this study uses CEO tenure to proxy for CEO’s ability to exercise
influence over the board of directors. Previous studies (Hermalin and Weisbach, 1991; Shivdasani and
Yermack, 1999) have suggested that CEOs can exert influence over the director selection process. Ryan
and Wiggins (2001) argue that the level of CEO entrenchment and CEO power over the board of directors
increase with CEO tenure. Specifically, they find that firms with long-tenured CEOs (i.e., more
entrenched managers) discourage board scrutiny of management and provide weaker incentives to
directors to monitor management. Therefore, CEO tenure is expected to be negatively associated with
director compensation. That is, the following hypothesis is proposed.

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D. Lin and L. Lin | IJBFR ♦ Vol. 8 ♦ No. 2 ♦ 2014

H1a: CEO tenure will be negatively related to director compensation.

CEO director is an important corporate governance variable that accounts for the CEO influence over the
board. Previous studies (Boyd, 1995; Daily and Schwenk, 1996; Conyon and Peck, 1998; Cordeiro and
Veliyath, 2003) have mostly used CEO chairman as the proxy; that is, whether the CEO is also the
chairman of the board of directors. However, this study argues that even in the case where the CEO is not
the chairman and is simply a board of director, he still has the ability to exert influence on the board.
Hence, this study argues that using a broader definition, CEO director, is a better proxy. To test for the
influence of CEO over the board of directors, we include a dummy variable, if the CEO also holds a
board seat. When a CEO is also a board of director, the board is likely to be entrenched. Brick et al. (2006)
find that directors of firms with a unitary leadership structure (that is, the CEO and the Chairman are the
same person) receive higher total compensation than directors of firms with a dual leadership structure
where the roles of CEO and the chairman are performed by different persons. They argue that this is
because the unitary leadership structure reflects weak governance. Accordingly, we offer the following
hypothesis.

H1b: CEO director will be positively related to director compensation.

Firms with larger boards are expected to be associated with higher director compensation for two reasons.
Firstly, as the number of directors increases, the total board compensation will increase. Secondly, firms
with larger boards are typically more complex firms and therefore should give higher pay to their
directors. Therefore, a positive relationship between board size and director compensation is proposed.

H1c: Board size will be positively related to director compensation.

CEO Compensation

As CEOs build a power base and gain voting control over time, they may exert greater influence over
board composition. Consequently, CEOs may be able to demand compensation packages that serve their
own interests rather than the shareholders’ (Hill and Phan, 1991; Cordeiro and Veliyath, 2003; Ozkan,
2011). Moreover, Finkelstein and Hambrick (1996) suggest that the tenure of an executive can affect and
proxy for his attitudes towards risk. This is because long-tenured executives have established high
firm-specific human capital and become less mobile (Hill and Phan, 1991). They will be unwilling to take
on any unnecessary risks that are likely to bring more harms than benefits. Hill and Phan (1991) further
argue that the positive relationship between pay and firm risk will be stronger the longer the tenure of the
CEO. Hence, CEO tenure is expected to be positively associated with CEO compensation.

H2a: CEO tenure will be positively related to CEO compensation.

A CEO who is also a board of director is likely to obtain higher pay since he can not only participate in
but also exert influence over the board’s pay determination process. Therefore, a positive relationship is
expected between CEO compensation and CEO director.

H2b: CEO director will be positively related to CEO compensation.

The level of CEO shareholdings shows the extent to which the wealth of the CEO is linked with firm
value and is related to the extent of agency problems faced by companies (Dong and Ozkan, 2008). CEOs
with greater shareholdings in the firm will have stronger incentives to boost the firm’s stock value.
Therefore, less incentive compensation is needed for aligning the interests of CEO and shareholders.
Accordingly, CEO shareholdings can act as a substitute for CEO compensation (Cordeiro and Veliyath,
2003) and a negative relationship is expected between CEO compensation and CEO shareholdings.

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H2c: CEO shareholdings will be negatively related to CEO compensation.

Male CEOs are expected to receive higher compensation than female CEOs given that the CEO market is
predominated by males. Therefore, we offer the following hypothesis.

H2d: Male CEO will be associated with higher CEO compensation.

The size of the board affects the effectiveness of the board in monitoring management. For example,
when the board size grows large, more resource networks and professional views can be brought to board.
However, these advantages may be overwhelmed by the efficiency losses in communication,
decision-making and coordination between board members as the number of board members increases. In
other words, a large board may in effect reduce the effectiveness of board monitoring and therefore be
associated with higher CEO compensation. Consistent with the latter view, Core et al. (1999) report that
larger boards pay more to their CEOs in terms of both cash compensation and total compensation. Based
on a sample of 414 UK companies between 2003 and 2004, Ozkan (2007) also reports that firms with
larger board size are associated with higher CEO compensation, measured by total compensation and cash
compensation. Moreover, Guest (2010) examines a comprehensive and long period dataset of 1,880 UK
firms over the period 1983-2002 and reports a positive relationship between board size and the rate of
increase in executive compensation, providing support for the argument that large boards suffer from the
problems of less efficient decision-making and poor communication. Therefore, this study expects a
positive relationship between board size and CEO compensation.

H2e: Board size will be positively related to CEO compensation.

To examine the impact of director compensation on CEO compensation, we include the residuals from the
director compensation model in the CEO compensation model, i.e., the excess director compensation.
While the pay of the CEO is determined by the board of directors, the CEO is involved in the selection of
the board of directors. Therefore, this study expects a “mutual back scratching” relationship between the
CEO and the board of directors; that is, a positive relationship between excess director compensation and
CEO compensation. Specifically, this study tests if CEOs receive a higher pay when directors are being
paid higher.

H2f: Excess director compensation will be positively related to CEO compensation.

Control Variables

To control for other variables documented in previous literature as important in determining

compensation levels, the following variables are also included in the models. Firm size controls for the
fact that larger firms which are typically more complex will require directors to spend more time and put
more effort in monitoring managers. In other words, larger firms are associated with greater complexity
and information processing demands and therefore, directors of larger firms are expected to receive higher
compensation. Hence, a positive relationship is expected between director compensation and firm size.
Similarly, CEOs of larger firms have greater responsibility, require more effort, and therefore are expected
to be more highly compensated (Smith and Watts, 1992; Core et al. 2003). The study by Conyon (1997)
has reported a significantly positive relationship between firm size and CEO compensation levels.
Accordingly, a positive relationship is also expected between CEO compensation and firm size.

Agency theory suggests that one way to align the interests of managers with that of shareholders is to tie
the compensation contracts to firm performance (Firth et al., 2006; Chhaochharia and Grinstein, 2009);
that is, to create a pay-for-performance linkage. In other words, to motivate directors to actively monitor
managers on behalf of shareholders, directors should be rewarded when firm performance is high.

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Therefore, we expect a positive relationship between director compensation levels and firm performance.
Similarly, making the CEOs hold accountable for firm performance is essential for motivating the CEOs
to initiate strategies that boost firm value. Hence, a positive relationship between CEO compensation and
firm performance is also expected.

The pay of directors and CEOs is likely to be set with reference to the pay of other directors and CEOs in
the same industry. Hilburn (2010) reports that directors of technology companies have higher pay than
their counterparts at general industry companies. Therefore, the differences in industry structures,
complexity and industry customs are likely to affect the level of compensation (Hempel and Fay, 1994).
Hence, this study includes a dummy variable for industry sectors to control for inter-industry differences
in compensation levels. Year dummies are also included in our models to control for unobserved
differences between years. The inclusion of these dummies can capture common factors that are driven by
industry- and economy-wide effects.

DATA AND METHODOLOGY

The data used in this study are obtained from the Standard and Poor’s ExecuComp database. To be
included in the sample, the sample firms must have all the required financial information, such as total
assets, sales, ROA and ROE, CEO compensation, and director compensation data. As the information on
director compensation in ExecuComp database is more complete from the year 2006 and onwards, the
sample period for this study is set between 2007 and 2010. Previous literature has suggested that banks
are likely to face greater potential conflicts of interests than industrial firms due to its distinct
characteristics such as the existence of deposit insurance, high debt-to-equity ratios and asset-liability
issues (Becher et al., 2005). Since the nature of financial services industry is different from that of
industrial firms, firms belonging to the financial services industry are excluded from the sample.
Therefore, our sample begins with a total of 940 firms (or 3760 firm-years). After eliminating 28 firms
with missing data and 199 firms in the finance, insurance and real estate industries (that is, Division H of
the SIC division structure), the final sample consists of 713 firms (or 2,852 firm-years).

The hypotheses are tested using pooled time-series cross-sectional regression analysis. The two models
tested in this study are outlined below. Model 1 is on director compensation and Model 2 is on CEO
compensation.

ln(DIRCOMPi ,t ) = α i ,t + β1CEOTENUREi ,t + β 2 CEODIRi ,t + β 3ln(BSIZEi ,t )

(1)
+ β 4ln(FSIZEi ,t ) + β 5 PERFORMANCEi ,t −1 + INDUSDUM t + YEARDUM t

The dependent variable (DIRCOMP) of Model 1 is measured in three ways, the total director
compensation, the average compensation of directors, and the compensation of the highest paid director.
Firstly, the total director compensation is the directors’ total compensation for the entire board, including
cash fees, stock awards, option awards, non-equity incentive plan compensation, change in pension value
and non-qualified deferred compensation earnings, and other compensation provided by ExecuComp
database. The reason for measuring director compensation for the entire board is that it is the board
collectively that monitors for and acts on behalf of the shareholders.

Secondly, the average director compensation is the per capita compensation of directors (Fernandes,
2008), where the compensation is measured in total and includes cash fees, stock awards, option awards,
non-equity incentive plan compensation, change in pension value and non-qualified deferred
compensation earnings, and other compensation provided by ExecuComp database. One weakness with
this measure is that measuring director compensation as an average ignores the dispersion within each
firm.

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As most studies focus on the CEO who holds the top paying job, this study also analyzes the highest paid
person on the board; i.e., the third measure of director compensation in this study. Gregg et al. (1993) who
examine the relationship between directors’ pay and corporate performance also adopt this measure.
Formally, the compensation of the highest paid director is the total compensation of the highest paid
director, where total compensation includes cash fees, stock awards, option awards, non-equity incentive
plan compensation, change in pension value and non-qualified deferred compensation earnings, and other
compensation provided by ExecuComp database.

The definitions of independent and control variables are as follows. CEO tenure (CEOTENURE) is
measured by the number of years the CEO had held the position in a given company. An alternative
measure for CEO tenure is the age of the CEO (CEOAGE), which is expected to have strong positive
correlation with CEO tenure and also proxies for CEO experience. CEO director (CEODIR) is a dummy
variable that equals one if the CEO is also a board of director. Board size (BSIZE) is measured by the
number of directors on the board.

Firm size (FSIZE) is measured by total assets and sales. Firm performance (PERFORMANCE) is
measured by the return on assets (ROA) and return on average equity (ROE), which are lagged one year
in order to avoid measuring the effect of compensation on performance. The lagged performance measure
can also account for the fact that director compensation paid in one year is usually determined by the firm
performance in the previous year. ROA has been widely used in previous studies on executive
compensation and corporate governance as a proxy for firm performance. ROA shows how efficient the
firm is in utilizing its assets (Finkelstein and Hambrick, 1996; Finkelstein and Boyd, 1998; Carpenter and
Sanders, 2002). On the other hand, ROE can better reflect firm performance from the shareholders’ point
of view. Therefore, in this study, models are estimated separately using both measures. Industry
(INDUSDUM) is determined by SIC division structure, ranging from Division A to J (Descriptions for the
SIC division structure are outlined below. Division A: agriculture, forestry, and fishing; Division B:
mining; Division C: construction; Division D: manufacturing; Division E: transportation, communications,
electric, gas, and sanitary services; Division F: wholesale trade; Division G: retail trade; Division I:
services; Division J: public administration.) Note that Division H, the finance, insurance, and real estate
industries, is excluded from the sample. In this study we also include year dummies (YEARDUM).

Based on Model 1, we derive the excess director compensation (EXDIRCOMP), which is the residual
from the director compensation model when total director compensation is used as the dependent variable.
The excess director compensation measures the extent of director under- or overpayment. This variable is
then included in the second model on CEO compensation, as outlined below, to test the impact of director
compensation on CEO compensation.

ln(CEOCOMPi,t ) = αi,t + β1CEOTENUREi,t + β2 CEODIRi,t + β3CEOHOLDINGi,t

+ β 4CEOGENDERi ,t + β 5ln(BSIZEi ,t ) + β 6 EXDIRCOMPi ,t + β 7 ln(FSIZEi ,t ) (2)
+ β 8 PERFORMANCEi ,t −1 + INDUSDUM t + YEARDUM t

The dependent variable (CEOCOMP) of Model 2 is measured in two ways, CEO total compensation and
CEO cash compensation. Ozkan (2011) suggests that firm performance may affect cash and equity-based
components of compensation differently. It is important to incorporate multiple measures for
compensation. In this study, the CEO total compensation comprises salary, bonus, other annual payment,
restricted stock grants, long-term incentive payouts, value of options granted and all other payments
provided by ExecuComp database. The second measure, CEO cash compensation, consists of salary and
bonus.

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D. Lin and L. Lin | IJBFR ♦ Vol. 8 ♦ No. 2 ♦ 2014

The additional variables introduced in the second model are defined as follows. CEO shareholdings
(CEOHOLDING) is calculated as the shares owned by the CEO, excluding options that are exercisable or
will become exercisable within 60 days, divided by the number of common shares outstanding. CEO
gender (CEOGENDER) is a dummy variable that equals one if the CEO is male. Excess director
compensation (EXDIRCOMP) is the residual from the director compensation model where the dependent
variable is the total director compensation.

Table 1 presents the descriptive statistics of CEO characteristics and CEO compensation for 713 sample
firms. The average and median age of CEOs is both 55, ranging from 34 to 80. The mean CEO ownership
is 1.53% and ranges from 0 to 75.8% of outstanding shares. CEO tenure, which measures the number of
years the CEO had held the position in a given company, has an average of 7.2 years and ranges from 0 to
47 years. The mean (or median) value of cash compensation, which consists of salary and bonus, received
by the CEOs of our sample firms is $1,116,474 (or $875,158). The total compensation has an average of
$5,838,773 and ranges from $30,002 to $128,706,100. In our sample, about 96.6% of CEOs are male and
96.8% of CEOs also hold a board seat.

Table 1: Descriptive Statistics of CEO Characteristics and CEO Compensation

Mean Median Max Min SD

CEO characteristics
CEO age 55 55 80 34 6.67
CEO shareholdings (%) 1.53 0.29 75.80 0.00 4.91
CEO tenure (years) 7.22 5.00 47.00 0.00 6.68
CEO cash compensation ($'000) 1,116.5 875.2 77,926 7.1 2,466.3
CEO total compensation ($'000) 5,838.8 4,076.8 128,706 30.0 6,722.0

CEO gender
Male 2754 96.56%
Female 98 3.44%
Total 2852 100.00%

CEO is also a board of director

Yes 2760 96.77%
No 92 3.23%
Total 2852 100.00%
This table reports the descriptive statistics of CEO characteristics and CEO compensation for 713 firms (or 2,852 firm-years) between 2007 and
2010. CEO shareholdings is calculated as shares owned by the CEO, excluding options that are exercisable or will become exercisable within 60
days, divided by the total number of common shares outstanding. CEO cash compensation includes salary and bonus. CEO total compensation
includes salary, bonus, other annual, total value of restricted stock granted, total value of stock options granted (using Black-Scholes), long-term
incentive payouts, and all other compensation.

The descriptive statistics for firm characteristics and director compensation are shown in Table 2. The
average board size is 9 and ranges from 3 to 26 directors. The average firm size, measured by total assets,
is $9,898 million and $7,849 million if measured by sales. Firm performance is measured by ROA and
ROE. The average ROA and ROE are 3.99% and 9.99%, respectively. The mean and median “average
director compensation per board” is $181,794 and $166,643, respectively. The mean “total director
compensation per board” is $1,597,003 and ranges from $33,374 to $14,685,740.

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Table 2: Descriptive Statistics of Firm Characteristics and Director Compensation

Mean Median Max Min SD

Firm characteristics
Board size 9 8 26 3 2.46
Total assets ($m) 9,898.2 2,345.1 797,769 10.0 36,640
Sales ($m) 7,849.1 2,034.8 425,071 0.1 25,797
ROA (%) 3.99 5.17 52.85 -163.38 11.77
ROE (%) 9.99 12.24 524.38 -906.03 36.19

Director compensation per board

DIRCOMP_Average ($'000) 181.8 166.6 1,796 3.6 114.6
DIRCOMP_Maximum ($'000) 305.6 221.4 7,779 13.6 430.3
DIRCOMP_Total ($'000) 1,597.0 1,402.6 14,686 33.4 1,081.1
This table reports the descriptive statistics of firm characteristics and director compensation for 713 firms (2,852 firm-years) between 2007 and
2010. DIRCOMP_Average is the average director compensation for each firm (or each board), that is, the per capita compensation of directors.
DIRCOMP_Maximum is the compensation of the highest paid director in each firm. DIRCOMP_Total is the total director compensation for the
entire board. Director compensation is defined to include cash fees, stock awards, option awards, non-equity incentive plan compensation,
change in pension value and non-qualified deferred compensation earnings, and other compensation

Table 3 reports the descriptive statistics for the components of director compensation. Between 2007 and
2010, there is a total of 24,604 director-years. The average cash fees paid to directors is $71,708,000. The
directors in our sample receive an average of $73,103,000 in stock awards, $28,111,000 in option awards,
and $515,000 in non-equity incentive plan. The total director compensation has an average of
$185,118,000 and ranges from -$1,299,073,000 to $7,778,702. The negative total compensation can be
attributed to the negative amounts in stock and option awards and the negative change in pension value
and non-qualified deferred compensation earnings.

Table 3: Descriptive Statistics of Director Compensation

Mean Median Max Min SD

Components of director compensation
Cash fees ($'000) 71.71 68.39 777.2 0.0 44.35
Stock awards ($'000) 73.10 60.69 7,612.0 -362.1 94.70
Option awards ($'000) 28.11 0.00 4,939.6 -1,886.1 95.45
Non-equity incentive ($'000) 0.52 0.00 2,619.0 0.0 29.02
Pension change ($'000) 0.96 0.00 406.0 -805.3 12.23
Other compensation ($'000) 10.68 0.00 6,004.4 0.0 94.02
Total compensation ($'000) 185.12 165.50 7,778.7 -1,299.1 182.22
This table reports the descriptive statistics of director compensation for 24,604 director-years between 2007 and 2010. Director compensation is
classified as cash fees, stock awards, option awards, non-equity incentive plan, change in pension value and non-qualified deferred
compensation earnings, and all other compensation. Cash fees are director fees that are earned or paid in cash. Stock awards are measured by
the value of stock-related awards (e.g. restricted stock, restricted stock units, phantom stock, phantom stock units, common stock equivalent units
etc.) that do not have option-like features. Option awards are measured by the value of option-related awards (e.g. options, stock appreciation
rights, and other instruments with option-like features). Non-equity incentive is measured by the value of amounts earned during the year
pursuant to non-equity incentive plans. Pension change is composed of above-market or preferential earnings from deferred compensation plans
and aggregate increase in actual value of defined benefit and actual pension plans during the year. Other compensation includes perquisites and
other personal benefits, contributions to defined contribution plans, life insurance premiums, gross-ups and other tax reimbursements,
discounted share purchases, consulting fees, awards under charitable award programs etc.

Table 4 reports the correlations between variables. Overall, the CEO and director compensation are
positively related to board size, firm performance, measured by ROA and ROE, and firm size, measured
by total assets and sales. The CEO shareholdings are negatively associated with CEO compensation,
suggesting a substitution effect between CEO shareholdings and CEO compensation (Cordeiro and
Veliyath, 2003). Consistent with the expectation, the CEO tenure, a proxy for CEO power, is positively
related to CEO compensation and negatively related to director compensation.

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Table 4: Correlation Matrix

1 2 3 4 5 6 7 8 9 10 11 12 13
1.CEO age 1
2.CEO shareholdings 0.11 *** 1
3.CEO tenure 0.42 *** 0.38 *** 1
4.Board size 0.07 *** -0.24 *** -0.22 *** 1
5.Assets 0.03 -0.06 *** -0.05 ** 0.32 *** 1
6.Sales 0.05 *** -0.07 *** -0.07 *** 0.29 *** 0.67 *** 1
7.ROEt-1 0.00 -0.01 0.01 0.07 *** 0.05 *** 0.08 *** 1
8.ROAt-1 0.00 0.02 0.02 0.04 ** 0.03 * 0.07 *** 0.67 *** 1
9.CEOCOMP_CASH 0.10 *** -0.02 0.06 *** 0.10 *** 0.14 *** 0.11 *** 0.02 0.01 1
10.CEOCOMP_TOT 0.12 *** -0.12 *** 0.00 0.34 *** 0.28 *** 0.32 *** 0.11 *** 0.09 *** 0.65 *** 1
11.DIRCOMP_AVE 0.01 -0.15 *** -0.03 * 0.10 *** 0.16 *** 0.15 *** 0.09 *** 0.07 *** 0.15 *** 0.37 *** 1
12.DIRCOMP_MAX -0.03 * -0.07 *** -0.07 *** 0.10 *** 0.06 *** 0.06 *** 0.02 0.02 0.05 *** 0.16 *** 0.73 *** 1
13.DIRCOMP_TOT 0.05 *** -0.19 *** -0.10 *** 0.51 *** 0.33 *** 0.30 *** 0.11 *** 0.08 *** 0.18 *** 0.51 *** 0.85 *** 0.66 *** 1
This table reports the correlations of variables used in the regression analysis for a sample of 713 firms during the period 2007-2010.
CEOCOMP_CASH denotes CEO cash compensation. CEOCOMP_TOT denotes CEO total compensation. DIRCOMP_AVE denotes the average
director compensation. DIRCOMP_MAX denotes the compensation of the highest paid director. DIRCOMP_TOT denotes the total director
compensation.

RESULTS

Table 5 reports OLS estimation results for director compensation. In Panel A, the dependent variable is
total director compensation, measured by the directors’ total compensation for the entire board. In Panel B,
the dependent variable is the average compensation of directors, which is measured as the per capita
compensation of directors, where the compensation is measured in total. In Panel C, the dependent
variable is the total compensation of the highest paid director. For each measure of director compensation
(i.e., in each panel), Model 1 is estimated four times as we have adopted alternative measures for CEO
tenure (i.e., CEO tenure and CEO age), firm size (i.e., total assets and sales), and firm performance (i.e.,
ROE and ROA).

The regression estimates in Table 5 show that CEOs with shorter tenure or younger age are significantly
associated with higher director compensation at the 1% level. This finding is consistent with our
prediction that short-tenured CEOs have less ability to exercise influence over the board of directors. The
result is consistent across three measures of director compensation. Inconsistent with our expectation,
CEO director dummy variable is negatively associated with the director compensation, significant at the
1% level. In other words, the director compensation is higher when the CEO is not a member of the board.
The result suggests that without the influence of CEO over the board, directors are able to set higher
compensation to favor themselves.

Board size is significantly positively related to total director compensation and the compensation of the
highest paid director at the 1% level. However, it is significantly negatively related to the average
compensation of directors. This is because as the number of board members increases, the total director
compensation per board evens out, leading to a negative relationship. Firm size, measured by total assets
and sales, are also are significantly positively related to director compensation. Interestingly, the study by
Song and Xu (2007) based on a sample of Chinese listed companies finds that the total compensation
received by board of directors is negatively associated with board size, CEO tenure and the proportion of
inside directors. They suggest that when the board lacks independence, the executives will dominate over
directors, resulting in less compensation to directors. Consistent with Song and Xu (2007), this study
finds that directors of larger firms receive more compensation.

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The International Journal of Business and Finance Research ♦ VOLUME 8 ♦ NUMBER 2 ♦ 2014

Table 5: Analysis of Director Compensation

Panel A: Dependent variable: ln(DIRCOMP_total) Panel B: Dependent variable: ln(DIRCOMP_average)

1 2 3 4 1 2 3 4
Intercept 3.877 *** 5.074 *** 4.003 *** 3.864 *** 3.877 *** 5.074 *** 4.003 *** 3.864 ***
(55.437) (21.725) (53.237) (51.494) (55.437) (21.725) (53.237) (51.494)
CEOTENURE -0.008 *** -0.008 *** -0.008 *** -0.008 *** -0.008 *** -0.008 ***
(-10.478) (-10.750) (-10.497) (-10.478) (-10.750) (-10.497)
ln(CEOAGE) -0.339 *** -0.339 ***
(-7.337) (-7.337)
CEODIR -0.101 *** -0.108 *** -0.098 *** -0.101 *** -0.101 *** -0.108 *** -0.098 *** -0.101 ***
(-5.935) (-6.132) (-5.891) (-6.275) (-5.935) (-6.132) (-5.891) (-6.275)
ln(BSIZE) 0.843 *** 0.889 *** 0.941 *** 0.843 *** -0.157 *** -0.111 *** -0.059 ** -0.157 ***
(34.922) (37.732) (33.208) (31.848) (-6.497) (-4.709) (-2.067) (-5.940)
ln(ASSETS) 0.196 *** 0.198 *** 0.198 *** 0.196 *** 0.198 *** 0.198 ***
(44.784) (44.852) (40.955) (44.784 ) (44.852) (40.955)
ln(SALES) 0.172 *** 0.172 ***
(36.447) (36.447)
ROEt-1 0.001 *** 0.001 *** 0.001 *** 0.001 *** 0.001 *** 0.001 ***
(4.032) (3.813) (2.609) (4.032) (3.813) (2.609)
ROAt-1 0.001 * 0.001 *
(1.754) (1.754)
Industry and
Yes Yes Yes Yes Yes Yes Yes Yes
year dummies

Adjusted R2 0.546 0.544 0.521 0.545 0.303 0.299 0.264 0.301

Panel C: Dependent variable: ln(DIRCOMP_max)
1 2 3 4
Intercept 4.208 *** 6.150 *** 4.297 *** 4.202 ***
(24.094) (14.841) (24.679) (23.425)
CEOTENURE -0.015 *** -0.015 *** -0.015 ***
(-8.503) (-8.603) (-8.465)
ln(CEOAGE) -0.555 ***
(-6.132)
CEODIR -0.114 *** -0.126 *** -0.112 *** -0.115 ***
(-3.472) (-3.854) (-3.364) (-3.481)
ln(BSIZE) 0.178 *** 0.258 *** 0.245 *** 0.177 ***
(10.925) (12.204) (11.519) (10.251)
ln(ASSETS) 0.152 *** 0.155 *** 0.153 ***
(68.617) (84.134) (59.841)
ln(SALES) 0.136 ***
(71.922)
ROEt-1 0.000 0.000 0.000
(1.369) (0.904) (0.674)
ROAt-1 0.000
(0.116)
Industry and
Yes Yes Yes Yes
year dummies

Adjusted R2 0.208 0.198 0.195 0.207

This table presents the regression analysis of director compensation for 713 firms between 2007 and 2010, where the director compensation
includes cash fees, stock awards, option awards, non-equity incentive plan, change in pension value and non-qualified deferred compensation
earnings, and all other compensation. In Panel A, B and C, the dependent variables are total director compensation, average director
compensation and the compensation of the highest paid director, respectively. CEOTENURE is measured by the number of years the CEO had
held the position in a given company. CEOAGE is the age of the CEO. CEODIR is a dummy variable that equals one if the CEO is also a board
of director. BSIZE is measured by the number of directors on the board. ASSETS and SALES are measures for firm size. ROE and ROA measure
firm performance and are lagged one year. t-statistics (in parentheses) are calculated using White's (1980) heteroskedasticity-consistent standard
errors. ***, ** and * indicate coefficient is significant at the 1, 5 and 10% level, respectively.

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D. Lin and L. Lin | IJBFR ♦ Vol. 8 ♦ No. 2 ♦ 2014

The results show that director compensation, measured by total director compensation and average
compensation of director, is higher when firms have better past performance, supporting the argument that
compensation contracts should be linked to firm performance. However, when the director compensation
is measured by the compensation of the highest paid director, the significant relationship with past firm
performance disappears. In other words, highly paid directors are often not paid based on their
performance. This finding supports the recent call for reviewing the compensation packages of “fat cat”
directors (Dong and Ozkan, 2008). The evidence also suggests that for highly paid directors, the
pay-for-performance linkage often does not exist. In particular, Gregg et al. (2005) argue that the
substantial rises in executive pay have far exceeded the increases in underlying firm performance.
Moreover, in terms of the firm performance measures, we find that ROE is a better predictor of director
compensation than ROA. This can be explained by the fact that ROE can better reflect how well a firm
performs from the shareholders’ point of view.

The OLS estimation results for CEO compensation by incorporating the effect of director compensation
are presented in Table 6. The dependent variable is CEO total compensation for Panel A and CEO cash
compensation for Panel B. The former measure comprises the CEO’s salary, bonus, other annual payment,
restricted stock grants, long-term incentive payouts, value of options granted and all other payments. The
latter measure consists of salary and bonus only. For each measure of CEO compensation (i.e., in each
panel), Model 2 is estimated four times as we have adopted alternative measures for CEO tenure (i.e.,
CEO tenure and CEO age), firm size (i.e., total assets and sales), and firm performance (i.e., ROE and
ROA).The results show that excess director compensation is significantly positively related to CEO
compensation at the 1% level. This finding supports our hypothesis that CEOs receive higher pay when
the directors are paid higher. Accordingly, the evidence is consistent with the argument of a “mutual back
scratching” relationship between the CEO and the board of directors (Brick et al., 2006). The results also
suggest that directors are not good monitors of the top management and support Jensen’s (1993) argument
that the effectiveness of directors’ monitoring role can be weakened by the fact that directors are selected
by the CEO.

Consistent with the expectation, CEO tenure and CEO age are positively related to CEO compensation.
Although the level of significance is weaker when the CEO compensation is measured by CEO total
compensation, CEO tenure and CEO age are significantly related to CEO cash compensation at the 1%
level. Inconsistent with our expectation, CEO director dummy variable is negatively related to CEO
compensation at the 5% significance level. That is, CEO compensation is higher when the CEO does not
hold the board seat. Therefore, the observed high compensation received by CEOs that we observe today
cannot be explained by their presence on the board of directors. Moreover, the result does not support the
argument that dual leadership where the roles of CEO and the chairman are performed by different people
is associated with better governance and therefore lower CEO compensation.

Additionally, the results demonstrate that CEO shareholdings are significantly negatively associated with
CEO total compensation at the 1% level, providing support for the hypothesis that CEO shareholdings
and CEO compensation contracts are substitute mechanisms for aligning the interests of CEO and
shareholders (Cordeiro and Veliyath, 2003). However, CEO shareholdings are insignificantly associated
with CEO cash compensation. This is because the cash component of CEO compensation contracts does
not link CEO wealth with firm value, and therefore, does not have the substitution effect like CEO total
compensation. Interestingly, we find that the gender of CEOs is significantly related to CEO cash
compensation but not CEO total compensation. Specifically, the results show that male CEOs receive
higher cash compensation. Board size and firm size are significantly positively related to CEO
compensation at the 1% level, consistent with the hypothesis. Since larger firms are typically more
complex and have larger boards, CEOs of larger firms are therefore more highly compensated.
Interestingly, we find that both measures of firm performance, ROE and ROA, cannot explain CEO total
compensation, therefore, providing evidence against the pay-for-performance linkage that have been

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The International Journal of Business and Finance Research ♦ VOLUME 8 ♦ NUMBER 2 ♦ 2014

raised by the popular press. Consistent with the finding of this study, Ozkan (2007) does not find a
significant relationship between CEO compensation and firm performance based a sample of large UK
companies for the fiscal year 2003/2004.

Table 6: Analysis of CEO Compensation

Panel A: Dependent variable: ln(CEOCOMP_total) Panel B: Dependent variable: ln(CEOCOMP_cash)

1 2 3 4 1 2 3 4
Intercept 4.087 *** 3.095 *** 4.352 *** 4.088 *** 5.155 *** 2.946 *** 5.280 *** 5.146 ***
(23.987) (12.027) (24.535) (24.673) (29.570) (15.665) (29.230) (28.565)
CEOTENURE 0.002 0.003 * 0.002 0.007 *** 0.007 *** 0.007 ***
(1.636) (1.917) (1.635) (13.410) (14.502) (15.361)
ln(CEOAGE) 0.261 *** 0.587 ***
(4.819) (43.189)
CEODIR -0.131 ** -0.125 ** -0.124 ** -0.130 ** -0.047 ** -0.033 -0.043 ** -0.049 **
(-2.172) (-2.084) (-2.094) (-2.142) (-2.286) (-1.641) (-2.241) (-2.575)
CEOHOLDING -0.009 *** -0.009 *** -0.011 *** -0.009 *** -0.002 -0.001 -0.003 -0.002
(-6.668) (-5.787) (-7.335) (-6.661) (-1.269) (-0.405) (-1.471) (-1.228)
CEOGENDER 0.050 0.041 0.038 * 0.047 0.028 *** 0.009 0.019 ** 0.034 ***
(1.449) (1.145) (1.908) (1.304) (2.816) (0.854) (2.520) (3.410)
ln(BSIZE) 0.143 *** 0.131 *** 0.310 *** 0.145 *** 0.120 *** 0.087 *** 0.191 *** 0.115 ***
(3.671) (3.021) (7.351) (3.551) (17.770) (17.702) (15.542) (20.068)
EXDIRCOMP 0.404 *** 0.407 *** 0.412 *** 0.405 *** 0.084 *** 0.092 *** 0.088 *** 0.083 ***
(13.220) (12.899) (13.181) (13.130) (6.692) (8.069) (7.032) (6.865)
ln(ASSETS) 0.433 *** 0.431 *** 0.433 *** 0.223 *** 0.219 *** 0.225 ***
(109.245) (113.227) (118.890) (45.888) (46.982) (56.629)
ln(SALES) 0.395 *** 0.208 ***
(53.933) (37.799)
ROEt-1 0.000 0.000 0.000 0.000 ** 0.000 ** -0.001 **
(0.885) (0.944) (0.147) (-2.332) (-2.327) (-2.383)
ROAt-1 0.001 -0.002 ***
(1.594) (-10.616)
Industry and
Yes Yes Yes Yes Yes Yes Yes Yes
year dummies

Adjusted R2 0.615 0.616 0.565 0.615 0.412 0.422 0.386 0.414

This table presents the regression analysis of CEO compensation for 713 firms between 2007 and 2010. In Panel A and B, the dependent
variables are CEO total compensation and CEO cash compensation, respectively. CEOTENURE is measured by the number of years the CEO
had held the position in a given company. CEOAGE is the age of the CEO. CEODIR is a dummy variable that equals one if the CEO is also a
board of director. CEOHOLDING is calculated as shares owned by the CEO divided by the number of common shares outstanding.
CEOGENDER is a dummy variable that equals one if the CEO is male. BSIZE is measured by the number of directors on the board.
EXDIRCOMP is the residual from the total board compensation model where the dependent variable is the total board compensation. ASSETS
and SALES are measures for firm size. ROE and ROA measure firm performance and are lagged one year. t-statistics (in parentheses) are
calculated using White's (1980) heteroskedasticity-consistent standard errors. ***, ** and * indicate coefficient is significant at the 1, 5 and 10%
level, respectively.

CONCLUDING COMMENTS

The global financial crisis in 2008 sheds light on the significance of reviewing the compensation
packages of top executives. Based on a sample of 713 US firms between 2007 and 2010, this study
examines the determinants of director and CEO compensation based on a number of board of director and
CEO characteristics. We also investigates whether there is a “mutual back scratching” relationship
between the CEO and the board of directors by analyzing the relationship between director compensation
and CEO compensation. Specifically, this study proposes two empirical models. The first is on director
compensation and the second is on CEO compensation.

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D. Lin and L. Lin | IJBFR ♦ Vol. 8 ♦ No. 2 ♦ 2014

The results show that CEOs with shorter tenure or younger age are associated with higher director
compensation but lower CEO compensation. This finding provides support for the argument that CEO
tenure or CEO age is related to CEO’s ability to influence the board’s pay determination process.
Interestingly, we find that CEO who also holds a board seat is not associated with higher CEO
compensation. The result thus indicates that sitting on the board of directors does not strengthen the
CEO’s power over the board during the pay negotiation process. More importantly, the results suggest
that CEOs receive higher pay when the director compensation is higher, supporting the “mutual back
scratching” relationship between the CEO and the board of directors. There is also a substitution effect
between CEO total compensation and the level of CEO ownership. Finally, firms with larger board size
and firm size give higher pay to their directors and CEOs. One limitation of this study is that due to the
constraint on the availability of board of directors’ data, the sample period of this study is limited to four
years only. Future research could extend the sample period by dropping the board size variable to see if
similar results can be reached.

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BIOGRAPHY

Dan Lin is an assistant professor at the Takming University of Science and Technology, and can be
reached at [email protected].

Lu Lin, the corresponding author of this paper, is an assistant professor at the Takming University of
Science and Technology, and can be reached at [email protected].

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The International Journal of Business and Finance Research ♦ VOLUME 8 ♦ NUMBER 2 ♦ 2014

THE RELATIONSHIP BETWEEN BRAND IMAGE AND

PURCHASE INTENTION: EVIDENCE FROM AWARD
WINNING MUTUAL FUNDS
Ya-Hui Wang, National Chin-Yi University of Technology
Cing-Fen Tsai, National Chin-Yi University of Technology

ABSTRACT

Mutual funds represent one of the most popular investment instruments. Some institutions offer fund
awards to recognize strong performing funds and fund groups that have shown excellent returns relative
to their peers. Many fund companies also use awards won in their advertising and marketing material.
This brings rise to the question: Do investors think award winning funds have a better brand image?
Can awards increase investors’ purchase intention? The purpose of this study is to investigate the
relationships and effects of brand image, perceived quality, perceived risk, perceived value, and purchase
intention, as well as to examine the effects of demographic variables on these five dimensions. The
research findings show significant relationships between brand image, perceived quality, perceived value,
and purchase intention. In addition, some demographic variables may lead to significant differences in
these five dimensions. Finally, the results from structural equation modeling show that there are positive
and direct effects among brand image, perceived quality, perceived value, and purchase intention.
Brand image indeed increases investors purchase intentions. The purchase intention is affected mainly
by perceived quality, not by perceived risk.

JEL: G1, M1, M5

KEYWORDS: Brand Image, Perceived Quality, Perceived Risk, Perceived Value, Purchase Intention

INTRODUCTION

M utual funds are one of the most popular investment instruments today. Many investors are
interested in mutual funds, because they have many advantages: professional management,
high liquidity, diversification, minimum amount of cash needed, etc. However, there exists a
vast array of mutual funds. The most important issue is how to choose a good fund for investment to
increase one’s wealth.

Some institutions hold fund awards to recognize strong performing funds and fund groups that have
shown excellent yearly returns relative to their peers. Examples include, the TFF-Bloomberg Best Fund
Awards, the Morningstar Fund Awards, and the Lipper Fund Awards. Many fund companies use awards
won in their advertising and marketing material, bringing rise to a question: Do investors think awarded
funds have a better brand image? Brand image is often used as an extrinsic cue when consumers
evaluate a product before purchasing (Zeithaml, 1988; Richardson, Dick and Jain, 1994). As such, from
the viewpoint of fund companies, does this branding work? Can it really increase investors’ purchase
intention?

Consumers are more likely to purchase well-known brand products with a positive brand image, because
a brand with this image has the effect of lowering consumers’ perceived risks (Akaah and Korgaonkar,
1988; Rao and Monroe, 1988) or increasing consumers’ perceived value (Loudon and Bitta, 1988;
Fredericks and Slater, 1998; Romaniuk and Sharp, 2003). Thus, will investors choose awarded funds as
their investment target? How do investors feel about awarded funds? Does an awarded fund really see
a better brand image? Higher perceived quality? Lower perceived risk? Higher perceived value?

Previous studies on awarded funds have focused on performance persistence by taking secondary data
from the financial market. Little or no research has investigated investors’ purchase intentions of

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awarded funds directly through questionnaires. Our study attempts to fill this gap. This paper studies
relationships between awarded funds’ brand image, perceived quality, perceived risk, perceived value, and
purchase intention using questionnaires. The aims of this study are: (1) to investigate the relationships
and effects of brand image, perceived quality, perceived risk, perceived value, and purchase intention; (2)
to analyze the differences between investors with different demographic variables in brand image,
perceived quality, perceived risk, perceived value, and purchase intention; (3) to analyze the implications
of these results. The rest of this paper is organized as follows. Section 2 reviews previous research on
brand image, perceived quality, perceived risk, perceived value, and purchase intention. Section 3
describes the data and method we employ. Section 4 reports the empirical results, and section 5
concludes the paper.

LITERATURE REVIEW

The most popular fund awards in Taiwan include TFF-Bloomberg Best Fund Awards, Morningstar Fund
Awards, and Lipper Fund Awards. The TFF-Bloomberg Best Fund Award is sponsored by the Taipei
Foundation of Finance (TFF) and co-sponsored by Bloomberg LP. It is a well-known mark of
recognition in the Taiwanese mutual fund industry and has been awarded for 15 years since 1998.
Qualifying funds compete in both domestic and foreign categories. Under the category “Domestic Fund
Award”, funds are recognized based on data and analytics provided by National Taiwan University
professors. “Foreign Fund Award” winners are selected by TFF based on Bloomberg’s Fund Scoring
Model, which analyzes overall performance and risk exposure of each qualifying fund.

Morningstar sponsors The Morningstar Fund Awards, with the objective to recognize those funds and
fund groups that have added the most value within the context of a relevant peer group for investors over
the past year and over the longer term. Funds are scored by their total return percentile ranks in their
Morningstar categories over one-, three- and five-year periods, with 30% of the total score on the
one-year period, 20% on the three-year period, and 30% on the five-year period, for a total of 80%
allocated to returns. The remaining 20% of a fund’s score is allocated to risk adjustment. The
Morningstar Risk of each fund is a robust risk measure using utility theory to penalize funds more for
downside variation in returns than for upside volatility thereby keeping with actual investor concerns.

Lipper sponsors The Lipper Fund Awards, taking place in 23 countries in Asia, Europe, MENA, and the
Americas. The Lipper Fund Awards program honors funds that have excellent consistent risk-adjusted
returns relative to their peers. The program also recognizes fund families with high average scores for
all funds within a particular asset class or overall. Lipper designates award-winning funds in most
individual classifications for the three-, five-, and ten-year periods and fund families with high average
scores for the three-year time period. The awards winners are formally announced between January and
April every year.

The American Marketing Association defines brand as “a name, term, sign, symbol, design or
combination, intended to identify goods and services and to differentiate them from the competition”.
Kotler (2000) claimed that “brand is a name, term, symbol, design or all the above, and is used to
distinguish one’s products and services from competitors”. Keller (1993; 1998) defined brand image as
“perceptions about a brand as reflected by the brand associations held in consumer memory”.
Accordingly, brand image does not exist in the features, technology or the actual product itself, but rather
it is something brought out by advertisements, promotions or users. Brand image is often used as an
extrinsic cue when consumers are evaluating a product before purchasing (Zeithaml, 1988; Richardson,
Dick and Jain, 1994).

Perceived quality is the consumer’s judgment about a product’s overall excellence and superiority, not the
actual quality of a product (Zeithaml, 1988; Aaker, 1991). Consumers often judge product quality via
informational cues. They form beliefs on the basis of these informational cues (intrinsic and extrinsic),
and then judge the quality of a product and make their final purchase decision based upon these beliefs

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(Olson, 1977). According to Zeithaml (1988), intrinsic attributes are physical characteristics of the
product itself, such as a product’s conformance, durability, features, performance, reliability, and
serviceability. On the contrary, extrinsic attributes are cues external to the product itself, such as price,
brand image, and company reputation. Garvin (1987) defined perceived quality to include five
dimensions: performance, features, conformance, durability, reliability, serviceability, aesthetics, and
brand image. Petrick (2002) developed a four-dimensional scale to measure the perceived quality of a
product: consistency, reliability, dependability, and superiority.

Bauer (1960) first proposed perceived risk to include two dimensions: uncertainty and adverse
consequences. Dowling and Staelin (1994) defined risk as a consumer’s perceptions of the uncertainty
and adverse consequences of engaging in an activity. Perceived risk was also defined as the unfavorable
outcomes related to a product or service (Engel, Blackwell and Miniard, 1995), the subjective perception
of possibility and severity of a wrong purchase (Sinha and Batra, 1999), or the uncertainty a consumer
perceives about the outcome of his or her purchase (Hoyer and Macinnis, 2010). The measurement of
perceived risk was not explicitly defined in Bauer’s (1960) original paper. Many researchers thus
regarded perceived risk as a multi-dimensional concept (Roselius, 1971; Jacoby and Kaplan, 1972; Stone
and Gronhaug, 1993). Jacoby and Kaplan (1972) defined perceived risk to include five components:
financial, performance, social, psychological, and physical risk. These five components can explain
74% of variation in perceived risk (Kaplan, 1974). Peter and Tarpey (1975), and Murray and
Schlacter (1990) expanded the components to include time risk. Stone and Gronhaung (1993) proved
that 88% of perceived risk can be explained by these six components. Perceived risk increases as the
probability of one or more negative outcomes increases (Dowling and Staelin, 1994). Consumer
behavior is motivated to reduce risk (Bauer, 1960; Taylor, 1974). Researchers found factors that
influence perceived risk: brand loyalty (Cunningham, 1967), store selection (Hirsh, Dornoff and Kernan,
1972), quality warranty (Terence and William, 1982), and some demographic variables such as age,
household income, and education level (Spence et al., 1970).

Consumers’ perceptions of value represent a trade-off between the perceived quality or benefits in a
product relative to the perceived sacrifice by paying the price. Monroe and Dodds (1985) defined
perceived value as a trade-off between buyers’ perceptions of quality and sacrifice. It is positive when
perceptions of quality are greater than the perceptions of sacrifice. Zeithaml (1988) defined perceived
value as “the consumer’s overall assessment of the utility of a product, based on perceptions of what is
received (e.g., quality, satisfaction) and what is given (price, nonmonetary costs)”. Monroe and Dodds
(1985) directly related perceived value to preferences or choice, whereby the larger the perceived value is,
the more likely the consumer will express a willingness to buy or have a preference for the product.
Perceived value has is the most important indicator to forecast purchase intentions and has been viewed is
an important measures for gaining a competitive advantage (Zeithaml, 1988; Dodds et al., 1991; Cronin et
al., 2000).

Purchase intention is the likelihood that a customer will buy a particular product (Fishbein and Ajzen,
1975; Dodds et al., 1991; Schiffman and Kanuk, 2000). A greater willingness to buy a product means
the probability to buy it is higher, but not necessarily to actually buy it. On the contrary, a lower
willingness does not mean an absolute impossibility to buy. Bagozzi and Burnkrant (1979) defined
purchase intention as personal behavioral tendency to a particular product. Spears and Singh (2004)
defined purchase intention as “an individual’s conscious plan to make an effort to purchase a brand”.
Purchase intention is determined by a consumer’s perceived benefit and value (Xua, Summersb, and
Bonnie, 2004; Grwal et al., 1998; Dodds et al., 1991; Zeithaml, 1988).

Brand Image’s Influence on Perceived Quality, Perceived Risk and Perceived Value

Brand image is an important cue during the process of consumers’ purchase decision making. Favorable
brand information positively influences perceived quality, perceived value, and consumers’ willingness to
buy (Dodds, Monroe & Grewal, 1991; Monroe and Krishnan, 1985). Consumers are more likely to
purchase well-known brand products with a positive brand image, because a brand with a more positive

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image does have the effect of lowering consumers’ perceived risks (Akaah and Korgaonkar, 1988; Rao
and Monroe, 1988) or increasing consumers’ perceived value (Loudon and Bitta, 1988; Fredericks and
Slater, 1998; Romaniuk and Sharp, 2003; Aghekyan, Forsythe, Kwon, and Chattaraman, 2012). Thus,
we note the first three hypotheses as follows.

H1: Brand image has a significantly positive impact on investors’ perceived quality.
H2: Brand image has a significantly positive impact on investors’ perceived risk.
H3: Brand image has a significantly positive impact on investors’ perceived value.

Influence of Perceived Quality on Perceived Value and Purchase Intentions

Monroe and Krishnan (1985), Zeithaml (1988), Dodds et al. (1991), and Petrick (2004) stated that a
higher perception of quality improves consumers’ perceived value that strengthens consumers’ purchase
intention. Garretson and Clow (1999), Chaudhuri (2002) and Yee and San (2011) found perceived
quality to have a significant impact on a consumer’s purchase intention. Tsiotsou (2006) investigated
the effects of perceived quality on purchase intentions and showed that perceived quality has a direct
effect and an indirect effect (through overall satisfaction) on purchase intentions. Thus, we set up the
following two hypotheses.

H4: Perceived quality has a significantly positive impact on investors’ perceived value.
H5: Perceived quality has a significantly positive impact on investors’ purchase intention.

Influence of Perceived Risk on Perceived Value and Purchase Intentions

Consumer behavior is motivated to reduce risk (Bauer, 1960; Taylor, 1974). According to Bettman (1973),
a consumer’s purchase intention is affected by perceived risk. Perceived risk exists in a consumer’s
decision process when he or she cannot foresee the purchase outcome and then uncertainty takes place
(Hoover et al., 1978). As a result, perceived risk is a critical factor influencing a consumer’s purchase
decision (Garrestson and Clow, 1999; Yee and San, 2011; Chen and Chang, 2012). Sweeney, Soutar and
Johnson (1999), and Snoj, Korda and Mumel (2004) also found that perceived risk has a significantly
negative impact on perceived value. Thus, we offer the next two hypotheses as follows.

H6: Perceived risk has a significantly negative impact on investors’ perceived value.
H7: Perceived risk has a significantly negative impact on investors’ purchase intention.

Influence of Perceived Value on Purchase Intentions

Perceived value plays an important role in purchase or consumption decisions. Many scholars have note
that perceived value is relevant to the emotional responses and consumption experiences of consumers,
which can further influence the consumer’s purchase behavior (Dumana & Mattil, 2005; Petrick, 2004;
Sweeney & Soutar, 2001). When other things remain unchanged, purchase intention is positively related
to perceived value (Della, Monroe and McGinnis, 1981; Monroe and Chapman, 1987; Zeithaml, 1988;
Chen and Chang, 2012; Yee and San, 2011; Wu, Chen, Chen, and Cheng, 2012). Accordingly, we
propose the following hypothesis.

H8: Perceived value has a significantly positive impact on investors’ purchase intention.

Influence of Demographic Variables on Each Dimension

Businesses have different marketing strategies for different consumer groups because market
segmentation is helpful in finding target consumers and creating competitive advantages. Demographic
segmentation means dividing the market into specific groups according to gender, marital status, age,
education, occupation, income, religion, nationality or race (Assael, 2005). These characteristics are the
link to buyers' wants and needs and affect purchasing behavior. Therefore, it is the most popular basis

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for segmenting customer groups mainly because it is the easiest, most measurable and most widely used
segmentation method (Plummer, 1974; Donthu and Garcia, 1999). Demographic variables such as age,
gender, occupation, income, and so on, have significant impacts on investors’ buying behavioral pattern
(Jani and Jain, 2013). Alexander et al. (1998) found that age has a significant impact on investor
behaviors. Jianakoplos and Bernasek (1998), Sunden and Surette (1998) also found gender differences
exist in investment decisions. Accordingly, we set up the following hypothesis.

H9: There are significant differences in each dimension for investors with different demographic
variables

DATA AND METHODOLOGY

According to the research framework, we design the questionnaire items for six dimensions: brand
image, perceived quality, perceived risk, perceived value, purchase intention, and demographic variables.
These items are measured on Likert’s seven-point scale, ranging from 1 point to 7 points, denoting
“strongly disagree”, “disagree”, “a little disagree”, “neutral”, “a little agree”, “agree”, and “strongly
agree.” We administered the questionnaires to investors living in Taiwan using random sampling from
October 5, 2012 to December 31, 2012. A total of 795 responses were distributed, and 691 usable
responses were collected. An acceptable response rate of 87% was achieved.

Figure 1 presents the research framework. This framework demonstrates the relationships and effects
among “brand image”, “perceived quality”, “perceived risk”, “perceived value”, and “purchase
intentions”. It also intends to measure the effects of “demographic variables” on brand image, perceived
quality, perceived value, and purchase intentions.

Figure 1: Research Framework

H1 H4
Perceived quality
H5

H3 H8

Brand image Perceived value Purchase intention

Perceived risk H6 H7

H2

Demographic Variables
H9

This figure shows the research design. It also shows how the hypotheses fit into the framework

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We perform data analyses on SPSS 12.0 and AMOS 17.0. The methods adopted include descriptive
statistics analysis, reliability and validity analysis, correlation analysis, one-sample t-test analysis, factor
analysis, one-way ANOVA, and structural equation modeling (SEM) analysis.

ANALYSES AND RESULTS

Through descriptive statistics analysis in Table 1, we are able to understand the distribution of participants’
basic attributes. The gender data shows 44.6% of the subjects are male, and 55.4% are female. The
results show 64% of participants unmarried and 36% married. The age categories show the main group is
21-30 years old, taking up 43.7%, followed by the group of 31-40 years old (24.9%), 41-50 years old
(16.4%), and younger than 20 years old (10.3%). The education levels indicate university education is
the main group, taking up 67.0%, followed by graduate school (14.5%) and high school education
(14.0%). Income data shows: most subjects (37.8%) earned below NT$20,000 per month, 30.8%
earned NT$20,001-NT$40,000, 16.5% earned NT$40,001-NT$60,000, and 14.9% earned more than
NT$60,000. Some 66.6% of the subjects live in central Taiwan, followed by northern Taiwan (22.1%),
southern Taiwan (9.0%), and eastern Taiwan (2.3%). Finally we collect data on occupation which show
students form the major group (32.4%), followed by financial industry (20.0%), service industry (17.9%),
manufacturing industry (6.9%), high-tech industry (6.4%), public servants (5.4%), and others (11%).

Table 1: Descriptive Statistics

Variable Category Frequency Percent (%)

Male 308 44.6
Gender
Female 383 55.4
Married 249 36.0
Marital status
Unmarried 442 64.0
Younger than 20 years old 71 10.3
21-30 years old 302 43.7
Age 31-40 years old 172 24.9
41-50 years old 113 16.4
Older than 50 years old 33 4.8
Junior high school 21 3.0
Senior high school 97 14.0
Education level University 463 67.0
Graduate school 100 14.5
Ph. D 10 1.4
Below NT$20,000 261 37.8
NT$20,001-NT$40,000 213 30.8
Monthly income
NT$40,001-NT$60,000 114 16.5
More than NT$60,000 103 14.9
Northern Taiwan 153 22.1
Central Taiwan 460 66.6
Residential area
Southern Taiwan 62 9.0
Eastern Taiwan 16 2.3
Financial industry 138 20.0
Public servants 37 5.4
Manufacturing industry 48 6.9
Occupation High-tech industry 44 6.4
Service industry 124 17.9
Students 224 32.4
Others 76 11.0
This table shows the descriptive statistics analysis for the sample data. The first column is demographic variables in this study. The third and
fourth column reveals the frequency and percentage of total number of observations in each category, respectively.

As presented in Table 2, all the dimensions have a Cronbach’s α greater than 0.9, which complies with the
criterion proposed by Guiedford (1965). Hence, the reliability coefficient (Cronbach’s α ) of the
questionnaire is within the acceptable level. Factor analysis is also taken as a tool to verify the
convergent validity of the questionnaire. This study adopts principal component analysis and uses the

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Varimax to maximize the sum of the variance of the loading factors. We extract factors with an
eigenvalue greater than 1, cumulative explained variation greater than 50%, and a factor loading greater
than 0.5 (Kaiser, 1958).

Table 2: Reliability and Validity Test

Dimensions (Factors) Eigen Value Explained Variance Cronbach’s Α

Brand image 6.587 65.867% 0.942

Perceived quality 6.933 69.328% 0.942

Perceived risk 6.743 74.927% 0.912

Perceived value 7.208 72.076% 0.957

Purchase intention 6.743 74.927% 0.958

This table shows the reliability and validity test of all factors in this study. The first and third figure in each cell is the Eigen value and the
Cronbach’s α value, respectively. The second figure in each cell represents the explained variance of each factor.

According to the results in Table 2, the questionnaire has convergent validity. In addition, it has content
validity, because our scale and item contents are constructed according to the literature review and passed
the questionnaire pre-test. The questionnaire also has discriminant validity, because the correlation
coefficient of each of the two factors in Table 3 is lower than the Cronbach’s α of each dimension.

Table 3: Correlation Analysis

Brand Perceived
Dimensions Perceived Quality Perceived Value Purchase Intention
Image Risk
Brand
1
image
0.845***
Perceived quality 1
(0.000)
0.042 0.039
Perceived risk 1
(0.276) (0.307)
0.784*** 0.866*** 0.076**
Perceived value
(0.000) (0.000) (0.046) 1
0.768*** 0.809*** 0.103*** 0.879***
Purchase intention
(0.000) (0.000) (0.006) (0.000) 1
This table presents the correlation analysis. The figures on the non-diagonal represent Pearson correlation coefficient between two factors.
The figures in parentheses represent p-value. ***, **, and * indicate significance at the 1, 5 and 10 percent levels respectively.

In this section we conduct the one-way ANOVA to investigate whether the demographic variables have
significant effects on brand image, perceived quality, perceived risk, perceived value, and purchase
intentions. As shown in Table 4, there are significant differences in these five dimensions for investors
with different education levels and occupation.

There are significant differences in perceived quality and perceived risk for gender. There are
significant differences in brand image, perceived quality, perceived risk, and purchase intention for
different residential areas, marital status only impact perceived value, and monthly income only impacts
perceived risk. The results partial support our hypothesis H9.

This section conducts structural equation modeling (SEM) analysis to test the fit of the factors
(dimensions) of brand image, perceived quality, perceived risk, perceived value, and purchase intention.
For a model with good fit, GFI (goodness of fit) should greater than 0.8 (Browne and Cudeck, 1993).

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AGFI (adjust goodness of fit) should be greater than 0.8 and CFI (comparative fit index) greater than 0.9
(Hair et al., 1998; Gefen et al., 2000). RMSEA (root mean square error of approximation) should be
under 0.05 (Bagozzi and Yi, 1988; Joreskong and Sorbom, 1992), and the ratio of chi-square value to
degrees of freedom 𝜒 2 /𝑑𝑑 should be no greater than five (Wheaton et al., 1977). A stricter criterion
is that 𝜒 2 /𝑑𝑑 should be smaller than three (Carmines and Maclver, 1981; Hair et al., 2006). The
goodness-of-fit indices of the model are as follows: GFI is 0.888, AGFI is 0.856, CFI is 0.962, RMSEA
is 0.043, and 𝜒 2 /𝑑𝑑 is 2.256. All these indices are within the acceptable range, meaning that the
overall model fitness is good.

Table 4: ANOVA of Demographic Variables

Gender Marital Status Education Monthly Residential Occupation

Income Area
Brand image 0.184 4.009*** 1.130 5.488*** 4.463***
2.607
(0.668) (0.003) (0.341) (0.001) (0.000)
(0.107)

Perceived 0.762 3.663*** 0.493 2.326* 2.622**

4.925**
quality (0.383) (0.006) (0.741) (0.074) (0.016)
(0.027)

Perceived risk 0.084 2.737** 3.854*** 3.067** 4.736***

4.644**
(0.772) (0.028) (0.004) (0.027) (0.000)
(0.032)

Perceived value 2.997* 3.902*** 1.084 1.977 2.201**

0.057
(0.084) (0.004) (0.363) (0.116) (0.041)
(0.811)

Purchase 0.579 3.463*** 1.199 2.628** 2.617**

1.978
intention (0.447) (0.008) (0.310) (0.049) (0.016)
(0.160)

This table shows ANOVA of demographic variables on brand image, perceived quality, perceived risk, perceived value, and purchase intention.
The figure in each cell represents the t-statistic or F-statistic. The figure in each parenthesis is the p-value. ***, **, and * indicate
significance at the 1, 5 and 10 percent levels respectively.

Table 5 presents the estimated values of the standardized parameters of the relationship model and the
results from the hypotheses verified. According to Table 5 and the path analysis in Figure 2, we find that
brand image has a significant positive influence on perceived quality (H1 is supported) and has an
insignificant positive impact on perceived risk and on perceived value (H2 and H3 are not supported).
Consistent with Monroe and Krishnan (1985), Zeithaml (1988), Dodds et al. (1991), and Petrick (2004),
perceived quality has a significant positive influence on perceived value and purchase intention,
respectively (H4 and H5 are supported). Perceived value also has a significant positive influence on
purchase intention (H8 is supported). The results are consistent with Della, Monroe and McGinnis
(1981), Monroe and Chapman (1987), Zeithaml (1988), Yee and San (2011), Chen and Chang (2012), and
Wu, Chen, Chen, and Cheng (2012). On the other hand, perceived risk has an insignificant positive
impact on perceived value (H6 is not supported) and has a significant positive impact on purchase
intention (H7 is not supported, because the sign is not “negative” as expected).
The results from SEM show that there are positive and direct effects among brand image, perceived
quality, and purchase intention. However, ‘the brand image impact on perceived value’, ‘the brand
image impact on perceived risk’, ‘the perceived risk impact on perceived value’, and ‘the perceived risk
impact on purchase intention’ are all not significant. It means that investors’ purchase intentions are
affected mainly by perceived quality, not by perceived risk.

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The International Journal of Business and Finance Research ♦ VOLUME 8 ♦ NUMBER 2 ♦ 2014

Table 5: Estimated Values of Standardized Parameters and the AMOS Model Fit Test Results

Standardized Factor
Hypotheses (Paths) T-Value Results
Loadings
H1: Brand image → perceived quality 0.895 21.556*** Supported

H2: Brand image → perceived risk 0.025 0.613 Not supported

H3: Brand image → perceived value 0.085 1.568 Not supported

H4: Perceived quality → perceived value 0.832 13.557*** Supported

H5: Perceived quality → purchase intention 0.125 2.247*** Supported

H6: Perceived risk → perceived value 0.022 1.096 Not supported

H7: Perceived risk → purchase intention 0.064 3.228*** Not supported

H8: Perceived value → purchase intention 0.851 13.383*** Supported

This table shows the estimated values of standardized parameters and the hypothesis test results. The first column represents our research
hypotheses (paths). The figure in second column is the standardized factor loading of each path. The figure in third column is the t-statistic.
***, **, and * indicate significance at the 1, 5 and 10 percent levels respectively.

CONCLUSION AND IMPLICATION

The purpose of this study is to investigate the relationships and effects of brand image, perceived quality,
perceived risk, perceived value, and purchase intention, as well as to examine the effects of demographic
variables on these five dimensions. The research findings’ show significant relationships among brand
image, perceived quality, perceived value, and purchase intention according to the correlation analysis.
In the test of the effects of demographic variables on brand image, perceived quality, perceived risk,
perceived value, and purchase intention, the one-way ANOVA result indicates significant differences in
all five dimensions for investors with different education levels and occupation. There are significant
differences in perceived quality and perceived risk for gender. There are significant differences in brand
image, perceived risk, and purchase intention for different residential areas, and monthly income has an
effect only on perceived risk. Finally, the results from SEM show that there are positive and direct
effects among brand image, perceived quality, perceived value, and purchase intention - that is, brand
image increases perceived quality, perceived quality increases perceived value, and perceived value
increases purchase intention. However, ‘the brand image impact on perceived value’, ‘the brand image
impact on perceived risk’, ‘the perceived risk impact on perceived value’, and ‘the perceived risk impact
on purchase intention’ are all not significant. It means that brand image indeed increases investors’
purchase intentions, and purchase intention is affected mainly by perceived quality, not by perceived risk.

This research discovered that brand image indeed increases investors’ purchase intention. Therefore, we
suggest that fund managers should devote efforts to elevating and maintaining their brand images via
advertising and marketing funds that have received awards. Once a positive image is established, fund
companies may utilize the added values to promote their other funds that have not yet won an award.
The results also show that brand image increases investors’ purchase intention, and purchase intention is
affected mainly by perceived quality, not by perceived risk. Therefore, fund companies should pay
attention to strategies that increase investors’ perceived quality when they are marketing their awarded
funds. Finally, because there are significant differences in brand image, perceived quality, perceived risk,
perceived value, and purchase intention for investors with different education levels and occupation, fund
companies should provide different marketing strategies according to these characteristics of investors.

Different product categories may lead to distinct results. The primary limitation of this study is that it
explores only a one-product category (awarded funds), potentially limiting generalizability to other
domains. Moreover, we did not classify the asset classes of awarded funds (e.g. equity, bond, and mixed

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YH. Wang & CF. Tsai | IJBFR ♦ Vol. 8 ♦ No. 2 ♦ 2014

assets). Further research is recommended to do this and identify additional differences. We also only
considered brand image, perceived quality, perceived risk, and perceived value in this study. Other
determinants of purchase intention could be included in comprehensive models thereby potentially
improving explanatory power. Finally, most of the respondents in our study are from the age group of
21-30 years old, or students or young persons who do not have much money to invest. Therefore, the
potential for bias exists due to the different purchase behaviors among different age groups. Therefore,
future studies might examine different age and education groups.

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BIOGRAPHY

Dr. Ya-Hui Wang is an assistant professor of Business Administration at National Chin-Yi University of
Technology in Taiwan. She received her Ph.D. degree in financial management from the National
Central University in Taiwan. She can be contacted at: Department of Business Administration,
National Chin-Yi University of Technology, No. 57, Sec. 2, Zhongshan Rd., Taiping Dist., Taichung
41170, Taiwan, R.O.C. Phone: +886-4-2392-4505 ext. 7783. E-mail: [email protected].

Cing-Fen Tsai is an administrative assistant of Asian First Refrigeration Corporation in Taiwan. She
received her MBA degree in business management from the National Chin-Yi University of Technology
in Taiwan, R.O.C. She can be contacted with E-mail: [email protected].

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TIME SERIES MODELING AND FORECASTING

INFLATION: EVIDENCE FROM NIGERIA
Ikechukwu Kelikume, Lagos Business School
Adedoyin Salami, Lagos Business School

ABSTRACT

A major concern of entrepreneurs and monetary authorities in Nigeria in the past decades was successful
prediction general price level movements. The results allow successful planning on the part of monetary
authorities and continued profit drive on the part of entrepreneurs and investors. This study uses a
univariate model in the form of Autoregressive Integrated Moving Average model developed by Box and
Jenkins and multivariate time series model in the form of Vector Autoregressive model to forecast
inflation for Nigeria. This paper use changes in monthly consumer price index obtained from the National
Bureau of Statistics and the Central bank of Nigeria over the period 2003 to 2012 to predict movements
in the general price level. Based on different diagnostic and evaluation criteria, the best forecasting
model for predicting inflation in Nigeria is identified. The results will enable policy makers and
businesses to track the performance and stability of key macroeconomic indicators using the forecasted
inflation.

JEL: E3 E17, E31

KEYWORDS: Modeling Inflation, Forecasting, ARIMA, VAR

INTRODUCTION

M aintaining a reasonable degree of price stability and ensuring an adequate expansion of credit to
foster steady and sustainable economic growth have been the primary goals of monetary policy.
A challenging problematic macroeconomic economic issue confronting nation states and
monetary authorities today is tracking and predicting the movement in the general price level. Nigeria like
most developing countries has had significant gaps between policy formulation, policy implementation
and policy targets. In most cases, policy goals lag behind targets and are often unattainable due primarily
to the prevalence of policy inconsistencies driven by the inability of monetary authorities to predict
inflation and its real determinants. Inflation is a major monetary policy performance indicator and is a
useful indicator in informing the public about trends in the movement of leading and lagging
macroeconomic indicators. The knowledge of these indicators drives inflationary expectation and
therefore serves as a nominal anchor for bargaining process and fixed contracts (Moser, Rumler and
Scharler, 2004). Generally, a clear understanding of inflation forecasting techniques is crucial for the
success of monetary policy in tracking the movement of macroeconomic aggregates and in maintaining
stabile and sustainable economic growth.

This paper compares Vector Autoregressive (VAR) model and Autoregressive Integrated Moving
Average (ARIMA) model for forecasting the rate of change of the Nigerian Consumer Price Index (CPI).
The main attraction to VAR modeling is that it has a natural basis for testing conditional predictability
unlike the ARIMA model which is poor in predicting turning points but is relatively robust in generating
short term forecast. Thus most empirical analysis on forecasting has focused on the use of VAR while
ARIMA is used as a benchmark forecasting tool. Forecasts of the models with the highest predictive
accuracy are then evaluated using a range of criteria that characterize optimal forecasts.

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Following the introductory section, the rest of the paper is organized as follows: Section 2 summarizes the
theoretical and empirical literature. Section 3 describes the models, methods and sources of data. Section
4 compares the forecasting performance of the models and evaluates the resulting models with the highest
predictive accuracy. Section 5 concludes the paper.

LITERATURE

The central role of monetary policy in developed, emerging and developing economies is the maintenance
of price stability and ensuring of adequate expansion of credit to foster economic growth and
development. Generally, economists across economic divides differ in their analysis of the root causes of
inflation and in the way and manner the inflationary spiral should be managed and controlled. While the
monetarists hold the strong view that sustained growth in money supply not matched by corresponding
growth in output will cause inflation at the long run (Milton Friedman 1956, 1960, 1971), structuralist
economist explain the long run inflationary trend in developing countries in terms of structural rigidities,
market imperfections and social tensions such as relative elasticity of food supply, foreign exchange
constraints, protective measures, rise in demand for food, fall in export earnings, hoarding, import
substitution, industrialization and presence of political instability ( Thirwell, 1974; and

Aghevei and Khan 1977). Given the monetarists view and structuralist view on the root causes of
inflation, it is increasingly difficult to forecast inflation in not only developed economies but also in
OECD countries and in particular in emerging and developing economies. The empirical studies
conducted by Olga, Kamps and Nadine (2009), and Stock and Watson (2008) found that over the longer
term (3-year), forecasting horizon, and monetary indicators contain useful information for predicting
inflation in most New Member States (NMS) countries of the European Union (EU).

Models of inflation forecast and accuracy has evolved in several studies ranging from extrapolation to
econometric modeling. The early study of inflation forecast by Landsman and Damodaran (1989) in
which the univariate autoregressive integrated moving average method was used drew the conclusion that,
ARIMA parameter estimator improves the forecast accuracy of the model because of its lower mean
squared percentage error. Although, inflation forecasting with autoregressive integrated moving average
method (ARIMA) compares favorably with other forecasting models such as the vector autoregressive
method (VAR), and the Bayesian VAR, it has been shown that the ARIMA performs poorly forecasting
turning points and yields poor forecast values when applied to volatile and high frequency data (Meyler,
Kenny and Quinn (1998). Ho and Xie (1998), using the ARIMA framework, concluded that the ARIMA
model is a viable alternative that gives satisfactory results in terms of its predictive performance.
According to Wayne (1998), the use of the vector autoregressive model in forecasting exhibits significant
degree of predictive accuracy when compared with other forecasting models. This same conclusion was
reached by Meyler et al (1998). Applying the Bayesian VAR approach forecasting, they found the VAR
approach improves forecasting performance.

Black, Corrigan and Dowd (2000), comparing an AR (1) with the Mean Absolute Percentage Errors
(MAPEs) of different models adding one variable at a time, found the money supply variable to improve
the forecast values of inflation significantly, while the study by Jacobson, Jansson, Vredin and Warne
(2001) shows that VAR model with long-run restrictions is useful for both forecasting inflation and for
analyzing other issues that are central to the conduct of monetary policy. Using a VAR model,
Gottschalk and Moore (2001) assessed the link between monetary policy instruments and
inflation in Poland. The result showed that although the exchange rate was found to be effective
with respect to output and prices, direct linkage between interest rate and inflation do not appear
to be very strong. Toshitaka (2001), found mark-up relationship in estimating and forecasting
inflation; excess money supply and the output gap were of importance in determining long run

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equilibrium correlation model of inflation. Other studies on inflation forecasting in different

region produced mixed results. Fritzer, Moser and Scharler (2002), found VAR models outperform
ARIMA in terms of forecasting accuracy while Bokhari and Feridun (2006), indicate that VAR models do
not perform better than the ARIMA model. Espasa, Poncela and Senra (2002), concludes that ARIMA
models outperformed the VECM and dynamic factor models while Hubrich K. (2003), found that VAR
models outperformed the autoregressive forecasting models.

The study by Alnaa and Ahiakpor, (2005) followed the same pattern as other models proving the VAR
modeling technique to be highly efficient in its predictive ability. But, the study by Binner, Bissoondeeal,
Elger, Gazely and Mullineux (2005) drew a different conclusion. Using Neural Networks (NN)
forecasting model-a nonlinear forecasting approach, they found the VAR and ARIMA modeling
technique to be statistically inferior to the Neural Network model.Recent studies by Clausen and Clausen
(2010), using Phillips curves showed that model forecasting based on ex post output gaps generally
improve the accuracy of inflation forecasts compared to an AR (1) forecast model. The literature is rich in
the support of the forecasting strength of ARIMA modeling technique in forecasting (Hill and Fildes,
1984; Libert, 1983; Poulos, Kvanli, and Pavur, 1987; Texter and Ord, 1989). Although, recent studies in
Nigeria, have shown the VAR modeling technique to be highly useful in predicting short run forecast
(Adebiyi, Adenuga, Abeng, Omanukwe and Ononugbo 2010, Uko and Nkoro 2012), there is however a
need to revisit the forecasting ability of both ARIMA and VAR model in Nigeria.

METHODOLOGY

This study forecasts core inflation in Nigeria with the aid of a univariate time series model in the form of
an Autoregressive Integrated Moving Average (ARIMA) model developed by Box and Jenkins and a
multivariate time series Vector Autoregressive model (VAR). The choice of both models is linked to
resent forecasting success in both ARIMA and VAR modeling. Our objective is to establish the best
forecasting model in tracking price movements in Nigeria. The data used in this study is sourced from the
Central Bank of Nigeria Statistical Bulletin and the National Bureau of Statistics. The frequency of the
data is monthly and the period covered is 2003:01 to 2012:06. The variable used is the rate of change in
the consumer’s price index, broad money supply (M2) and our focus is to forecast core inflation. The
INF and M2 data gathered was estimated and analyzed with E-views 7 estimation software. Modeling and
forecasting inflation with the Box-Jenkins methodology requires the following systematic steps. The first
step is the data collection and examination stage, the second step is the identification of the data, while the
third step is the estimation of the model. The fourth and fifth step is the diagnostic checks and forecasting
stage respectively.

ARIMA Model

ARIMA entails the use of Box-Jenkins methodology which requires that the sample data be at least more
than 50 observations (Meyler et al 1998) and even when sample observations is greater than 50 there is
need to examine the data for the existence of structural breaks which if present in the data will necessitate
only the examination of a sub-section of the data or the need to introduce a dummy variable but in this
case, the data was stationary at levels as shown by Figure 1 and 2, this can easily be verified in the.
augmented Dickey-Fuller test of unit root with 5 per cent level of significance reported in Table 1 below
The estimation of a univariate time series variable with the autoregressive integrated moving average
method ARIMA (p,d,q), requires identification of the appropriate value of p, d and q. Where p denotes
the number of autoregressive term, d equals the number of times the series has to be differenced to obtain
an I(0) series and q measures the moving average term. The chief identification tool is the plot of the
autocorrelation function (ACF), the partial autocorrelation function (PACF), the correlograms and the
augmented Dickey and the Fuller (1971, 1981) test for unit roots. From Figure 1 and 2, it can be seen that
the series is stationary.

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I. Kelikume & A. Salami | IJBFR ♦ Vol. 8 ♦ No. 2 ♦ 2014

Figure 1: Autocorrelation Function Figure 2: Partial Autocorrelation Function

1.2 1.5

1
1
0.8
PAC
0.5
0.6

ρkk
ρk

0.4 AC
0
1 4 7 10 13 16 19 22 25 28 31
0.2
-0.5
0
1 4 7 10 13 16 19 22 25 28 31
-0.2 -1
Lag length Lag length

Figure 1 and 2 is the Autocorrelation and Partial Autocorrelation functions showing that the core inflation series is stationary at levels and that
it is an Autoregressive Moving Average (ARMA) process. This is seen in the pattern.

Table 1: Unit Root Teston Core Inflation with Intercept and a Linear Trend

T-Statistics Prob. Status

Augmented Dickey-Fuller test Statistics -3.4590** 0.0490 I(0)

Test Critical Values : 1% level -4.0420
5% level -3.4504
10% level -3.1505
the table is the result of the augmented dickey-fuller (adf) which indicates the core inflation series is integrated or stationary at levels. **
indicates significance at 5 per cent level.

Having obtained the order of integration (d), our next step is to obtain the ARMA pattern in the inflation
series by considering the autocorrelation function (ACF), the partial autocorrelation function (PACF) and
the associated correlograms. This process involves using the Box-Jenkins methodology where the ACF
and the PACF plots are used to predict p and q in the ARMA model. The selection of p and q is usually
based on the following characteristics of the ACF and the PACF plots. If data is purely AR (p), then ACF
will decline steadily and PACF will cut off suddenly after p lags but if data is purely an MA (q), ACF will
cut off suddenly after q lags and PACF will decline steadily. An ARMA (p, q) model usually exhibits a
complex pattern in the ACF and PACF function. From the plot of the autocorrelation function and the
partial autocorrelation function reported in Figure 1 and 2, we got a clear pattern to help predict p and q.
The criteria used in this case are;

 rss   k
BIC = Log   +  Log (n) * 
 n   n (1)

 rss   k
HQC = Log   +  2 * Log ( Log (n)) * 
 n   n (2)

 rss   k 
AIC = Log   + 2* 
 n   n (3)

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Where, SC = Schwarz criterion, HQC= Hannan-Quinn criterion and AIC = Akaike information criterion,
K = the number of coefficient estimated, rss = residual sum of squares and n = the number of observations
With the aid of the correlogram and the partial correlogram reported in Figure 1 and 2, we obtained the
identified model which is seen clearly in the plot of the ACF and the PACF function reported in Figure 1
and 2. The selection of the ARMA (p, q) model in equation (4) is based on the ACF and the PACF
function reported in Figure 1 and 2. Since the core inflation variable was stationary at levels as shown in
the unit root test reported in Table 2, there was no need to difference the variable. The graph of the
correlogram reported in Figure 1 and 2 reveals some interesting patterns. First, both the ACF function
(Figure 1) and the PACF function (Figure 2) exhibits some form of exponential decay. The spikes from
the graph shows the ACF to be statistically significant at lags 1, 2, and 14 while for the PACF, lags 1, 2,
12 and 14 appeared to be statistically different from zero The tentatively identified ARMA (p, q) model is
specified as follows;

CINFL = δ + α 1CINFt −1 + α 12 CINFt −12 + α 14 CINFt −14 + β1U t −1 + β 2U t − 2 + β12U t −12 + β14U t −14 (4)

Where; CINFL is inflation series at levels; α 1 , α 12 and α 14 are the coefficients of the AR (p) process
while β1 , β 2 , β12 and β14 are the coefficients of the MA (q) process. AR (p) is autoregressive process
while MA (q) is moving average process.

VAR Model

The seminal work by Sims (1980) brought a succor to the modeling of multivariate autoregressive models
with the use of an unrestricted vector autoregressive model (VAR). Conventionally, in the VAR modeling
technique, we consider several endogenous variables together with each endogenous variable explained
by its lagged values and the lagged values of all other endogenous variables in the model. In VAR
estimation and forecasting, a unit root test is not necessary because of the loss of information, observation
(Sims 1980). In modeling and forecasting inflation with VAR, we used a univariate autoregressive
framework, in which the model is specified describing the interdependence of money supply (broad
money supply) and core inflation. In its simplest form, we express the set of n variables collected in the n
x 1 vector Yt on their own lags and those of the other variables in the model. The model can be expressed
as;

Y t = α + β 1i Y t −1 + β 2i Y t − 2 +…+ β pi Y t − p + u t (5)

The coefficient matrix β 1i are the n x n matrix (made up of the inflation and money supply variables) and
u t is an n x 1 vector of serially uncorrelated random error which is assumed to have a multivariate normal
distribution u t ~ iidN (0, ∑ u ).

Assuming Y t is an n x 1 column vector composed of all the variables in our study, the VAR model
simply relates current values of Y t to past values of Y t and an n x 1 vector of innovations U t . This can
be written precisely as follows;

y1t = β1 + β11 y1t −1 + β12 y 2t −1 + α 11 y1t −2 + α 12 y 2t −2 + ∈1t (6)

y 2t = α 1 + β 21 y1t −1 + β 22 y 2t −1 + α 21 y1t −2 + α 12 y 2t −2 + ∈2t (7)

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I. Kelikume & A. Salami | IJBFR ♦ Vol. 8 ♦ No. 2 ♦ 2014

The VAR equation can be written more compactly as;

y t = α + β1 y t −1 + β 2 y t − 2 + u t (8)

Where α , is an n x 1 vector and β j ' s are n x n metrics.

RESULTS AND ANALYSIS

After successful identification of the ARMA (p, q) process, we proceed to estimate the ARMA (p, q)
process with EVIEW 7 estimation software. The result of the ARMA process is reported in Table 2.
Thereafter, we proceed to check the reasonableness of the model fit to the data. This is done by simply
obtaining the ACF and the PACF from the residual of the regression estimate reported in Table 2.

Table 2: Estimated ARMA (p, q) Coefficient

Variables Coefficient Std. Error T-Statistic Prob.

C 10.210 1.0247 9.9637 0.0000
AR (1) 0.9709 0.0154 62.996*** 0.0000
AR (12) -0.2555 0.0389 -6.5681*** 0.0000
AR (14) 0.1892 0.0385 4.9124*** 0.0000
MA (1) 0.8045 0.0750 10.727*** 0.0000
MA (2) 0.2108 0.0571 3.6923*** 0.0004
MA (12) -0.0764 0.0301 -2.5338*** 0.0130
MA (14) 0.4434 0.0428 10.345 *** 0.0000

R-squared 0.9959 Adjusted R-squared 0.9956

F-statistic 3268.8*** Durbin-Watson 1.7836
The table shows that 99 per cent of the systematic variation in core inflation is explained by it lag. The *** indicates that AR, MA and F-statistics
are significant at the 1% level while the Durbin-Watson shows the absence of serial correlation.

The model diagnostic check entails examining the graphical analysis of the residuals plot of the estimated
model and the autocorrelogram plot of the residuals to verify whether the residuals of the estimated
models are purely random. This is seen clearly in Figure 3 where the residual of the autocorrelation
function at various the lags hover around zero with the exception of lags 2, 9 and 15 while in Figure 4 the
residual of the partial autocorrelation function at various lags hover around zero with the exception of lags
2, 15 and 23. The estimated ARMA (p, q) model can therefore be accepted as a purely random walk
hence there is need to look for another ARIMA model. We however, proceed to forecasting core inflation
with the ARMA (p, q) model with the forecast shown in Table 5 below. To determine the appropriate lag
length for the VAR model, we employ the Akaike information criterion (AIC) and Schwarz criterion
(SC). This is determined precisely with the aid of E-view 7 estimating software shown in Table 3 below
and the period with the lowest criterion was asterisked.
Figure 3: Residual Autocorrelation Function Figure 4: Residual Partial Autocorrelation Function

0.4 0.4
0.3 0.3

0.2 0.2
0.1
0.1
ρkk
ρk

ACF 0 PACF
0
-0.1 1 3 5 7 9 11 13 15 17 19 21 23 25
1 4 7 10 13 16 19 22 25
-0.1 -0.2
-0.2 -0.3
Lag Length Lag Length

Note: Figure 3 and 4 is the Autocorrelation and partial autocorrelation function of the residual showing that the residual is a random walk.

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Table 3: VAR Lag Order Selection Criteria

Lag LogL LR FPE AIC SC HQ

0 -2063.8 0.0000 0.0000 39.727 39.778 39.747
1 -1607.2 886.70 0.0000 31.024 31.177 31.086
2 -1527.0 152.70 0.0000 29.559* 29.813* 29.662*
3 -1524.6 4.4521 0.0000 29.590 29.946 29.734
4 -1522.8 3.4246 0.0000 29.631 30.088 29.816
5 -1521.0 3.1998 0.0000 29.673 30.233 29.900
6 -1519.1 3.3489 0.0000 29.713 30.374 29.981
7 -1515.9 5.4911 0.0000 29.728 30.491 30.038
8 -1513.1 4.5463 0.0000 29.753 30.618 30.103
Note: * indicates lag order selected by choosing the lowest AIC and SC.

From the VAR estimate in Table 4 below, the intercept (C) for the inflation model was positive and
statistically significant at the 5 per cent level showing that inflation cannot be zero at any point in Nigeria.
Furthermore, while the parameters for lag inflation was significant at the 1 per cent level as shown by the
T-statistics although with different direction of impact, the lag broad money supply was not significant in
explaining the variation in current inflation. While the immediate past period inflation will increase
current inflation, the two periods past inflation will cause current inflation to fall.

Table 4: Vector Autoregression Estimate

Variables CINF M2
C 0.4187 1.7473
[2.3901]** [1.7737]
CINF(-1) 1.8475 20649
[38.893]*** [-0.7730]
CINF(-2) -0.8744 15022
[-18.335]*** [0.5601]
M2(-1) 0.0000 0.9273
[-0.0780] [9.5022]
M2(-2) 0.0000 0.0740
[-0.0000] [0.7550]
R2 0.9941 0.9947
Adjusted- R2 0.9939 0.9945
F-statistics 4,495.8*** 4,963.3***
Durbin-Watson Stat 2.0591 2.0292
Note: CINF is the core inflation series and M2 is the broad money supply, while numbers in brackets are the lag length, numbers in parenthesis
are the T-statistics. ** and *** indicate 5 and 1 per cent level of statistical significance respectively.

Furthermore, the adjusted R2 shows that more than 99 per cent of the systematic variation in inflation is
explained by lag inflation and money supply although money supply is not significant. Overall, the model
was significant at the 1 per cent level with a high F-statistic of 4,495.8 and the Durbin-Watson statistic
shows the absence of serial autocorrelation in the model. The result of the ARIMA and the VAR model
shows a good fit as shown by the Adjusted R-squared. While current inflation is explained by over 99
percent systematic variation in the independent variables in the ARIMA model, the VAR model also
showed predictive power given the value of its coefficient of determination and adjusted coefficient of
determination values of 0.9941 and 0.9939 respectively.

The F-statistics for both models show an overall significance at the 1 per cent level. While the AR and
MA’s were all significant at the 1 per cent level in the ARIMA model, the VAR model only lag inflation
was significant at the 1 per cent level while all the lags of money supply was not significant in
determining variation in inflation confirming the earlier findings of Salami and Kelikume (2012) that
inflation is not always and everywhere a monetary phenomenon. Since our aim is to predict and forecast
inflation and compare the forecast values of the ARIMA with that obtained from the VAR model, we
generated the forecast values directly using the Eview 7 estimating software.

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I. Kelikume & A. Salami | IJBFR ♦ Vol. 8 ♦ No. 2 ♦ 2014

Table 5: Forecast Comparism of the VAR and ARIMA Model

months actual cinf arima forecast var forecast

2012m05 12.40 10.235 12.197
2012m06 12.70 10.227 12.102
2012m07 13.00 10.219 11.929
2012m08 13.30 10.212 11.689
2012m09 13.50 10.205 11.397
2012m10 - 10.199 11.064
Table 5 show a comparison of the ARIMA and VAR forecast with actual core inflation published by the Central Bank of Nigeria. The forecast
result shows the VAR forecast to be closer to the actual inflation values. CINF is core inflation.

CONCLUSION

Current inflation in Nigeria which is 11.3 per cent in September 2012 (All Item Consumers Price Index)
is expected to increase in the last quarter of 2012 following severe flooding and the washing away of farm
lands in the earlier part of the year. Predicting price movements under periods of volatile food price
increases has been made much more difficult. This study forecasts inflation in Nigeria using monthly
data over the periods 2003:01 to 2012:06. Two methods used extensively in the literature for forecasting
inflation are the Vector Autoregressive Method (VAR) and the Autoregressive Integrated Moving
Average Method (ARIMA). This paper uses these methods for study with the sole objective of comparing
both forecasting method. While the ARIMA model was a univariate time series model, the VAR model
was a multivariate model that incorporates the interdependency amongst several endogenous variables.

The result of our estimate from both ARIMA and VAR model tracks actual inflation values for the period
2012: 06 to 2012: 09. However, the VAR model had smaller errors in terms of the minimum square error
and is the closest approximate to current inflation in Nigeria. The study forecasted core inflation using
VAR for the month of 2012:10 to be 11.06 percent. A major limitation of this study is that it focused on
two major forecast tool the VAR method and the ARIMA method and neglected the use of neural
network analysis. In addition only core inflation was used as a measure of inflation. Subsequent studies
on inflation forecasting in Nigeria should attempt to forecast inflation across a wider spectrum of inflation
measures.

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(2011) “ core measure of inflation as predictors of total inflation” Research Department, Federal Resrve
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Valle, S. (2002) “Inflation Forecasting with ARIMA and Vector Autoregressive Models in Guatemala,”
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ACKNOWLEDGE

The Author would like to thank the editor of the International Journal of Business and Finance Research,
the anonymous reviewers and the management of the Lagos Business School for funding this research.

BIOGRAPHY

Ikechukwu Kelikume is currently a doctoral student of the Swiss University of Economics (SMC)
Switzerland and leads sessions in Microeconomic and macroeconomic environment of business at the
Lagos Business School (LBS), Pan-African University. He researches and consults in areas which include
macroeconomic modeling, financial and monetary economics as well as econometrics and quantitative
methods in economics. +234 813 7978 069, [email protected]

Adedoyin Salami holds a doctoral degree of Queen Mary College, University of London. He is a full time
faculty member at the Lagos Business School (LBS), Pan-African University. He leads sessions in
economic environment of business and had served as director of programs for five years until January
2005. He is a member of the Monetary Policy Committee of the Central Bank of Nigeria and had been a
member of the Federal Government’s Economic Management Team. Dr. Salami’s research interest
include issues in corporate long term financial management; macroeconomic policy; corporate
competitiveness and risk management; and characteristics of small and medium enterprise (SMEs). +234
803 5767 562, [email protected]

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CAPITAL STRUCTURE DETERMINANTS OF PUBLICLY

LISTED COMPANIES IN SAUDI ARABIA
Turki SF Alzomaia, King Saud University

ABSTRACT

This paper investigates the capital structure of listed firms in Saudi Arabia, using firm specific data to
study the determinants of leverage. The study is based on an analysis of the capital structure of 93 Saudi
listed companies. The study extends from 2000 to 2010 and employs cross-sectional pool data
methodology. The results suggest there exists a positive relationship between size, growth of the firm and
leverage. On the other hand, the results show there are negative relationships between tangibility of
assets, profitability, risk and leverage.

JEL: G32

KEYWORDS: Capital Structure Determinants, Leverage, Saudi Arabia, Tradeoff Theory,

Pecking Order Theory

INTRODUCTION

T
he capital structure decision is one of the most controversial subjects in corporate finance and has
been extensively researched since the seminal paper of Modigliani and Miller (1958). A huge body
of financial literature exists relaxing many assumptions of the Modigliani and Miller paper. From
that, several competing theories of capital structure choice were formed including trade-off theory,
agency theory, and pecking order theory. Nonetheless, the capital structure decision is an empirical
concern as well. Numerous scholarly papers examine the financing decision of public companies
theoretically and empirically. In the early stage, the majority of empirical papers examined the case of
US companies (Warner 1977, Castanias 1983, Altman 1984, Bradley et al., 1984, Titman and Wessels
1988, Crutchley and Hansen 1989, Harris and Rivav 1991). Rajan and Zingales (1995) extend the analysis
of capital structure to G-7 countries focusing on four factors as determinants of leverage: tangibility of
assets, the market to book ratio, profitability, and size. Moreover, Booth et al. (2001) extend the analysis
of capital structure decision across 10 developing countries. The paper finds that the determinants of
capital structure in developed countries are also significant in these 10 developing countries. Since then
many financial researchers investigate capital structure decisions in individual countries around the world
(Shah and Hijazi 2004, Gaud et al. 2005, Correa et al.2007, Gajural 2005, Waliullah and Nishat 2008).

This paper attempts to explain the capital structure decision and its determinants in listed companies of
Saudi Arabia. One main characteristic of the Saudi financial market environment is the absence of a
corporate tax, a vague and general bankruptcy law, and a undersize and illiquid bond market. Our focus
will be trying to determine factors that affect capital structure decisions in a unique institutional
environment such as the Saudi Arabia case. We assume that the macroeconomic variables such as
inflation and economic growth play minimal role in capital structure decision for Saudi Companies. Thus,
for our analysis we consider only specific company factors such as size, growth, tangibility, profitability
and risk.

Our results indicate that factors affecting capital structure decision in developed and developing countries
prevail for the Saudi public companies as well. Size and growth opportunities are found to be positively
related to leverage while risk, profitability and tangibility are found to be negatively related to leverage.

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T. SF. Alzomaia | IJBFR ♦ Vol. 8 ♦ No. 2 ♦ 2014

Moreover, profitability and risk were the most important independent variables as determinants of the
leverage ratio.

This paper proceeds as follows. Section 2 briefly reviews the relevant theoretical and empirical capital
structure literature. Section 3 is a brief discussion of the Saud Capital Markets and Institutional factors.
Section 4 discusses the dataset and the hypotheses. Section 5 briefly explains the methodology. The
results are discussed in section 6. Section 7 discusses briefly the decomposition of leverage ratio. Section
8 provides a summary and conclusions.

LITERATURE REVIEW

Theoretical Literature Review

The publication of Modigliani and Miller (1958) is the most important development in financial
economics dealing with capital structure. Modigliani and Miller(henceforth M&M) make the following
assumptions: Capital markets are perfectly competitive and frictionless, firms and individuals can borrow
and lend at the risk free rate (implying that there is no bankruptcy cost), investors are with homogenous
expectations, all cash flow streams are perpetuities (no growth), all firms are assumed to be in the same
risk classes, firms issue only risk free debt and risky equity, no agency cost (managers always maximize
shareholders wealth) and there exists no signaling opportunity (insiders and outsiders have the same
information. Under these specific set of assumptions, M&M argued that in the absence of taxes, the
capital structure of the firm is irrelevant to its value.

In their 1963 paper, M&M extend the basic propositions in their original article by allowing for a
corporate profit tax under which interest payments are deductible. They conclude that the value of the
firm is a function of leverage and the tax rate. There are two extreme conclusions of the above theories.
On the one hand; M&M (1958) suggest that capital structure is irrelevant while, on the other hand, in
(1963) theorize the optimal structure is all debt.

Miller (1977) extends the M&M model to consider the effects of personal taxes. Miller argues the M&M
model with corporate taxes overstates the advantages of corporate debt financing. Personal taxes offset, to
some extent, the benefits from the tax deductibility of corporate interest payments. Therefore, in the
equilibrium, the value of the firm will still be independent of its capital structure. The following we will
discuss briefly the four main theories of Capital Structure.

Modigliani and Miller (1958) assumed implicitly that there are no bankruptcy costs. With relaxing this
assumption, many researches argue that with the existence of bankruptcy costs an optimal debt-equity
ratio will exist. This is referred to as the trade-off theory. The optimal debt to equity ratio is determined
by increasing the amount of debt until the marginal tax gain from leverage is equal to marginal expected
loss from bankruptcy costs.

In providing the capital structure irrelevancy theorem, M&M implicitly assume no agency cost and
mangers will act in the best interest of the firm's shareholders. Jensen and Meckling (1976), however,
furnish an agency cost-based rationalization for optimal capital structure determination. Separation of
ownership and control as well as conflict of interest between corporate managers, shareholders, and
bondholders give rise to agency costs. Thus, the optimal capital structure mix of the firm is established
through the efforts of all parties involved (agents, and investors) to minimize total agency-related costs.
Therefore, it is possible to establish an optimal financial mix in a world without taxes or bankruptcy cost.
Myers (1977) also provides an agency type of argument for the determination of a firm's capital structure.
In Myer's model, a firm’s capital structure decision is influenced by the value of its underlying real
options (in the form of growth opportunities). The greater this value, the less likely that a firm will take

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on risky debt. As the proportion of risky debt rises, there is an incentive for managers to take on
suboptimal investment strategies, because good investments will tend to benefit bondholders, rather than
shareholders.

The M&M approach to capital structure irrelevance also assume that the market possesses full
information about the activities of a firm. Ross (1977), however, proposes an alternative formulation for
the firm's capital structure determination that is based on the existence of symmetric information between
the firm's insiders and outsiders. Ross argues that if managers possess inside information, the managerial
decisions about the financial structures signal information to the market. Thus, managerial decisions to
alter financial structure will alter the market's perception of the firm. Consequently, the value of the firm
will rise with leverage.

Myers (1984) noted that if we relax the homogenous expectation assumption, asymmetric information by
different groups of market participants is admitted. Myers' work resulted in the symmetric information
theory of capital structure. In world with asymmetric information, corporations should issue new shares
only if they have extraordinary profitable investments that cannot be postponed or financed by debt, or if
management thinks the shares are overvalued. Moreover, investors recognize this tends to reduce the
firm's share price when it announces plans to issue new shares (signaling bad news). Finally, Myers
suggests a pecking order theory of capital structure. Firms are said to prefer retained earnings as their
main source of funds, next in order of preference is debt, and last comes external equity financing.

Empirical Literature Review

Warner (1977) discussed the role of bankruptcy costs in capital structure decisions and presents evidence
of the direct costs of bankruptcy for a number of US railroad firms. Warner collects data for 11 railroad
bankruptcies that occurred from 1933 to 1955. The study shows that direct bankruptcy costs may not be
large enough to be a determinant factor in capital structure decisions. Castanias (1983) and Altman (1984)
follow Warner's research of bankruptcy costs. Castanias analyzes the relation between failure and
leverage in small firms. The study finds that firms with high rates of failure tend to have low debt-equity
ratios. Although Castanias' results indicate the possibility of an optimal capital structure, the study
focuses on industry data and does not account for indirect bankruptcy costs. Altman, in contrast, provides
evidence of indirect costs. Altman compares expected profits with actual profits and shows that indirect
costs are 8.1% of the value of the firm three years prior to bankruptcy and 10.5% the year of bankruptcy.
The study indicates that total bankruptcy costs are not trivial.

Bradley, Jarrell and Kim (1984) use cross-sectional, firm specific data to test for the existence of an
optimal capital structure. BJK analyze three firm specific factors that influence the optimal capital
structure: the variability of firm value, the level of non-tax shields and the magnitude of the cost of
financial distress. Bradley et.al. find that firm leverage ratios are related inversely to earnings volatility
provided there are significant cost of financial distress. However, BJK’s results indicate a strong positive
relationship between leverage and non-tax shields. Titman and Wessels (1988) analyze the explanatory
power of various factors that have been proposed by a number of capital structure theories as attributes
that influence the choice of optimal capital structure.

Crutchley and Hansen (1989) present an empirical test of the Agency theory. They focus on equity
agency costs that result from the conflict of interest between managers and stockholders. C&H identify
five proxies for agency costs; i.e., earning volatility, discretionary investment (advertising expenses and
R&D), flotation costs, diversification loss to managers from holding firm's common stock, and firm size.
The results are consistent with the Agency theory. An increase in earnings volatility will have a
significant negative impact on leverage. Also, if discretionary expense increased, the firm uses less debt.
Moreover, the authors find that large firms tended to rely more on debt. Thies and Klock (1993) provide

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some support for Pecking Order theory. They suggest that the pecking order theory provides one
explanation for the inverse relationship found in their study between profitability and all forms of
leverage.

Rajan and Zingales (1995) examines the capital structure of G-7 countries (US, UK, Japan, Germany,
France, Italy, and Canada). The authors focus on four factors as determinants of leverage: tangibility of
assets, the market to book ratio, profitability, and size. The results of the study indicate that tangibility of
assets is positively correlated with leverage in all countries. The results also indicate that leverage
increase with size in all countries except Germany. On the other hand, the market to book ratio is
negatively correlate with leverage in all countries except Italy where it is positively correlated.
Furthermore, profitability is negatively correlated with leverage in all countries except Germany.
However, Bevan and Danbolt (2002), based on analysis of capital structure of 822 UK firms, examine the
sensitivity of Rajan and Zingales' results to variation in leverage measures. They find that Rajan and
Zingales' results are highly dependent upon the precise definition of leverage being examined. Thus, the
authors argue that the determinant of leverage vary significantly depending on the nature of the debt sub-
component being studied.

Booth et al. (2001) analyzed capital structure decisions of firm across 10 developing countries (Brazil,
Mexico, Jordan, Indi, Pakistan, Turkey, Zimbabwe, Korea, Thailand, and Malaysia) for the period 1980-
1990, utilizing both firm specific and institutional factors. The authors find that related factors for
explaining capital structure in developed countries are also relevant in developing countries. In general,
the results show that for developing countries profitability was the most successful independent variable
and negatively related to leverage. Size and tangibility of assets are positively related to the leverage
ratio.

Shah and Hijazi (2004) analyze the determinants of capital structure in listed firms in Pakistan for the
period 1997 to 2001. They follow Rajan and Zingales (1995) of selecting only four independent variables:
size, tangibility of assets, growth, and profitability. The results show that asset tangibility and size are
positively correlated with leverage. In contrast, growth and profitability are negatively correlated with
leverage.

Gaud et al. (2005) analyses the determinants of the capital structure for 104 Swiss listed companies from
1991-2000, employing a dynamic panel framework. The results show that size and tangibility of assets
are positively related to leverage, whereas profitability and growth are negatively related to leverage.
Following the same methodology of dynamic panel framework, Correa et al. (2007) examines the
determinants of capital structure decisions of the largest 500 Brazilian companies for the period 1999-
2004. The results show that profitability and tangibility of assets are negatively related to leverage, while
business risk is positively related to leverage. Gajural (2005) investigates the pattern and determinants of
capital structure of Non-financial Nepalese firms for the period 1992-2004. The analysis shows that asset
structure and size are positively related to leverage ratio. While liquidity, growth opportunities,
profitability, and non-debt tax shield are negatively related to the leverage ratio.

Frank and Goyal (2009) investigate the relative importance of several factors in the capital structure
decision of listed US companies for the period of 1950-2003. Among these factors they found a core of
six reliable factors that correlated with cross-sectional differences in leverage. The results of the study
indicate that leverage is positively related to firm size, tangible assets, median industry leverage, and
expected inflation. On the other side, leverage is negatively related to profits and market-to-book ratio.
According to the authors all six factors, except profit, have the sign predicted by the static tradeoff theory
in which the tax saving of debt are traded-off against deadweight bankruptcy costs.

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Waliullah and Nishat (2008) examines capital structure determinant choices of 533 non- financial firms
publicly listed on Karachi Stock Exchange (KSE) for the period from 1988 to 2005. Employing
autoregressive distributed lag (ARDL) methodology, the paper divided the determinants of financiering
behaviors into firm’s specific characteristics, reforms and industry characteristics. The results indicate
that size of the firm and growth opportunities are positively related to the debt ratio. On the other hand,
the results suggest that profitability and liquidity are negatively correlated with debt financing.
Furthermore, the results show that firms with high risk and more tangible assets will rely more on equity
financing and use less debt.

SAUD CAPITAL MARKETS AND INSTITUTIONAL FACTORS

Equity Market

As of the end of 2010 there are 146 listed companies in Saudi Arabia with a market capitalization of
about 80 percent of GDP. Market Capitalization is dominated by petrochemical companies (36.6 percent),
financial companies (27.6 percent) and telecoms (10 percent). In April 2008, the Capital Market
Authority restructured the Saudi stock market sectors based on the nature of business of each listed
company, its income, and earnings structure. After the new market structure, the Saudi stock market
consists of 15 sectors instead of its previous eight sectors. Since the new industry coding established only
at the end of the period for our study, we will not include the average leverage of the industry as an
explanatory variable in the study. The following table shows Saudi capital market indicators over the
period 2000-2010.

Table 1 illustrates some important characteristics of the Saudi Equity market during the period of the
study. For instance, the number of listed company increased from 75 companies at the end of year 2000 to
111 companies at the end of year 2007 and reached 146 at the end of year 2010. Furthermore, Table 1
indicates the importance of the equity market in the Saudi economy, which can be approximated by
market capitalization of listed companies to the GDP. The ratio of market capitalization to GDP was 32
percent at the end of 2000, then reaches its peak of 208% at the end of 2005, then fell to 79.6 percent at
the end of 2010. The main characteristic of the stock market during the period of study, 2000-2010, is the
high volatility of the market. The main index, the Tadawul All Share Index (TASI) was only 2,258 point
at the end of 2000. Then from the year 2003 on it started to accelerate rapidly until reaching its peak of
20,635 points on February 25, 2006. Thus, between 2003 and its peak the index gained a staggering 700
percent. From that peak, the correction started and the market collapsed reaching 7,933 points at the end
of 2006. Another collapse occurs during the world financial crises of 2008 when the Saudi index reach its
bottom at the end of the year 2008 of 4,803 points. For the years 2009-2010 the index swings between
6,000-7,000 points. In general, even with this very obvious fluctuation, the equity market becomes an
important financing tool for Saudi companies during the period of study.

Bond Market

Bond market development in Saudi Arabia traces its roots back to mid-1988, when government securities
were issued in the domestic market to fund government fiscal deficits. The market stagnated until 2009
when the Capital Market Authority (CMA) approved the trading of Sukuk (Islamic bond) and traditional
bonds for the first time in Saudi Arabia. This is an important step towards launching a second regulated
market. However, the Saudi bond market is still viewed as illiquid and thin. The total amount of issued
Sukuks and Bonds since the foundation of the market to end of 2010 stood at only at SRs 35.7 billion
with 7 issuances by 3 companies. Thus, with such undersized bond and Sukuk market companies
continue to rely heavily on short term bank loans as a the main debt instrument.

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Table 1: Saudi Equity Market Indictors

End of Period Listed Companies Market Capitalization Market Share Price Index
Year of issued shares Capitalization to (1985= 1000)
(Billion RLs) GDP
Annual % (%) Annual %
No. Change Value Annual % Change Index Change
2000 75 9 255 11.3 32.2 2258.29 65
2001 76 1 275 7.8 40.5 2430.11 8
2002 68 -11 281 2.5 40.2 2518.08 4
2003 70 3 590 100.1 74 4437.58 76
2004 73 4 1149 94.7 123 8206.23 85
2005 77 5 2439 100.12 208 16712.64 104
2006 86 12 1226 -49.7 92.5 7933.29 -53
2007 111 29 1946 58.8 136 11038.66 39
2008 127 14 924.5 -52.5 52.2 4802.99 -56
2009 135 6 1195 29.3 82.8 6121.76 27
2010 146 8 1325 11 79.6 6620.75 8
This table shows some indicators of the Saudi equity market for the period under the study (2000-2010). These indicators include: number of
listed companies, market capitalization of issued shares, market capitalization to GDP, and share price index. The number of listed companies
increases from 75 companies in year 2000 to 146 companies in year 2010. The ratio of market capitalization to GDP was only 32 percent at the
end of the year 2000, reaches its peak of 208% at the end of the year 2005, then dropped to 79.6 percent at the end of year 2010. The main index
(TASI) was only 2,258 point at the end of 2000, then reaches its peak of 20,635 point in February 25, 2006. During the world financial crises of
2008 the Saudi index reaches its bottom at the end of 2008 at 4,803 points. The Sources of the data are: Saudi Stock exchange Company
(Tadawul) and Saudi Arabian Monetary Agency (SAMA).

Bank Lending

Historically commercial bank loans have been the main source of financing corporations in Saudi Arabia.
According to the Saudi Arabian Monetary Agency (SAMA), at the end of year 2010, there were 21
commercial banks operating in Saudi Arabia including branches of five foreign banks. During the 1980s
and 1990s, bank financing and lines of credit dominated corporate financing channels. Bank credit
continues to be the most popular financing channel, catering to more than 80% of the total funding
needed. The main characteristic of bank loans is their short-term nature. For example, 59% of total loans
to companies were short-term loans with less than one-year maturity. This is in a line with Booth et al.
(2001) findings that for ten developing countries the amount of long-term debt is much lower in
comparison with developed countries.

During the 1970’s the Saudi Government created five major lending institutions namely; Public
Investment Fund, Saudi Credit Bank, Saudi Industrial Development Fund, Saudi Agricultural Bank, and
the Real Estate Fund. These government institutions provided direct credit programs to major business
sectors in Saudi Arabia. These programs are medium and long-terms credit programs. They charge
minimal fees. The total loans distributed by these institutions since their inception up to the end of 2010
is SRs 414.3 billion.

Tax System

Saudi Public companies are not subject to income tax. Instead, they are subject to an Islamic Tax called
'Zakat', which is a religious tax based on Islamic law (the Sharia) and is assessed on earnings and
holdings. Zakat is levied at a flat rate of 2.5% and is chargeable on the total of the company's capital
resources and income that are not invested in fixed assets. These include the company's capital, net
profits, retained earnings and reserves not created for specific liabilities. Moreover, loans used to finance

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acquisition of capital assets, investments, and inventory are added to Zakat bases. Only resources
(including income) which have been held for at least 12 months are subject to Zakat. Thus, we presume
that there are no obvious tax advantages for debt financing for Saudi Companies and therefore the tax will
not be considered as a factor for determining capital structure decisions for Saudi companies.

DATA AND HYPOTHESES

The sample consists of non-financial Public Saudi Firms over the years 2000-2010. The data are annual
and the data source is Gulf Base (Zughaibi and Kabbani Financial Consultants (ZKFC)). The database
contains balance sheet, profit and loss, and cash flow statement information for all Saudi public
companies. The exclusion of financial firms was motivated by the fact that these firms have to comply
with very strict legal requirements pertaining to their financing (Gaud et al., 2005). There were 146 listed
companies in the Saudi market by the end of the year 2010. However, after excluding financial firms (11
banks and 31 insurance companies) the number of companies in the study is 104 companies. Moreover,
we omitted any company with less than 3 years of available data. As a result we exclude all listed IPOs
companies in the years 2009 and 2010 (11 companies). These procedures resulted in smaller number of
93 companies in our sample, with a total of 967 observations available for analysis. Table 2 shows basic
statistics of selected financial statement items of Saudi companies for the period under the study.

One important element from Table 2 is that almost 36% of total observations have no long term debt, and
the value long term debt to total assets is around 20%. This assures the notion that Saudi companies
depend heavily on short-term bank loans as a main source of leverage. The low long-term debt ratio are
consistent with Booth et al. (2001) findings that companies in developing countries have substantially
lower long term debt compared with companies in developed countries.

Table 2: Statistics of Selected Financial Statement Items

Variable Observations Median Mean Standard Percentile

(N) (SR Million) (SR Million) Deviation 0.10 0.90
Total Assets 967 1,122,984 6,897,762 26,195,388 183,157 9,641,749
Current Liabilities 967 173,286 1,284,519 4,910,702 19,750 1,418,089
Long Term Debt 625 19,202 1,347,604 7,001,614 0 1,337,799
Book Equity 967 659,070 3,150,109 10,241,793 117,073 5,177,969
Book Liabilities 967 272,080 3,747,312 16,374,737 28,269 3,327,414
Profit 967 61,117 374,113 2,218,699 -13,492 538,288
This table shows the number of observations, the median, mean, standard deviation, the .10 percentile and the .90 percentile of some key
financial statement items for Saudi listed companies (excluding the financial institutions) covering the period 2000-2010. The number of
companies under the study is 93 companies. From the total of 967 observations, only 625 of them have some form of long term debt.

In accordance with previous studies concerning capital structure decision, proxies of the variables covered
were used for analysis of leverage determinants. Numerous definitions of leverage have been suggested
in the literature. In this study, the leverage ratio is defined as the ratio of book value of total debt divided
by book value of total assets. We consider the book leverage rather than market leverage since we think
the Saudi stock market was very volatile during the period of the study. Thus, using market leverage will
be unreliable since there will be stock mispricing across the stock market over the period of the study.
Furthermore, many empirical studies use long term debt only in calculating the leverage ratio. However,
as mentioned before, looking carefully at the data we notice that many Saudi companies have zero long
term debt which can be attributed to the new and illiquid bond market in Saudi Arabia. Thus, many of
those companies depend mainly on short commercial banking loans as the only source of debt. Therefore,
we consider the total debt (short + long term debt) in the measurement of the leverage ratio. In this study
we define the dependent variable (leverage ratio) as follows:

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𝑇𝑜𝑡𝑎𝑙 𝐿𝑖𝑎𝑏𝑙𝑖𝑡𝑖𝑒𝑠
Leverage Ratio =
𝑇𝑜𝑡𝑎𝑙 𝐴𝑠𝑠𝑒𝑡𝑠
(1)

For the independent variables we extend Rajan and Zingales' model (1995) to include business risk. Thus,
our independent variables include: size, growth opportunities, tangibility of the assets, profitability, and
business risk.

Large firms are usually more diversified and have more stable cash flow. Therefore, they are less risky.
This results in lower cost of debt as well as easier access to the external debt markets. Accordingly, we
predict a positive relationship between size and leverage. In this study, firm size is measured by the
natural log of sales.

Size = ln(Sales) (2)

Hypothesis 1: Firm size will have a positive relationship with leverage.

Due to the agency cost of debt firms with high growth opportunities are expected to rely more on retained
earnings and stakeholders co-investment than debt financing. Thus, we expect a negative relationship
between growth opportunities and leverage. While the majority of empirical studies employ the market-
to-book value as a proxy for growth opportunities, we measured it by the change in log of sales. Even
though many studies employ log assets as a proxy of the firm growth, we employ log of sales as a proxy
of growth. This is will not affect the analysis since there exists high correlation between change in assets
and change in sales. The main reason for not using the market-to-book value is that, as mentioned before,
the Saudi Stock market witnessed great volatility during the period under study. Thus using any market
value will be unreliable. Therefore, following Titman and Wessels (1988), the growth rate of sales will be
used as a proxy for growth opportunities.

𝑆𝑎𝑙𝑒𝑠𝑡 −𝑆𝑎𝑙𝑒𝑠𝑡−1
𝐺𝑟𝑜𝑤𝑡ℎ = (3)
𝑆𝑎𝑙𝑒𝑠𝑡−1

Hypothesis 2: The percentage change of sales will have a negative relationship with leverage.

Tangible assets can be used as collateral and are less subject to information asymmetries. As a result,
tangible assets minimize the agency cost of debt. According to agency cost and information asymmetry
theories, firms with high tangible assets tend to depend more on debt financing. Tangibility of assets is
defined as the ratio of fixed assets to total assets. We expect a positive relationship between tangibility of
assets and leverage.

𝐹𝑖𝑥𝑒𝑑 𝐴𝑠𝑠𝑒𝑡𝑠
𝑇𝑎𝑛𝑔𝑖𝑏𝑖𝑙𝑖𝑡𝑦 𝑜𝑓 𝐴𝑠𝑠𝑒𝑡𝑠 = (4)
𝑇𝑜𝑡𝑎𝑙 𝐴𝑠𝑠𝑒𝑡𝑠

Hypothesis 3: The greater the proportion of tangible assets the higher the leverage.

The relationship between profitability and leverage is an unresolved issue in capital structure theories. In
one hand, according to pecking order theory, firms prefer retained earnings as their main source of funds.
Next in order of preference is debt, and last comes external equity financing. On the other hand, trade-off
theory suggests that profitable firms prefer debt financing to benefit from the tax shield. However, in the
case of Saudi Arabia where there is no tax advantage of debt and most profitable companies usually
maintain large retained earnings, we believe that Saudi companies will exploit retained earnings as the
first source of fund before turning to raise debt. Profitability will be measured by return on assets and we
anticipate a negative relationship between profitability and leverage.

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𝑁𝑒𝑡 𝑃𝑟𝑜𝑓𝑖𝑡
𝑃𝑟𝑜𝑓𝑖𝑡𝑎𝑏𝑙𝑖𝑡𝑦 = (5)
𝑇𝑜𝑡𝑎𝑙 𝐴𝑠𝑠𝑒𝑡𝑠

Hypothesis 4: Profitability of the firm will have a negative relationship with leverage.

Firms with high volatility of earning might find some difficulty of honoring the payment of debt
obligations, which will result in high probability of bankruptcy. Thus, firms with high volatility of cash
flow can lower their risk by reducing debt levels. We measure risk by variability of the return on assets
(standard deviation of return on assets) and anticipate a negative relationship between risk and leverage.

𝑅𝑖𝑠𝑘 = 𝑆𝑡𝑎𝑛𝑑𝑎𝑟𝑑 𝑑𝑒𝑣𝑖𝑎𝑡𝑖𝑜𝑛 𝑜𝑓 𝑡ℎ𝑒 𝑟𝑒𝑡𝑢𝑟𝑛 𝑜𝑛 𝑎𝑠𝑠𝑒𝑡𝑠 = σ (𝑅𝑂𝐴) (6)

Hypothesis 5: The variability of the return on assets will have a negative relationship with leverage.

Table 3 shows a large difference for the leverage ratio for the Saudi companies which range from only
9.4% for the 10th percentile to 63.2% for the 90th percentile. The average debt ratio is 33.6% for Saudi
public companies, which is comparable to the debt ratio of some of developing countries (Booth et al,
2001) such as Brazil 30.3%, Mexico 34.7%. However, the debt ratio is much lower in comparison to debt
ratios of other developing countries included in Booth et al. study. Examples include the debt ratio for
South Korea 73.4%, India 67.1%, Pakistan 65.5%, and Turkey59.1%. Furthermore, the debt ratio of Saudi
Companies is much lower than the debt ratio of developed countries. Rajan and Zingales (1995) find debt
ratio for listed companies in Germany 73%, France 71%, Italy 70%, Japan 69%, US 58%, Canada 56%,
and UK 54%.

Table 3: Descriptive Statistics for Leverage Measure and Explanatory Factors

Variable Observations (N) Median Mean Standard Deviation Percentile

.10 .90
Leverage Ratio 967 0.292 0.336 0.205 0.094 0.632
Firm Size 967 12.726 12.281 3.073 9.714 14.815
Firm Growth 967 0.069 0.441 3.827 -0.172 0.474
Tangibility of Assets 967 0.681 0.651 0.211 0.330 0.896
Profitability 967 0.055 0.066 0.103 -0.025 0.185
Risk 967 0.0455 0.055 0.047 0.017 0.097
This table presents descriptive statistics of the leverage ratio and five independent variables: firm size, firm growth, tangibility of assets,
profitability, and risk. The sample contains 93 companies listed in the Saudi stock exchange (TASI). The data covers 2000-2010.We define the
leverage ratio as total liabilities divided by total assets. We measure size as the natural logarithm of sales. We define growth as the parentage
change of sales. We measure asset tangibility by fixed assets divided by total assets. Profitability is net profit divided by total assets. Risk is
defined as standard deviation of return on assets. The leverage ratio for Saudi Companies, with a mean of 33.6 percent, is low in comparison to
the leverage ratio of most developed and developing countries.

For the independent variables the table shows the size of Saudi companies generally rang between mid-
size companies to large-size companies, ranging from 9.7 to 14.8. The growth opportunities demonstrate
significant variability ranging from negative 17.2% to positive 47.4%. The value of the mean of the
growth opportunities is about 44.1% which is much higher than the value of the median 6.9%. The table
also shows high mean and median of tangibility of assets (65.1% and 68.1%), in which reflect the intense
use of fixed assets for the Saudi's public companies. Table 4 shows the correlation coefficients between
and among leverage ratio and each of the expletory variables, as well as the correlation among the
independent variables.

Table 4 shows the leverage ratio has a positive and significant correlation with size and growth.
Conversely, the leverage ratio has a negative and significant correlation with tangibility, profitability and
risk. The correlations among independent variables show that growth has non-significant correlations
with any of the explanatory variables. Size has a positive significant correlation with tangibility and

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negative but non-significant correlation with risk. Moreover, we examine the variance inflation factor
(VIF) to evaluate for the presence of multicolinearity among the independent variables. The VIF statistics
are substantially lower than 10 indicating no multicolinearity between the independent variables. This
implies we do not need to eliminate any independent variables for reasons of multicolinearity.

Table 4: Correlations between Individual Variable and VIF Coefficients

Leverage Size Growth Tangibility Profitability Risk VIF

Ratio
Leverage Pearson 1 0.302*** 0.083** -0.152*** -0.117*** -0.116***
Ratio Correlation
Size Pearson 1 -0.034 0.256*** 0.279*** -0.002 1.134
Correlation
Growth Pearson 1 0.047 0.001 -0.001 1.004
Correlation
Tangibility Pearson 1 -0.246*** 0.027 1.113
Correlation
Profitability Pearson 1 -0.134*** 1.145
Correlation
Risk Pearson 1 1.020
Correlation
This table presents Pearson correlation coefficients for the variables used in the analysis and VIF (variance inflation factor) tests between
independent variables. The sample contains 93 companies listed in the Saudi stock exchange (TASI). The data cover the period 2000-2010.
Leverage ratio is defined as total liabilities divided by total assets. Size is defined as the natural logarithm of sales. We define growth as the
parentage change of sales. We measure asset tangibility by fixed assets divided by total assets. Profitability is net profit divided by total assets.
Risk is the standard deviation of return on assets. ***, **, and * indicate significant at the 1, 5 and 10 percent level respectively.

METHODOLOGY

We follow the literature by using a cross-sectional pooled data model to study capital structure decision
determinant factors of Saudi Companies. The firm's debt ratio will be regressed against the natural log of
its sales, the change in log of total sales, the tangibility of its assets, its return on assets, and the standard
deviation of its return on assets. The coefficients are estimated using ordinary least square (OLS). For the
outliers in our data sample we follow Bevan and Danbolt (2002), eliminate them by winsorising the
dependent variable and all independent variables at the one percent level. The regression equation is:

𝑠𝑖𝑧𝑒, 𝑔𝑟𝑜𝑤𝑡ℎ 𝑜𝑝𝑝𝑜𝑟𝑡𝑢𝑛𝑖𝑡𝑖𝑒𝑠, 𝑡𝑎𝑛𝑔𝑖𝑏𝑙𝑖𝑡𝑦 𝑜𝑓 𝑎𝑠𝑠𝑒𝑡𝑠,

𝐿𝑒𝑣𝑒𝑟𝑎𝑔𝑒 = ƒ � � (7)
𝑝𝑟𝑜𝑓𝑖𝑡𝑎𝑏𝑙𝑖𝑡𝑦, 𝑏𝑢𝑠𝑖𝑛𝑒𝑠𝑠 𝑟𝑖𝑠𝑘

𝐿𝑒𝑣𝑒𝑟𝑎𝑔𝑒�𝑓𝑖𝑟𝑚𝑖,𝑡 � = α + β1 𝚕𝚗 𝑠𝑎𝑙𝑒𝑠𝑖,𝑡 + β2 ∆𝚕𝚗 𝑠𝑎𝑙𝑒𝑠𝑖,𝑡 + β3 𝑡𝑎𝑛𝑔𝑖𝑏𝑙𝑖𝑡𝑦 𝑜𝑓 𝑎𝑠𝑠𝑒𝑡𝑠𝑖,𝑡 +

β4 𝑟𝑒𝑡𝑢𝑟𝑛 𝑜𝑛 𝑡𝑜𝑡𝑎𝑙 𝑎𝑠𝑠𝑒𝑡𝑠𝑖,𝑡 + β5 σ 𝑟𝑒𝑡𝑢𝑟𝑛 𝑜𝑛 𝑡𝑜𝑡𝑎𝑙 𝑎𝑠𝑠𝑒𝑡𝑠𝑖,𝑡 + ε𝑖,𝑡 (8)

Where i denote firm and t denotes the time, α is the intercept and ε𝑖,𝑡 is error term.

EMPIRICAL RESULTS

From the result of our analysis we construct our regression model as follows:

𝐿𝑒𝑣𝑒𝑟𝑎𝑔𝑒 = 0.207 + 0.023 𝚕𝚗 𝑠𝑎𝑙𝑒𝑠 + 0.004 ∆𝚕𝚗 𝑠𝑎𝑙𝑒𝑠 − 0.125𝑡𝑎𝑛𝑔𝑖𝑏𝑙𝑖𝑡𝑦 𝑜𝑓 𝑎𝑠𝑠𝑒𝑡𝑠

− 0.521𝑟𝑒𝑡𝑢𝑟𝑛 𝑜𝑛 𝑡𝑜𝑡𝑎𝑙 𝑎𝑠𝑠𝑒𝑡𝑠 − 0.638 σ 𝑟𝑒𝑡𝑢𝑟𝑛 𝑜𝑛 𝑡𝑜𝑡𝑎𝑙 𝑎𝑠𝑠𝑒𝑡𝑠
+ ε𝑖,𝑡
Tables 5 shows the regression model summery as well as the output of the regression analysis. For our
model in general, the R2 is 17.2%, which means these five independent variables account for only 17.2%
of the variation in leverage ratios for listed Saudi companies. This value is close to the R2 of Frank and

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Goyel (2003) of 17.5%. The F-statistics shows the validity of the model with a value of 41.140 which is
significant at the one percent level meaning the model is capable of determining variation of the total debt
ratio of Saudi listed companies.

Table 5: The Model Summary and Cross Sectional Regression Results

95.0% Confidence Interval for B

Coefficients B Std. Error t-value Lower Bound Upper Bound
(Constant) 0.207*** 0.036 5.718 0.136 0.278
Size 0.023*** 0.002 10.885 0.019 0.027
Growth 0.004*** 0.002 2.640 0.001 0.007
Tangibility -0.125*** 0.030 -4.174 -0.184 -0.066
Profitability -0.521*** 0.062 -8.399 -0.643 -0.399
Risk -0.638*** 0.128 -4.975 -0.889 -0.386
R-Square 0.176 MSE 0.035
Adjusted R- Square 0.172 Durbin-Watson 0.535
F 41.140 AIC -3243.835
Prob (F Statistic) 0.0001
This table shows results of the estimates from the Ordinary Least Square (OLS) Model. The sample contains 93 Saudi Firms listed in the Saudi
Stock Exchange for which there is a minimum of 3 consecutive years of data for the 2000-2010 period. The leverage ratio was regressed against
five independent variables: size, growth, tangibility, profitability, and risk. The estimated model is: 𝐿𝑒𝑣𝑒𝑟𝑎𝑔𝑒�𝑓𝑖𝑟𝑚𝑖,𝑡 � = α + β1 𝚕𝚗 𝑠𝑎𝑙𝑒𝑠𝑖,𝑡 +
β2 ∆𝚕𝚗 𝑠𝑎𝑙𝑒𝑠𝑖,𝑡 + β3 𝑡𝑎𝑛𝑔𝑖𝑏𝑙𝑖𝑡𝑦 𝑜𝑓 𝑎𝑠𝑠𝑒𝑡𝑠𝑖,𝑡 + β4 𝑟𝑒𝑡𝑢𝑟𝑛 𝑜𝑛 𝑡𝑜𝑡𝑎𝑙 𝑎𝑠𝑠𝑒𝑡𝑠𝑖,𝑡 + β5 σ 𝑟𝑒𝑡𝑢𝑟𝑛 𝑜𝑛 𝑡𝑜𝑡𝑎𝑙 𝑎𝑠𝑠𝑒𝑡𝑠𝑖,𝑡 + ε𝑖,𝑡 . We define the leverage
ratio as total liabilities divided by total assets. Size is the natural logarithm of sales. We define growth as the parentage change of sales. We
measure asset tangibility by fixed assets divided by total assets. Profitability is net profit divided by total assets. Risk is defined as standard
deviation of return on assets. ***, **, and * indicate significant at the 1, 5 and 10 percent level respectively.

The results of the study show that size has a positive and significant relationship with leverage, though
the size of the coefficient tends to be small. This suggests that size of the company has limited impact on
the capital structure of Saudi Companies. Growth has a significant and positive relationship with leverage,
contrary to our expectations, though the size of the coefficient tends to be small. This finding is consistent
with the pecking order theory which predicts that growth companies accumulate more debt over time.
One the other hand, this finding is contradictory to the agency theory prediction where firms with greater
growth opportunities are expected to use less risky debt. Since the coefficient of growth is small, growth
has very little effect of the capital structure of Saudi Companies.

Tangibility has a negative and significant relationship with leverage, opposite from what we anticipated.
This negative relationship is in accordance with the pecking order theory which asserts that because of
low asymmetric information, large tangible assets makes equity issuance less costly. Another explanation
for this unanticipated relationship between tangibility and leverage is that, as Beger and Udell (1994)
argue, firms with close relationships with creditors need to provide less collateral because the relationship
substitutes for physical collateral. With only 11 commercial banks in Saudi Arabia, at the time of the
study, the close relationship between banks and listed companies is obvious. Furthermore, this outcome
confirms the results of Booth et al. (2001) that total debt ratios decrease with the tangibility of assets.

Profitability has a significant and strong negative relationship with leverage, with a size of a coefficient of
-0.521. This result is consistent with the pecking order theory where profitable firms are predicted to use
less debt. Booth et al. (2001) argue that the strong negative relationship can be related to agency and
information asymmetry problems as well as the underdeveloped nature of the long-term bond market,
which we believe is the case in Saudi Arabia.

Risk has a significant and strong negative relationship with leverage. This means firms with more volatile
cash flow will use less debt. This result is consistent with agency theory which predicts that an increase in

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earnings volatility will have a significant negative impact on leverage. In summary, it seems that risk and
profitability are the strongest explanatory powers of capital structure determinants for Saudi companies.

DECOMPOSITION OF LEVERAGE RATIO

Bevan and Danbolt (2002) suggest that the determinants of leverage are sensitive to the components of
debt being analyzed. In addition, since we found that almost 36% of the study observations have no long-
term debt, we think it more accurate if we divide the debt ratio to long term debt ratio and short term debt
ratio. Thus, we decompose the leverage ratio into its sub-component as long and short term debt ratios,
and then estimate the extent to which each of these ratios might be related to our five explanatory
variables. The long-term debt ratio is defined as total liabilities minus current liabilities divided by total
assets. The short-term debt ratio is defined as current liabilities divided by total assets.

As discussed in the main body of the paper all five explanatory variables have significant relations with
the total debt ratio. However, growth opportunities and tangibility of assets appeared with signs contrary
to expectations. As noted earlier, total debt ratio risk and profitability, both negatively related to leverage,
are the major factors determining the capital structure for Saudi companies. However, when we
decompose the total debt ratio into long-term ratio and short-term ratios we get different results for some
of coefficients as shown in Table 6.

For the long-term debt ratio model, size is negatively related to leverage instead of positively related to
leverage with total debt model, still for both models size have very small effect on the capital structure of
Saudi companies. Growth is positively related to long term leverage but with a small effect. Tangibility of
assets becomes positively related to the long-term leverage. Both profitability and risk have the same sign
as before but with less effect when measuring long-term debt than the total debt ratio. Adjusted R2 and F-
statistic are a little lower with long term debt ratio with values of 0.165 and 23.932 respectively.

For the short-term debt model, all coefficients are significant and have the same signs as the total-debt
model. However, tangibility becomes the most important factor for explaining the capital structure,
followed by profitability and risk. Thus, the order of the importance of these three factors reverses.
Additionally, the short-term model comes with the best explanatory power compared with the other two
models. The adjusted R2 increased to 28.7 which mean these five independent variables account for
28.7% of the variation in short-term leverage ratios for listed Saudi companies. The F-statistics shows
better validity of the model with a value of 78.678 in comparison to 41.140 for the total-debt ratio and
only 23.932 for the long-term debt model. The short-term model is best fits the data set of listed
companies in Saudi Arabia. These results assure the claim of Bevan and Danbolt (2002) that the
determinants of leverage are significantly sensitive to the components of debt being analyzed.

CONCLUSION

This paper presents a study of capital structure determinants for 93 listed companies in Saudi Arabia for
the period 1999-2010. The analysis is conducted using a cross-sectional pooled model. The study
suggests size and growth opportunities are positively related to leverage. Tangibility, profitability and risk
are negatively related with leverage. Moreover, the results indicate that risk and profitability are the major
factors driving capital structure decisions for listed companies in Saudi Arabia. Our results provide some
unexpected signs for some coefficients namely growth opportunities and tangibility of assets. In general,
most empirical results of the study support the pecking order theory. This study can be extended by
considering ownership structure and median industry leverage as explanatory variables for capital
structure decision of Saudi companies.

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Table 6: Cross-sectional Results of Decomposed Leverage Ratio

Model Coefficient St. Error t-Value

1. Total Debt Ratio Model
Constant 0.207*** 0.036 7.718
Size 0.023*** 0.002 10.885
Growth 0.004** 0.002 2.64
Tangibility -0.125*** 0.03 -4.174
Profitability -0.521*** 0.062 -8.399
Risk -0.638*** 0.128 -4.975
Adjusted R2 0.172
F-statistic 41.14
Prob. of (F-Stat.) 0.0001

2. Long Term Debt Ratio Model

Constant 0.108** 0.035 3.115
Size -0.006** 0.002 -3.087
Growth 0.003* 0.001 2.498
Tangibility 0.194*** 0.028 6.96
Profitability -0.158** 0.051 -3.064
Risk -0.467*** 0.095 -4.921
Adjusted R2 0.165
F-statistic 23.932
Prob. of (F-Stat.) 0.0001

3. Short Term Debt Ratio Model

Constant 0.263** 0.024 10.781
Size 0.013*** 0.001 9.344
Growth 0.000** 0.001 0.314
Tangibility -0.306*** 0.02 -15.174
Profitability -0.227*** 0.042 -5.434
Risk -0.112*** 0.086 -1.304
Adjusted R2 0.287
F-statistic 78.678
Prob. of (F-Stat.) 0.0001
This table shows estimates from Ordinary Least Square (OLS) models. The sample contains 93 Saudi Firms listed in the Saudi Stock Exchange.
for 2000-2010. Model 1 defines the total debt ratio as total liabilities divided by total assets. Model 2 defines the long-term debt ratio as total
liabilities minus current liabilities divided by total assets. Model 3 defines short term debt ratio as current liabilities divided by total assets. In
each model the leverage ratio was regressed against five independent variables: size, growth, tangibility, profitability, and risk. The estimated
model is: 𝐿𝑒𝑣𝑒𝑟𝑎𝑔𝑒�𝑓𝑖𝑟𝑚𝑖,𝑡 � = α + β1 𝚕𝚗 𝑠𝑎𝑙𝑒𝑠𝑖,𝑡 + β2 ∆𝚕𝚗 𝑠𝑎𝑙𝑒𝑠𝑖,𝑡 + β3 𝑡𝑎𝑛𝑔𝑖𝑏𝑙𝑖𝑡𝑦 𝑜𝑓 𝑎𝑠𝑠𝑒𝑡𝑠𝑖,𝑡 + β4 𝑟𝑒𝑡𝑢𝑟𝑛 𝑜𝑛 𝑡𝑜𝑡𝑎𝑙 𝑎𝑠𝑠𝑒𝑡𝑠𝑖,𝑡
+β5 σ 𝑟𝑒𝑡𝑢𝑟𝑛 𝑜𝑛 𝑡𝑜𝑡𝑎𝑙 𝑎𝑠𝑠𝑒𝑡𝑠𝑖,𝑡 + ε𝑖,𝑡 . ***, **, and * indicate significance at the 1, 5 and 10 percent level respectively.

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Bevan, A., and J. Danbolt (2002) “Capital Structure and its Determinants in the United Kingdom A
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Correa, C., L. Basso and W. Nakamura (2007) “What Determines the Capital Structure of the Largest
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Frank, M.Z., and V.K. Goyal (2007) “Trade-off and Pecking order theories of debt,” Handbook of
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(Elsevier/north-Holland, Amsterdam).

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Shah, A., and T. Hijazi (2004) “The Determinants of Capital Structure of Stock Exchange-Listed
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BIOGARPHY

Dr. Turki Alzomaia is an assistant professor of finance at College of Business Administration, King Saudi
University, Riyadh, Saudi Arabia. He received a PhD in finance and investment from the George
Washington University. His research interests lie in the area of corporate finance. His email address is:
[email protected]

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COST EFFICIENCY OF GHANA’S BANKING

INDUSTRY: A PANEL DATA ANALYSIS
Kofi Adjei-Frimpong, Lincoln University
Christopher Gan, Lincoln University
Baiding Hu, Lincoln University

ABSTRACT

This study analyzes the efficiency of the banking industry in Ghana over the period of 2001–2010 using
the data envelopment analysis. The study investigates the impact of size, capitalization, loan loss
provision, inflation rate and GDP growth rate on Ghana’s bank efficiency using both static and dynamic
panel data models. The static model is estimated by the fixed effects estimator whereas the dynamic
mdoel is estimated by the two step system GMM estimator. The results suggest that Ghana banks are
inefficient. This study reveals that well-capitalized banks in Ghana are less cost efficient. In addition,
bank size has no influence on bank cost efficiency suggesting that larger banks in Ghana have no cost
advantages over their smaller counterparts. The findings also exhibit that loan loss provision ratio has no
effect on bank efficiency in Ghana. This study finds GDP growth rate negatively influences bank cost
efficiency and that lagged cost efficiency tends to persist from year to year.

JEL: E44, E50, E60

KEYWORDS: Data Envelopment Analysis, Bank Efficiency, Cost Efficiency

INTRODUCTION

T he banking industry in Ghana has changed considerably since 1988 as a result of the gradual and
steady implementation of financial services deregulation, globalisation and the emergence of
communication and information technologies. The financial deregulation was undertaken as part of
the structural economic adjustment and stabilization program launched in 1983 with the assistance of the
International Monetary Fund and World Bank. These financial sector reforms are aimed at increasing
banks competitiveness, efficiency and performance in Ghana’s banking system that could then contribute
in greater measure to stimulate economic growth and ensure financial stability. During the pre-reform era,
Ghana banking system was dominated by the state owned banks and totally controlled by the government.
Ghana’s economic performance declined and its banking system was in distress. Banks were
characterised by inadequate capital, insufficient loans loss provisions, high operating costs due to
inefficient operations, a large portfolio of nonperforming loans and endured enormous political influence
(International Monetary Fund, 1999; World Bank, 1989). The financial system was distorted by interest
rate controls and selective credit policies, lack of competition, and weak supervision by the Bank of
Ghana (World Bank, 1989).

As a result, financial reforms were undertaken and most restrictions on foreign entry, interest rates and
exchange rates were removed. The results have increased the capacity of financial institutions to mobilise
domestic savings, enhanced efficiency among banks, and strengthened economic growth. The central
bank set up the payments system infrastructure and appropriate measures that facilitate a competitive and
efficient banking sector. The Ghana banking sector has shown considerable improvements in
communication and computing information technology, as banks modernized their distribution networks
and introduced new banking services such as Automated Teller Machines (ATMs), telephone banking,
mobile banking and internet banking are now prevalent in Ghana. The Ghana banking sector is reasonably
efficient, financially innovative, competitive, profitable, and growing quite quickly (Acquah, 2009). The

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sector has seen some structural changes with reduced concentration and strong competition for market
shares, increase in branch network and provision of various new banking products in Ghana. For example,
the number of banks actively operating in Ghana has grown from 7 in 1987 to 27 in 2010. Most of the
new entrants were foreign banks. During the same period, the number of foreign banks in Ghana
increased from 3 to 15. The bank concentration based on the Herfindahl-Hirschman index (HHI) has
dropped considerably from 1,065.9 points in 2000 to 600.0 points in 2010 (Bank of Ghana, February
2009) representing a decrease in market concentration of 30.2 percent, as a result of the increase of the
number of banks. During the period 2001 to 2010 the real gross domestic product has grown between 4.5
percent and 8.4 percent (International Monetary Fund, 2011).

Ghana’s financial sector reforms policies have long been pursued with great enthusiasm and consistency
than in some other African countries. Despite the considerable progress for the past 12 years as a result of
the financial reforms, no study has been conducted to evaluate the level and determinants of bank
efficiency in Ghana. This paper attempts to fill this gap in literature by providing empirical evidence on
efficiency in the Ghana’s banking industry. In addition, better understanding of the factors affecting
Ghana banks’ efficiency is vital to both bank regulators and policy makers because improvements in
efficiency in the banking industry are essential prerequisite for providing a more efficient system of asset
allocation in the financial system which then facilitates lower cost of capital to firms and accelerates
capital accumulation and productivity growth (McKinnon, 1973)..The aim of this study is to determine
whether deregulation has improved the level of bank cost efficiency of Ghana’s banking sector and
examine the determinants of bank cost efficiency using both static and dynamic models.

The rest of the paper is organized as follows. Section 2 discusses the relevant literature on bank
efficiency. Section 3 provides the methodology and data employed. Section 4 presents the empirical
results; and Section 5 concludes the paper.

LITERATURE REVIEW

Many studies have used various methods to estimate bank efficiency as well as different econometric
approaches to determine the factors that affect bank efficiency. Many of the previous studies on bank
efficiency have been conducted on developed economies (Pasiouras, 2008 and Delis et al., 2009 on Greek
banks; Mukherjee et al., 2001 on US banks; and Girardone et al., 2004 on Italian banks). However, the
recent resurgence of economic and financial reforms across the developing countries has also raised the
awareness of the importance of bank efficiency (Tecles & Tabak, 2010 on Brazilian banks; Ariff & Can,
2008 on Chinese banks; Altunbas et al., 2007 on banks from 15 European countries and; Ataullah & Le,
2006 on India and Pakistan banks).

Previous studies revealed mixed results regarding the relationship between financial reforms and
efficiency. Casu & Molyneux (2003) use a sample of 530 banks from five European Union countries
covering the period 1993 to 1997 to investigate the existence of productive efficiency across the European
banking markets since the introduction of the Single Internal Market. Their results show an evidence of a
small improvement in bank efficiency levels. Similarly, Ataullah & Le (2006) analyze the efficiency of
the Indian banking sector during 1992–1998 using the data envelopment analysis (DEA) method and find
evidence of efficiency gain in the Indian banking industry during the post-economic reforms era. A recent
study by Loukoianova (2008) who uses DEA to investigate the cost and revenue efficiency of Japanese
banks from the period 2000-2006 finds enhancement in efficiency for the period between 2001 and 2006.
Staub et al. (2010) estimate cost, technical and allocative efficiencies for Brazilian banks for the period
2000–2007 and conclude that banks in Brazil are inefficient.

In assessing the determinants of bank efficiency, the relationship between efficiency, on one hand, and
bank size, bank capitalization, loan loss provisions ratio and GDP growth, on the other hand, is

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ambiguous. The results of previous studies on the relationship between bank size and bank efficiency are
inconsistent. Some previous studies have found that larger banks are more efficient (e.g. Miller & Noulas,
1996; Ataullah & Le, 2006; Tecles & Tabak, 2010). In contrast, Isik & Hassan (2002), Girardone et al.
(2004) and Altunbas et al. (2007) studies have documented a significantly negative effect of bank size on
bank efficiency. Other studies have observed insignificant influence of bank size on bank efficiency (e.g.
Berger & Mester, 1997, Ariff & Can, 2008; Staub et al., 2010).

Some previous studies such as Casu & Girardone (2004) , Ataullah et al.(2004), Staikouras et al. (2008)
and Yildirim & Philippatos (2007) reported a negative impact of loan loss provisions ratio on bank
efficiency. However, Altunbas et al. (2007) find a positive relationship between loan loss provision and
bank efficiency while Staub et al. (2010) observed an insignificant relationship. The relationship between
bank capitalization and bank efficiency clearly show mixed results. For example, some studies have
reported a positive relationship between bank capitalization and bank efficiency (see Casu & Girardone,
2004; Pasiouras, 2008, Yildirim & Philipatos, 2007; Staikouras et al., 2008). On the other hand, Kwan &
Eisenbeis (1997), Altunbas et al. (2004), Altunbas et al. (2007) and Kablan (2010) studies reveal a
negative relationship. A negative relationship can be attributed to the fact that financial capital influences
costs through its use as a source of financing loans (Berger & Mester, 1997; Ariff & Can, 2008;
Staikouras et al., 2008). Thus, raising capital that involves higher costs than taking deposits, for example
issuing shares, could generate a negative relationship between bank capitalization and bank efficiency.
Others studies such as Ariff & Can (2008), Casu & Molyneux (2003) and Staub et al. (2010) find no
significant impact of bank capitalization on bank efficiency.

In regards to the macroeconomic factors on bank efficiency, Maudos et al. (2002) study 10 European
Union countries for the period 1993–1996 and report that GDP growth rate has a positive correlation with
profit efficiency but a negative correlation with cost efficiency. Yildirim & Philippatos (2007) investigate
cost and profit efficiency of 12 transition economies of Central and Eastern Europe (CEE) banks from
1993 to 2000. The authors investigate the determinants of bank efficiency employing the generalized least
squares fixed-effects estimators and find that economic growth has a positive relationship with bank cost
efficiency but a negative relationship with profit efficiency.

Previous empirical studies on bank efficiency have mostly employed static panel data methods to analyze
the determinants of bank efficiency. However, many financial processes exhibit dynamic adjustment over
time so failing to incorporate dynamic aspect of the data can lead to serious misspecification biases in the
estimation and results. De Jonghe & Vennet (2008) report that most banking studies failed to consider the
time it takes for the impacts of bank efficiency to materialize. However, there is gradual awareness of the
need to include lagged efficiency such as in the studies of Ataullah & Le (2006), Staub et al. (2010) and
Fiordelisi et al. (2011).

METHODOLOGY

Data Envelopment Analysis as Measure of Bank Efficiency

Due to the small number of banks in Ghana, this paper employs the data envelopment analysis to
determine efficiency scores of Ghana’s banks. This is because DEA works well with small sample size as
opposed to parametric methods which require large sample size to generate reliable estimate (Isik &
Hassan, 2002; Ariff & Can, 2008). DEA also does not specify any functional form of the underlying
production relationship (Berger & Humphrey, 1997). Further, DEA is used extensively in studying the
banking industry of developed and developing economies; for individual countries as well as cross-
country comparisons (Aly et al., 1990; Chen & Ye, 1998; Sathye, 2001; Casu & Girardone, 2006.
Following Aly et al. (1990), Sathye, (2001), Casu & Girardone (2006) and Tecles & Tabak (2010), this
study uses variable return to scale (VRS) model (Banker et al., 1984) as constant returns-to-scale

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(Charnes et al., 1978) assumption is unlikely to prevail since Ghana banks operate in an imperfect
competitive environment and are also subject to financial constraints and regulatory requirements (see
Coelli et al., 1998). These factors might compel or cause the banks not to operate at optimal scale.
Following Elyasiani & Mehdian (1990), Drake (2001), Goddard et al. (2001) and Berger (2007) studies,
this study assumes that bank management has more control over costs rather than over outputs (and with
high bank operating costs in Ghana) and adopts an input-orientation approach.

Estimating Bank Cost Efficiency

Cost efficiency measures how close a bank’s cost is to the minimal cost (or best practice bank’s cost) for
producing a certain level of output with given input prices and technology. Consider N banks that
employ a vector of input quantities xi for the i-th bank, given the prices of input wi and the levels of
output yi, the cost efficiency model for bank i can be expressed in a linear programming as follows:

Minimizeλ,x∗i wi′ xi∗ (1)

Subject to −yi + Yλ ≥ 0
xi∗ − Xλ ≥ 0
NI ′ λ = I
𝜆 ≥ 0 i = 1, …N

where xi∗ is the frontier or cost-minimizing vector of input quantities for the i-th bank and λ is a Nx1
vector of constants. To estimate cost efficiency the optimal values xi∗ are estimated by solving the linear
programming (equation 1), where X and Y are the matrix of observed inputs and outputs for all the banks.
The cost efficiency of the i-th bank is calculated as the ratio of minimum cost to actual cost:

wi′ xi∗
CE = (2)
wi′ xi

The measure of cost efficiency is bounded between zero and one. A cost efficiency score of one
represents a fully cost efficient bank and are also known as best practice banks in the sample, whereas
inefficient cost banks exhibit a value less than one. However, those inefficient cost banks with a value of
zero are considered worst practice banks.

Inputs and Outputs for the DEA

In order to estimate cost efficiency, inputs, input prices and outputs must be calculated. Table 1 shows the
description of the variables used in the computation of bank efficiency. The choice of the inputs and
outputs is essential for measuring the relative efficiencies in banks. The two most widely used approaches
in the banking literature for the selection of bank inputs and outputs are the production and intermediation
approaches. This study employs a variation of the intermediation approach originally developed by Sealy
& Lindley (1977) which views banks as financial intermediaries, producing intermediation services
through the collection of deposits and other liabilities and use them to generate interest-earning assets
such as loans, securities and other investments. This study identifies two outputs, namely total loans and
other earning assets and three inputs, that is, labour (proxy by personnel expenses), capital-related
expenses and deposits. Deposits are the most important input resources for Ghana banks to perform their
banking activities such as lending and investing. The choice of labour (personnel expenses) and capital
expenses are other input resources used in the production of bank products and services. In the case of
output, loans and investments securities (especially government securities) constitute the major activities

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Table 1 Variables used in the Computation of Bank Efficiency

Variable Description
Inputs:
Deposits Customers deposits
Labour Personnel expenses of bank staff such as salaries, wages and benefits
Outputs:
Loans Total customers’ loans
Other earning assets Banks’ investments in different types of securities (e.g. government securities,
bonds, Treasury bill and equity investment)
Input prices:
Price of deposits Interest expenses divided by total deposits
Price of labour Personnel expenses divided by the total assets
Price of capital Capital-related expenses (operating expenses - personnel expenses) divided by
total fixed assets.

(especially government securities) constitute the major activities of the banks that channel their funds into
investment or lending for profits. In Ghana, loans and other earning assets account for about two thirds of
the bank assets and are important generator of revenues. The inputs prices are estimated as proxies since
data on the number of personnel and input prices are not available. The production approach is not
considered because it is difficult to obtain detailed bank information relating to transactions and financial
documents which are required in the approach.

Determinants of Bank Efficiency

Empirical Model

This study investigates the underlying relationship between the estimated efficiency levels and a variety
of bank-specific and macroeconomic factors. In the second stage, both the static and dynamic panel data
models are estimated with the DEA cost efficiency scores as the dependent variable and bank-specific and
macroeconomic factors as the explanatory variables. Many banking studies have examined the factors that
affect the efficiency of banks. In the banking literature some studies investigate only bank-specific factors
while others assess both bank-specific and external factors. The widely used bank-specific factors are
size, profitability, capitalization, loans to assets, loan loss provision to total loans (see Casu & Molyneux,
2003; Casu & Girardone, 2004; Ataullah & Le, 2006; Ariff & Can, 2008). The inflation and real GDP
growth rates are commonly used to control for the macroeconomic conditions (see Salas & Saurina, 2003;
Girardone et al., 2004; Yildirim & Philippatos, 2007). In this study, bank size, bank capitalization, loan
loss provision to total loans, inflation and real GDP growth rates considered as the factors influencing
bank cost efficiency in Ghana.

The static panel data model used to determine the bank-specific and macroeconomic factors that affect
bank cost efficiency in Ghana is given as follows:

EFFit = α1 CAPit + α2 SIZEit + α3 LLPit + α4 INFit + α5 GDPit + +η𝑖 + µit (3)

where i represents the individual bank and t denotes time, α are the parameters to be estimated, ηi is the
individual bank specific-effect, EFFit is cost efficiency scores, CAPit is bank capitalization, SIZEit is bank
size, LLPit is loan loss provision ratio representing credit risk, GDPit is real gross domestic product
growth rate, INFit is inflation rate and µit is the random error term.

A dynamic panel data model is specified by including one-year lagged efficiency among the explanatory
variables to capture the dynamic nature of the efficiency of banks. This study attempts to test whether
bank efficiency tends to persist over time in the Ghanaian banking context. According to Staub et al.
(2010), banks that are more efficient in a specific year tend to be efficient in the following year. On the

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other hand, Ataullah & Le (2006) suggest that the one-year lagged efficiency indicates accumulation of
knowledge and technological endowment that may assist banks to produce higher outputs with their
inputs or reduce cost by adjusting comparatively quickly to the financial reforms. Ataullah & Le (2006)
and Staub et al. (2010) studies find significant and positive relationship between the efficiency of the
previous year and that of the current year. Furthermore, early banking studies have confirmed the
persistence of efficiency over time (Berger & Humphrey, 1991; Kwan & Eisenbeis, 1997). Following the
procedure of Ataullah & Le (2006), Solis & Maudos, (2008) and Staub et al. (2010) the dynamic panel
model specification for the determinants of bank cost efficiency in Ghana is given as follows:

EFFit = β1 EFFit-1 + β2 CAPit + β3 SIZEit + β4 LLPit + β5 INFit + β6 GDPit + ηi + ϵit (4)

where i represents the individual bank and t denotes time, β are parameters to be estimated, ηi is the
individual bank specific-effect, EFFit is cost efficiency scores, EFFi,t-1 is one-year lagged cost
efficiency, CAPit is bank capitalization, SIZEit is bank size, LLPit is loan loss provision ratio
representing credit risk, GDPit is real gross domestic product growth rate, INFit is inflation rate
and ϵit is the random error term.

The logit method has been used in recent studies on bank efficiency (see for example, Ataullah & Le,
2006; Maudos & Fernandez de Guevara, 2007; Solís & Maudos, 2008). Since the estimated values of
DEA efficiency (EFFR) range between 0 to 1, logistic specification is used to transform the efficiency
scores into natural log odds ratio as follows:

EFFR
Ln �
1−EFFR
�. (5)

However, the transformed efficiency score is undefined when the efficiency score, EFFR is zero or one.
This problem reduces the total observations by the number of undefined efficiency scores, causing some
loss of the data. Consequently, as in Cox (1970 p.33), Voos & Mishel (1986), Campbell et al. (2007) and
Kader et al. (2010), the logit transformation is modified by adding 1/2N to both numerator and
denominator, where N represents the number of observations for the efficiency. The advantage of this
modified logit transformation is that there is no reduction or elimination of the observations when the
efficiency score is equal to zero or one (Maddala, 1983 p.30). The transformed efficiency score, EFF, is
employed as the dependent variable for the evaluation of the determinants of efficiency. DEA-Solver Pro
is used to estimate the efficiency scores.

Model Variable Definitions

The variable definitions are presented in Table 2.

Table 2: Definition of Model Variables

Variable Symbol Description Expected

Signs
Cost efficiency EFF Estimated using data envelopment analysis
Size Size Natural logarithm of total assets (+/-)
Credit risk LLP Loan loss provisions over total loans (-)
Capitalization CAP Total value of shareholders equity over total assets (+/-)
Macroeconomic Factors:
Inflation rate INF Change in consumer price index (+)
GDP growth rate GDPG GDP growth rate between two consecutive years (+)

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Estimation Techniques

The study employs the fixed effect model to estimate the coefficients in the static equation (3). In terms of
the static model, the regression equation for the determinants of bank efficiency assumes exogeneity of
the explanatory variables and account for unobservable heterogeneity. The fixed effect model is estimated
using robust standard errors (White/Huber (1980) test) to control for potential heteroscedasticity. Under
these assumptions, the fixed effect estimator generates efficient parameter estimates and it is considered
better than the GMM estimator. However, with a lagged dependent variable and endogenous explanatory
variables in the dynamic panel estimation, the GMM estimator is more superior to fixed effect estimator
which generates inconsistent estimates (Baltagi, 1995). Following Arellano and Bover (1995) and
Blundell and Bond (1998) we developed the system GMM estimator that was designed to overcome
potential bias and imprecision associated with first difference GMM estimator when the explanatory
variables are persistent (or the sample size is small, as in this study) to estimate the coefficients in
equation (4). The first-difference GMM estimator may suffer from the weaknesses of its instruments as
the lagged levels of persistent explanatory variables are weak instruments for the equation in first-
difference (Blundell & Bond, 1998; Bond, 2002). Particularly, in this study, a two-step system GMM
estimator with Windmeijer (2005) corrected standard error is used because it is more efficient and robust
to autocorrelation and heteroscedasticity and provides the least bias in small samples. In addition, forward
orthogonal deviation is used in place of first-difference as recommended by Roodman (2006 pp. 20,
2009) because first-difference enlarges gaps in unbalanced panel data as it uses only lags variables as
observations (Roodman, 2006 pp.19) that can produce biased results especially in small sample. This
approach preserves sample size in panels with gaps (Roodman, 2009) . Forward orthogonal deviations
approach subtracts the mean of all future available observations of a variable instead of subtracting the
past value of observations of a variable.

Based on previous banking studies loan loss provision and bank capitalization are assumed to be
endogenous to efficiency is instrumented with their own lags. In this study, the second and third lags of
loan loss provision and bank capitalization are used as instruments for the system GMM estimates as well
as collapsing instruments (Roodman, 2006, 2009) . The use of these techniques allows us to considerably
reduce the number of instrument counts in order to avoid over-fitting of the endogenous variables to have
more reliable estimations.

In terms of the static equation (3), the F-test is used to test the null hypothesis that the overall significance
of the coefficients of the explanatory variables is jointly equal to zero. This must be rejected to ensure the
model is correctly specified. On the other hand, the following tests must be satisfied under the system
GMM estimation. First, the Hansen (and difference-in-Hansen) test should not be rejected suggesting that
instruments in the system GMM estimation are valid. Second, it is imperative that the second order
autocorrelation test under the null hypothesis of no second order autocorrelation is not rejected. This leads
to the conclusion that the original error term is serially uncorrelated. The regressions are estimated by
employing the Hansen and second order autocorrelation tests to select an appropriate set of instruments
for estimation.

Data

The study covers Ghana banks during the period 2001 to 2010. The data used in this study depend on the
amount of information available for each bank involved. The data exclude banks which have less than
three years of operation during the study period. There were very few mergers and acquisitions and exit
during the study period. The data were analyzed for inconsistencies, reporting errors, and outliers. In
addition, the years with zero or missing values on input and output variables are omitted. With these
restrictions, the sample data for this study is an unbalanced panel data of 25 banks with 211 annual
observations, which accounts for more than 99% of bank assets in the time period under consideration.

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The choice of an unbalanced panel is due mostly to entry during the study period. The number of banks in
each year varied between 14 and 25. The data are based on balance sheets and income statements of the
banks’ annual reports. The data are obtained from PricewaterhouseCoopers. The macroeconomic
variables are obtained from International Monetary Fund's World Economic Outlook. The 25 banks
consist of 4 state-owned banks, 8 domestic private banks, and 13 foreign-owned banks. A bank is
identified as foreign-owned in Ghana if the foreign ownership share in its assets exceeds 50%.

EMPIRICAL RESULTS

Descriptive Statistics and Correlation Analysis

Table 3 shows large variation across banks shown by the minimum and maximum values of the factors
during the study period 2001 to 2010. The rate of inflation depicts a minimum figure of 10.2 percent and
a maximum of 32.9 percent with an average of 16.4 percent from 2001 to 2010. The loan loss provision
ratio exhibits a worrying trend. On average, 8.8 percent of the total loans in Ghana’s banking industry
exhibits a minimum of zero percent and a maximum of 64 percent.

Table 3: Summary Statistics of the Determinant Factors

Variable Observations Mean Standard Deviation Minimum Maximum

size 211 11,935 1,388 7,910 14,560
inf 211 0.164 0.067 0.102 0.329
llp 211 0.088 0.084 0.000 0.640
gdpg 211 0.057 0.012 0.045 0.084
cap 211 0.136 0.113 -0.150 0.980
This table presents the descriptive statistics including the sample size, mean, standard deviation, minimum and maximum values for the 25
banks used in this study. inf, llp, gdpg and cap are in ratios size is in million cedis.

The range is overwhelmingly substantial during the study period. Even though the loan loss
provision ratio has been decreasing steadily, it is still considered relatively high. However,
Ghana banks are well-capitalized. The average bank in the sample has a capital ratio of 13.6
percent. There are also noticeable differences in bank size during the study period. The average
GDP growth is 5.7 percent during the study period. The Ghanaian economy has enjoyed a sustained
economic growth from 2001 to 2010. However, the inflation rate continues to be high despite the
economic and financial reforms.

Table 4 presents summary statistic of the bank specific factors exhibiting yearly values of mean and
standard from 2001 to 2010. The dispersion of bank specific factors (measured by standard deviation) is
high, indicating that the factors are dispersed around the average. This suggests that Ghana’s banks are
heterogeneous. The introduction of universal banks policy in 2003 in Ghana could reduce the
heterogeneity across banks.

In order to avoid multicollinearity problems in the determinant factors of bank efficiency, pairwise
correlations of the explanatory variables used in the regressions are examined. Table 5 reports the results
of the correlation matrix of the factors. The result shows low correlation among the variables and allays
the fear of multicollinearity problems. This suggests that there is no significant correlation between the
explanatory variables.

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Table 4: Summary Statistic of Bank Specific Factors (2001-2010)

Size llp Cap

Year Mean Standard Mean Standard Mean Standard
Deviation Deviation Deviation
2001 10.486 1.474 0.1 0.094 0.134 0.073
2002 10.859 1.29 0.122 0.111 0.104 0.075
2003 11.268 1.179 0.116 0.088 0.097 0.074
2004 11.563 1.085 0.097 0.063 0.119 0.043
2005 11.502 1.248 0.086 0.063 0.192 0.232
2006 11.835 1.124 0.067 0.046 0.14 0.076
2007 12.287 0.995 0.066 0.067 0.103 0.045
2008 12.479 1.218 0.059 0.058 0.143 0.153
2009 12.797 1.117 0.082 0.071 0.152 0.11
2010 13.152 0.858 0.106 0.13 0.158 0.091
This table presents the descriptive statistics showing the mean and standard deviation of the bank specific factors for the period under study.
llp and cap are in ratios size is in million cedis.

Table 5: Correlation Coefficients of Determinants of Bank Efficiency

Variable size inf llp gdpg cap

size 1.0000
inf -0.3089 1.0000
llp -0.0149 0.0821 1.0000
gdpg 0.2117 -0.2290 -0.1298 1.0000
cap -0.2362 -0.0347 -0.1229 0.0336 1.0000
This table presents correlation coefficients of determinants of bank efficiency. inf, llp, gdpg and cap are in ratios and size is in million cedis.

Bank Efficiency in Ghana

Average Bank Efficiency Scores by Year

Table 6 presents the results of the yearly and overall efficiency of Ghana’s banking system over the
period 2001 to 2010. The results show that the overall average cost efficiency score for Ghana’s banking
industry is 0.505. This implies that Ghana’s banks wasted 49.5 percent (half) of its costs relative to the
“best-practice” banks. In other words, on average, the industry could reduce their cost by 49.5 percent and
still produce the same amount of output. The results suggest Ghanaian bank managers did not use their
inputs efficiently over the study period. Overall, the results show relatively low average efficiency scores
during the study period, which suggests that Ghana banks are operating far from the efficiency frontier.
On the contrary, Fang et al. (2011) in their study reported a relatively higher efficiency score of 76.95
percent for the Croatian banking sector over the period 1998 to 2008. Similarly, Ariff & Can (2008) and
Maudos & Pastor (2003) studies reported an average cost efficiency score of 79 percent for the Chinese
banking industry during the period 1995-2004 and 87.1 percent for the Spanish banking sector during
1985-1996. However, high levels of inefficiency in some emerging countries such as India, Turkey and
Brazil have also been reported (Das & Ghosh, 2006; Denizer et al., 2007; Tescles & Tabak, 2010).

In terms of yearly results, the cost efficiency of Ghana’s banking industry improved considerably from
0.452 in 2001 to 0.661 in 2010, an increase of 46.2 percent. In early years, from 2002 to 2005, cost
efficiency increases from 0.416 in 2002 to 0.486 in 2005, showing improvement in input utilization, but
then declines to 0.469 in 2006 and eventually starts to show a steady improvement in input utilization
from 2007 to 2010. The trend in cost efficiency from 2007 to 2010 suggests that banks managers in
Ghana have begun to use their inputs more efficiently that is, the managers are able to control the
underutilization or wastage of valuable input resources. Nevertheless, more effort is still required. The
high interest rates in the Ghana confirm the high financial costs of the capital, and high non-performing
loan problems which result in low cost efficiency of the banks. Casu & Girardone (2009) in their study of
five European countries banking sector report an increase in input waste from 2000-2001 onwards leading

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to lower average bank efficiencies. They attribute the input waste to reduction in costs facilitated by bank
deregulation and increased competition leading to many mergers and acquisitions that may have increased
bank costs leading to a decline in their cost efficiency. The authors further explain that decreases in bank
efficiency can be the cause of bank consolidation which allows managers to exploit market power.

Table 6: Average Efficiency Scores of Ghana’s Banking Industry (2001-2010)

Year Number Ce
of Banks Mean Standard Deviation
2001 17 0.452 0.263
2002 18 0.416 0.253
2003 18 0.451 0.201
2004 18 0.484 0.188
2005 20 0.486 0.174
2006 22 0.469 0.201
2007 23 0.453 0.196
2008 25 0.526 0.206
2009 25 0.577 0.250
2010 25 0.661 0.276
Mean 0.505 0.231
This table provides the average efficiency scores. The table shows the number of banks, mean and standard deviation scores,
Ce represents cost efficiency.

Our results show bank cost efficiency is relatively unstable over the study period. The results also show
the low level of the efficiency scores in Ghana’s banks. However, since 2007 there has been a remarkable
improvement in the efficiency scores in Ghana’s banks. For instance, the average cost efficiency score
increased from 0.577 in 2009 to 0.661 in 2010 representing a yearly increase of 14.6 percent, also the
biggest during the study period.

Composition of Efficient Frontier Banks

Table 7 describes the composition of the Ghana’s bank efficiency frontier, which is the input and output
combination of the ‘best-practice’ banks in Ghana. The data in Table 7 shows a total of 62 of the 211
bank observations are regarded cost efficient over the study period. Based on individual years, only 7 out
of 25 banks are on the cost efficiency frontier in 2010.

Table 7: Number of Efficient Frontier Banks (2001-2010)

Year 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 Total
All Banks 3 5 5 6 7 7 9 7 6 7 62
Number
of banks 17 18 18 18 20 22 23 25 25 25
This table shows the number of efficient frontier banks for the period 2001-2010. All banks indicate the banks under study. Ce represents cost
efficiency

With the exception of 2001 and 2007, the rest of the study period indicates a fairly distributed cost
efficiency frontiers. The results indicate that 36 of the 62 efficient observations are recorded from 2006 to
2010 representing 58 percent. This shows the weakness of Ghana’s banks in regards to cost efficiency.
The low bank cost efficiency apparently reflects the high operating and financial costs of managing a
bank in Ghana. Even though the financial reforms have improved the bank efficiency in Ghana in
comparison to pre-reforms period, there is more room for improvement, especially in terms of bank cost
efficiency.

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Determinants of Bank Cost Efficiency

Table 8 presents the result of the determinants of cost efficiency in Ghana banks. The F-test is statistically
significant at 1 percent level for all the explanatory variables. This indicates that the factors used are
relevant in explaining the cost efficiency. The results indicate that bank size and bank capitalization are
the most important factors in determining bank cost efficiency in Ghana. The analysis of the residuals
indicates the presence of heteroskedasticity and as a result White/Huber robust standard error is applied.
In terms of the system GMM, the p-value of Arellano-Bond test statistics AR(1) is 0.042 which shows
that AR(1) test rejects the null hypothesis of no existence of first-order serial autocorrelation. However,
the Arellano-Bond test statistics for the second order serial correlation AR (2) in the residuals do not
reject the specification of the error term, since the p-value of AR (2) is 0.948. Thus, there is no second
order serial correlation in the error term. The p-value of the Hansen test is 0.881. Accordingly, the Hansen
test of over-identification reports that the instruments used in the system GMM estimation are valid. The
difference-in-Hansen test of exogeneity indicates that the instruments used for the equation in levels are
exogenous which strengthens the validity of instruments employed in the system GMM estimation. There
is no evidence of correlation between the instruments and error terms. Hence, the dynamic cost efficiency
equation is correctly specified. In addition, since the loan loss provision and bank capitalization are
endogenous variables, the results in this study are based on the two-step system GMM instead of the
static fixed effect estimator.

Impact of Bank Specific Factors on Bank Cost Efficiency

The system GMM results in Table 8 show that lagged cost efficiency, GDP growth rate and bank
capitalization are the important factors in determining bank cost efficiency in Ghana. The lagged cost
efficiency is significant and has a positive effect on the bank efficiency in the current year. This implies
that bank cost efficiency tends to persist from year to year. This suggests that an increase in lagged cost
efficiency could help increase the current year’s cost efficiency. The positive lagged cost efficiency may
constitute some accumulated knowledge and technologies that may help banks to reduce their costs (see
Ataullah & Le, 2006). This implies that the financial services in Ghana’s banking industry have
encouraged banks to improve their cost efficiency. The result is consistent with the study of Staub et al.
(2010) and Manlagnit (2011) which reveal lagged cost efficiency to have positive and significant effect
on the current year efficiency.

Table 8 shows that bank size is positive but has no significant impact on cost efficiency. This result
implies that larger banks in Ghana have no cost advantages over their smaller counterparts. Similarly,
some previous studies did not observe any significant efficiency advantage for large banks. For instance,
Girardone et al. (2004) study on the Italian banking sector indicates no evidence of correlation between
size and bank efficiency suggesting that larger banks are not more cost efficient than the smaller banks.
Similarly, Staub et al. (2010) study on the Brazilian banking system in the period 2000 to 2007 find that
bank size is not an important factor in determining bank cost efficiency.

The bank capitalization coefficient is negative and statistically significant at 10 percent level. Ghana
banks have been recapitalized by the Bank of Ghana, first in 2003 and then in 2009. This result suggests
that well-capitalized banks are less cost efficient in Ghana. This could be due to a higher shareholders'
leverage which forces banks to sacrifice costs in exchange for achieving better results. This finding is
similar to the results reported by Tabak et al. (2011) on 495 Latin American banks operating in 17
countries over the period 2001-2008, Sufian (2009) on Malaysian banks from 1995 to 1999 and Ariff &
Can (2008) on 28 Chinese commercial banks from 1995 to 2004. Based on the results, bank cost
efficiency decreases with increases in the level of bank capitalization. This suggests that well-capitalized
banks incur higher costs in providing banking products and services due to high level of non-performing

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loans and higher cost of capital resulting from the increase in minimum regulatory capital requirement
(PricewaterhouseCoopers, 2011).

Financial capital affects costs through its use as a source of financing loans (Berger & Mester, 1997; Ariff
& Can, 2008, Manlagnit, 2011). However, raising equity capital involves higher costs than raising
deposits leading to increase in financial costs and may lead to decrease cost efficiency. In addition, bank
capitalization may likely increase moral hazard incentives and is more likely to increase costs (Ariff &
Can, 2008; Fiordelisi et al, 2011). This may reduce cost efficiency. Thus, bank capitalization, on the one
hand may reduce bank capital risk, but on the other hand, may increase moral hazard incentives leading to
increase in costs and therefore decline in cost efficiency (Ariff & Can, 2008).. The culture of risk
management is not well-developed in Ghana’s banking industry (Amissah-Arthur, 2010). Intuitively, the
level of bank capitalization may not be adequate to cover increases in bank risk taking that may contribute
to bank insolvency which could lead to reduction in bank efficiency (Soedarmono et al., 2011).

Table 8: Determinants of Bank Cost Efficiency

Variable Fixed Effect Model System GMM

Ce Estimates Estimates
Ce t-1 - 0.269*
(1.85)
size 0.511** 0.033
(2.42) (0.07)
inf 1.722 0.794
(1.33) (0.38)
llp 0.916 -5.445
(0.34) (-1.03)
gdpg -8.665 -42.910*

(-1.30) (-1.97)
cap 3.501** -28.743*
(2.18) (-1.81)
Trend 0.356
(1.36)
Constant -6.138 3.815
(-2.49)** (0.59)
R-squared 0.109
F-Statistic (p-value) 0.000 0.004
Wald Test Heteroscedasticity (p-value) 0.000
Number of observations 211 186
Number of banks 25 25
Number of instruments 14
Hansen J test (p-value) 0.881
Arellano-Bond test:
AR(1) p-value 0.042
AR(2) p-value 0.948
Difference-in-Hansen test (p-values):
GMM instruments for levels 0.784
This table presents the regression estimates of the static equation: 𝐸𝐹𝐹𝑖𝑡 = 𝛼1 𝐶𝐴𝑃𝑖𝑡 + 𝛼2 𝑆𝐼𝑍𝐸𝑖𝑡 + 𝛼3 𝐿𝐿𝑃𝑖𝑡 + 𝛼4 𝐼𝑁𝐹𝑖𝑡 + 𝛼5 𝐺𝐷𝑃𝑖𝑡 + 𝜂𝑖
+𝜇𝑖𝑡 using fixed effect estimator and the dynamic equation: 𝐸𝐹𝐹𝑖𝑡 = 𝛽1 𝐸𝐹𝐹𝑖𝑡−1 + 𝛽2 𝐶𝐴𝑃𝑖𝑡 + 𝛽3 𝑆𝐼𝑍𝐸𝑖𝑡 + 𝛽4 𝐿𝐿𝑃𝑖𝑡 + 𝛽5 𝐼𝑁𝐹𝑖𝑡 + 𝛽6 𝐺𝐷𝑃𝑖𝑡
+𝜂𝑖 + 𝜖𝑖𝑡 applying two-step system GMM estimator. t-statistics are in parentheses below the estimates. *, ** and *** indicate
level of significance at 10%, 5% and 1% respectively. The first column shows the variables entered into the equations. Ce represents
cost efficiency.

The loan loss provision coefficient has a negative effect but does not appear to have a significant
influence on bank cost efficiency in Ghana during the study period. This result supports the finding of
Yildirim & Philippatos (2007) and Brissimis et al. (2008) who find loan loss provision to be negatively
related to bank cost efficiency. In addition, Staikouras et al. (2008) assess the cost efficiency of banks
operating in six emerging South Eastern European countries and finds a negative relationship.

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Furthermore, Staub et al. (2010) study on the Brazilian banking system in the period 2000 to 2007 show
that loan loss provision ratio has a negative and insignificant impact on cost efficiency.

Impact of Macroeconomic Factors on Cost Efficiency

The GDP growth rate has a negative and significant effect on bank cost efficiency. This shows that
economic growth reduces the banks’ cost efficiency. This finding is consistent with the studies of Fries &
Taci (2005) and Chan & Karim (2010) on the Middle Eastern/North African banks, but opposite to the
findings of Maudos et al. (2002) on 10 European countries’ banks, Grigorian & Manole (2006) on 17
Eastern European countries’ banks and Lozano-Vivas & Pasiouras (2010) on 87 countries’ banks, where
real GDP growth rate is positively related to bank cost efficiency. On the contrary, it is hypothesized that
economic growth will positively influence cost efficiency in Ghana’s banks. One possible explanation is
that during higher economic growth (and therefore increased demand for bank financing) the banks lower
their operating standards, such as relax evaluation of borrowers and monitoring of credit (reduce their
capital ratio through aggressive lending resulting in higher costs) and thereby become less cost efficient.
Thus, higher economic growth leads to greater risk taking (in less competitive banking markets) resulting
in reduction in bank efficiency (Soedarmono et al., 2011).

Generally an increase in inflation rate leads to increase in bad debts which reduces bank cost efficiency
because the banks incur more costs in managing bad debts indicating a negative relationship between
inflation rate and cost efficiency. Contrary to our expectation, the results show that the inflation
coefficient is positive but statistically insignificant, implying that inflation has a weak influence on
efficiency. In other words, the evidence suggests that high inflation in Ghana does not contribute to bank
cost efficiency. The positive relationship revealed in this study indicates that Ghana’s banks are able to
charge higher rates in a high inflationary environment to compensate for their returns (see Chan & Karim,
2010). This finding supports the study of Kasman &Yildirim (2006) who find no relationship between
inflation and cost efficiency.

The cost inefficiency in Ghana’s banking industry reflects the higher cost of operation mainly due to
inadequate credit monitoring (and hence high non-performing loans) and inefficient control of operating
expenses particularly high staff cost and cost of funds. This implies that banks operating in a less
competitive banking market such as Ghana are able to charge higher prices and surprisingly, are not under
any pressure to control their costs (see Maudos et al, 2002) and therefore become less cost efficient. In
general, banks encounter problems of adverse selection and moral hazard caused by asymmetric
information between the bank and its customers. Banks can reduce adverse selection by screening and
monitoring borrowers to reduce moral hazard behavior (Vennet, 2002) in order to reduce bad debts (non-
performing loans) and therefore total costs leading to increase in cost efficiency.

CONCLUSIONS

Ghana banking industry has undergone considerably transformation over the last 20 years. Using 25
banks over the period 2001-2010, this paper examines the cost efficiency of banks in Ghana using the
DEA. In addition, fixed effect and two-step system GMM estimators are to investigate the determinants
of bank cost efficiency. The findings reveal relatively low average efficiency scores for Ghana’s banks
during the study period, suggesting that Ghana banks are operating far from the efficiency frontier. This
finding is attributed to underutilization or waste of input resources. The cost efficiency scores show
variance over time. The findings reveal that bank capitalization has negative and significant effect on
bank cost efficiency suggesting that well-capitalized banks are less cost efficient. Similarly, GDP growth
rate negatively impacts bank cost efficiency. The findings also show that lagged cost efficiency is an
important factor in determining bank cost efficiency in Ghana. The level of bank cost efficiency is low in

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K. Adjei-Frimpong et al | IJBFR ♦ Vol. 8 ♦ No. 2 ♦ 2014

Ghana, but it persists from year to year. Loan loss provision ratio, bank size and rate of inflation,
however, are not important factors in influencing bank cost efficiency in Ghana.

The findings of this study offer important implications for bank regulation, policy decisions and bank
management in Ghana. The results indicate that GDP growth negatively influences bank cost efficiency.
This suggests that banks lower their evaluation standards of borrowers or reduce their monitoring of loan
performance during the boom period. Therefore, regulators and policymakers should pay attention to risk
management and control procedures of Ghana banks (e.g., loan review, collateral appraisal). Bank of
Ghana has twice increased the minimum capital requirement in 2003 and 2009, but the findings indicate
that bank capitalization reduces cost efficiency. The bank cost efficiency in Ghana persist from year to
year which indicates bank management ability and quality (knowledge) and technologies assist the banks
to lower costs (see Ataullah & Le, 2006). The persistent cost efficiency should encourage banks to focus
on reducing cost efficiency in order to reduce financial and operating costs which would help increase the
bank’s profits.

The small number of Ghana banks prevents this study from employing more determinant factors such as
bank profitability, liquidity, interest rate, market share and bank concentration (measured by the HHI) for
both bank efficiency and competition for the dynamic system GMM estimations. This is because
increasing the determinant factors will increase the number of instruments in the system GMM estimation
which may invalidate the system GMM results. The increase in the number of instruments could become
large relative to the number of banks in the regression. This could generate too many instruments (over-
fitting endogenous variables) in the system GMM estimations which will weaken the specification tests
and bias the results (Roodman, 2007, 2009). Thus, when the instrument count is high, the Hansen test of
validity of the instruments weakens (Roodman, 2009). This could mean accepting a model as valid when
the problem of endogeneity is partially solved.

Recommendations for Further Research

Profit efficiency essentially captures the efficiencies (or inefficiencies) using both input and output
variables, unlike cost efficiency which involves only input variables. Computing profit efficiency,
therefore, constitutes a more important source of information for bank management. Therefore,
investigating the profit efficiency of Ghana banks in future research would enrich the banking literature.
This study only examines Ghana’s banking industry and we suggest that future research could use cross-
country studies including other African states such as Nigeria, Kenya, Zambia, Tanzania and Uganda
which have also undertaken similar financial reforms. Such a study may provide useful information about
cross-country comparison of bank efficiency and competition in other countries with banks in Ghana.

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BIOGRAPHY

Kofi Adjei-Frimpong, Former PhD Student, Faculty of Commerce, Department of Accounting,

Economics and Finance, PO Box 84, Lincoln University, Canterbury, New Zealand, Tel: 64-3-325-2811,
Fax: 64-3-325-3847, Email: [email protected]

Christopher Gan, corresponding author, Professor of Accounting and Finance, Faculty of Commerce,
Department of Accounting, Economics and Finance, PO Box 84, Lincoln University, Canterbury, New
Zealand, Tel: 64-3-325-2811, Fax: 64-3-325-3847, Email: [email protected]

Baiding Hu, Senior Lecturer, Faculty of Commerce, Department of Accounting, Economics and Finance,
PO Box 84, Lincoln University, Canterbury, New Zealand, Tel: 64-3-325-2811, Fax: 64-3-325-3847,
Email: [email protected]

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EFFECTS OF SERVICE INNOVATION ON FINANCIAL

PERFORMANCE OF SMALL AUDIT FIRMS IN
TAIWAN
Yi-Fang Yang, Chang Jung Christian University
Lee-Wen Yang, Chaoyang University of Technology
Yahn-Shir Chen, National Yunlin University of Science and Technology

ABSTRACT

This study examines the effects of service innovation on financial performance of proprietorship audit
firms in Taiwan. This study divides total sample into three business strategy categories, including
conventional, non-conventional, and general firms. Non-conventional firms have the highest degree of
service innovation followed by general firms. Conventional firms have the lowest degree of service
innovation. Empirical results indicate that non-conventional firms financially outperform general firms,
and the latter outperforms conventional firms.

JEL: M42

KEYWORDS: Service Innovation, Financial Performance, Audit Firms

INTRODUCTION

W hen society becomes more complex, the investing public needs reliable information to make
economic decisions, including whether to invest in an organization. Reliable accounting and
financial reporting aid society in allocating resources in an efficient manner. Independent
auditors provide credibility to the information, reducing information risk. Auditors practice by
establishing audit firms in the forms of proprietorships, partnerships, or corporations (Elder, Beasley and
Arens, 2008). A dual market structure exists in the audit market with a few larger audit firms and a large
number of smaller firms (Bröcheler, Maijoor and Witteloostuijn, 2004). Most prior studies explore topics
relating to large audit firms, especially big international audit firms (e.g., Iyer and Iyer, 1996;
McMeeking, Peasnell and Pope, 2007; Minyard and Tabor, 1991). Small audit firms, such as
proprietorship firms, experience less investigation due primarily to limited data availability. A study of
proprietorship audit firms appears warranted.

To fulfill their social role, audit firms traditionally provide audit and non-audit services. Audit related
services include audits of financial statements and income tax returns, corporate registration, and
accounting and bookkeeping. Non-audit related services typically refer to management advisory services
(MAS). As an innovative service, MAS range from a simple suggestion for improving the clients’
accounting system to advising in risk management, information technology, e-commerce system design,
mergers and acquisitions, and actuarial benefit consulting (Elder et al., 2008). Audit firms provide audit
services for years but their clients increasingly demand MAS due to global competition and rapid
technological changes in recent years. Prior studies designate audit related services as traditional
practices and MAS non-traditional practices (Banker, Chang and Natarajan, 2005; Rescho, 1987).

The environment-strategy-performance (ESP) perspective posits that specific environmental conditions

have a corresponding preferred strategic response (e.g. Luo, Tan and Shenkar, 1998; Tan and Tan, 2005).
In terms of s resource-based view of the firm, audit firms provide different services to satisfy clients’
demands and thereby adopt different business strategies. Some audit firms adopt a conservative business
strategy to provide traditional practices.. Some take an aggressive business strategy and focus on
providing MAS practices, which have the highest degree of service innovation. Furthermore, more audit
firms adopt a strategy to offer both traditional and MAS practices, the moderate innovative service

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provision firms. Of interest is whether the financial performance of proprietorship audit firms taking
varied degree of service innovation differs? To answer the question constitutes our motivation. This
study obtains empirical data of proprietorship audit firms from the 1989-2009 Survey Report of Audit
Firms in Taiwan. Focusing the research on proprietorship audit firms adds research homogeneity (Fasci
and Valdez, 1998). In terms of the degree of service innovation audit firms take, this study divides total
sample firms into three categories: conventional, non-conventional, and general firms.

Conventional firms are defined as proprietorship audit firms which adopt a conservative business
strategy to provide traditional practices only. In contrast, non-conventional firms refer to proprietorship
audit firms which take an aggressive business strategy and focus on providing MAS practices. If audit
firms adopt a moderate strategy to offer both traditional and MAS practices, they are general firms. The
main results indicate that non-conventional firms financially outperform general firms, and the latter
outperforms conventional firms. In short, service innovations have positive effects on financial
performance, the higher the service innovation degree, the better the operating results of audit firms.
Findings of this study add knowledge to service business-related literatures. The rest of this paper
proceeds as follows. The next section presents a literature review and hypothesis development, followed
by the depiction of research methodology. The subsequent section reports empirical results. Finally, this
study concludes in the last section.

Literature Review and Hypothesis Development

The environment-strategy-performance (ESP) perspective posits that specific environmental conditions

have a corresponding preferred strategic response (e.g. Tan and Tan, 2005; Tang and Tang, 2012;
Volberda and Lewin, 2003). Companies seek to respond to the external environment effectively to gain
competitive forces (Porter, 1990). Strategies serve to exploit the companies’ capability as a weapon to
achieve their missions and objectives. A clear strategy can play an important role in the companies’
success. Strategies link external market requirements with internal organizational and technological
resources, and capabilities (Sun and Hong, 2002). Discussions on strategies at different levels include
corporate, business, and functional strategies. Corporate strategies describe a company’s overall
direction. Business strategies occur at a business unit level. Functional strategies develop a distinctive
competence to provide a company or a business unit with a competitive advantage (Hunger and Wheelen,
2001). The three strategies are not mutually exclusive, and link in implementing a particular strategy
(Miles, Kastrinos, Flanagan, Bilderbeek, Hertog, Huntink and Bouman, 1995). Business strategies are a
set of decisions about the direction of a company. Companies select a business strategy according to
evaluations the companies make about their distinctive competencies and the competing environment
(Mintzberg, 1990). Because audit firms take different strategies as a means of organizational adaptation,
a strong relationship exists between strategy type and performance (Rescho, 1987). Facing varied
degrees of market competition and regulation, proprietorship audit firms provide different services to
fulfill the business strategies they adopt.

A typical proprietorship audit firm may provide different practices, including auditing financial
statements of privately held companies, auditing financial statements for granting a bank loan, auditing
financial statements for other purposes, auditing an income tax return, corporate registration, accounting,
and MAS (Elder et al., 2008). For long, audit firms have provided the preceding four audit services,
corporate registration, and accounting services. Prior studies thus designate them as traditional practices,
and MAS as non-traditional practices (Banker et al., 2005; Rescho, 1987). Traditional practices are
law-protected and statutory and regulated by the Generally Accepted Auditing Standard (GAAS).
Specifically, audit services are required by the Company Act, Business Accounting Act, and the
Securities and Exchange Act. However, MAS practices require a diverse product line, customization,
and service innovation. As the traditional practices are a long-standing service, auditors offer them with
standardized procedures to relatively stable clients.

Audit firms offer MAS such as personal financial planning, integrated tax planning, information
technology (IT) and electrical commerce advisory services, mergers and acquisitions (M&A), budgeting

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and forecasting services, business valuation, and pension funds actuarial advisory services (Arens, Elder
and Mark, 2012). MAS practices require a diverse product line, customization, and service innovations.
Proprietorship audit firms adopt varied business strategies according to their capacity and proprietors’
distinctive competencies, such as academic background, professional experience and expertise, and the
customer network. Audit firms may adopt a conservative business strategy to provide traditional
practices only. In contrast, audit firms can adopt an aggressive business strategy and focus on providing
MAS practices. The third type of business strategy audit firms take falls between aggressive and
conservative business strategies, a moderate strategy with which audit firms offer both traditional and
MAS practices. In terms of service innovations, this study defines proprietorship audit firms only
providing traditional practices as conventional firms. In contrast, this study terms proprietorship audit
firms focusing on MAS practices as non-conventional firms. When proprietorship audit firms offer both
traditional and MAS practices, this study names them general firms.

In Taiwan, related laws and regulations require companies’ financial statements to be audited by audit
firms, resulting in law-protected and statutory traditional practices. Because traditional services are a
general requirement by various governmental agencies, some accounting educators and accounting
practitioners view them as services that clients need but do not necessarily want (Istvan, 1984). Early
entrants gain competitive advantage more easily than subsequent ones. However, beginning in 1988,
Taiwanese authorities have raised the passing rate of the Certified Public Accountant (CPA) uniform
examination, leading to substantial increases in the number of qualified CPAs and in market competition.
In 1998, the authorities abolished the long-standing audit fee standard to ensure fair audit market
competition. Cancelling the audit fee standard adversely impacts the traditional practice market.

Since then, a rumor of price-cutting strategy for client solicitation has prevailed in the industry and the
audit market competition has enhanced. Furthermore, the tax authorities established a tax agent system
and legalized the provision of corporate registration and accounting services by tax agents to small and
medium-sized entities (SMEs) in 2004. Proprietorship audit firms have provided the same traditional
practices to the SMEs for years. Tax agent legalization negatively affects proprietorship audit firms
because of the competitive advantages the tax agents possess for a relatively lower service fees and easy
service access by the clients. Facing recent worldwide competition and business globalization,
companies consult with a professional management advisor concerning business administration and
information technology to advance their international competitiveness. In practice, auditors have
provided services to the same clients for years and are familiar with the clients’ daily operation and
financial condition. Under the situation of long-term partnership and close client relations, audit firms
gain a more favorable position in providing MAS than an ordinary professional consulting firm, such as
McKinsey & Company. Further, joint provisions of audit services and non-audit (MAS) theoretically
create synergy and knowledge spillover effects for audit firms (Beck, Frecka and Solomon, 1988;
Simunic, 1984). Auditors devote more involvements and communications in providing MAS to meet
clients’ demand for specific services, resulting in more flexible service provisions in format, timing, and
place. As a tailor-made and innovative practice, MAS generally brings higher profits, higher growth
potential and industry expansion rather than predatory competition (Rescho, 1987).

Beginning in the 1990s, auditors have begun shifting their human resources from traditional, low-margin
revenue product areas of auditing and accounting into relatively new, high-margin revenue product areas
of MAS (Banker et al., 2005). In public accounting profession, different business strategies adopted by
auditors lead to provision of varied services. A typical proprietorship audit firm provides either audit or
non-audit services or both. Audit services include, but not limited to, attestation of financial statements
for granting a bank loan, and attestation of an income tax return. Non-audit services comprise provisions
of tax planning, administrative remedy of internal taxation, other tax operations, consultation, corporate
registration, bookkeeping and accounting services. In practice, attestation, corporate registration,
bookkeeping and accounting services have been provided for years. These services are referred to as
traditional businesses, which are offered to relatively stable customers with standardized serving
procedures. Auditors providing traditional services adopt a relatively conservative and moderate
business strategy. In contrast, tax planning, administrative remedy of internal taxation, other tax

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operations, and consulting services are referred to as non-traditional businesses, which require diverse
product line, customization, and service innovation. Auditors focusing on non-traditional business tend
to adopt service differentiation as their business strategy.

Porter (1990) utilizes methods of gaining or sustaining competitive advantages to develop three general
business strategies: low-cost producer, product differentiator and focused operation. Miles and Snow
(1984) identify three types of strategies, including prospector, defender, and analyzer. The prospector
pursues market expansion and innovation, the defender strives to maintain market position, and the
analyzer seeks some combination of market expansion/innovation while endeavoring to preserve
stability in existing markets. Although the classifications of business strategies differ, underlying
concepts in Miles, Snow, Meyer and Coleman (1978) and Porter (1990) are qualitatively the same. The
defender, prospector, and analyzer business strategies in Miles et al. (1978) essentially equate the
low-cost producer, product differentiator and focused operation in Porter (1990) in terms of the overall
strategic orientations (Miles and Snow, 1984). A typical proprietorship audit firm may provide
traditional services only, non-traditional services only, or both. Following Miles et al. (1978) and based
on auditing industrial peculiarity, we define proprietorship audit firms providing traditional services only,
non-traditional services only, and both services as conventional firms, non-conventional firms, and
general firms, respectively. In sum, the traditional practice market is saturated and increasingly
competitive but MAS practice market exists potentially unlimited opportunities, resulting in low-margin
profits for conventional firms but high-margin profits for non-conventional firms. Because general firms
situate between traditional and MAS practice markets, they have moderate-margin profits. As a result,
this study establishes the following hypotheses to distinguish the financial performance effects of
proprietorship audit firms taking varied business strategies.

H1: Financial performance of non-conventional audit firms is better than that of general audit firms

H2: Financial performance of general audit firms is better than that of conventional audit firms

H3: Financial performance of non-conventional audit firms is better than that of conventional audit
firms.

METHODOLOGY

Data

Empirical data are from the 1989-2009 Survey Report of Audit Firms in Taiwan, published by the
Financial Supervisory Commission (FSC) annually except in 1991 due to the year’s inseparable data
from other industries’ statistics. To collect business information on the public accounting profession for
macro-economic analysis and industrial policy formation, the FSC administers the survey over all
registered audit firms annually. Contents of the survey include quantitative information of total revenues
and their compositions, total expenses and their compositions, demographics of various levels of
employees, and ending amounts of and changes in fixed assets. An open questionnaire collects
qualitative information by asking about operating difficulties audit firms encounter and future business
orientation audit firms take. Because the FSC administers the survey pursuant to the Statistics Act, it
require audit firms surveyed to fill out the questionnaire correctly within the due time. Thus, the Survey
Report reveals an annual response rate of over eighty percent. As the sample period of this study is 20
years, this study deflates all monetary variables by the yearly Consumer Price Index to account for
inflation. This study deletes firm-year observations that newly established in the survey year and that
with dependent variables having values more or less than three standard deviations away from their
means. The final number of observations is 9,220, including 123 non-conventional firms, 5,016 general
firms and 4,081 conventional firms. This information indicates that most proprietorship audit firms,
54.40 percent (5,016/9,220), provide both traditional practices and MAS.

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The percent of audit firms only providing traditional services is 44.26 percent (4,081/9,220) and that of
firms exclusively focusing on MAS is 1.33 percent (123/9,220). Taken together, over half of the
proprietorship audit firms, 55.74 percent (5,139/9,220), render MAS.

Model Specification

This study obtains empirical data of registered audit firms from Taiwanese public accounting industry.
From the perspective of industrial economics and based on the structure-conduct-performance
theoretical framework (Cowling and Waterson, 1976), this study establishes the following linear
regression equation to test our hypotheses.

𝑃𝑃𝑃𝑃𝑃𝑃𝑃 = α0 + α1 𝐷𝐷_𝑠𝑠𝑠𝑠𝑠𝑠𝑠𝑠 + α2 𝑃𝐼𝑃𝑃𝑃𝑆𝑃𝐼𝐶𝑃 + α3 𝑃𝐷𝑈𝐶𝐴𝑇𝑆𝑃𝐼 + α4 𝐶𝐶𝐶

+ 𝛼5 𝑆𝑆𝑆𝑆 + 𝛼6 𝐼𝐼𝐼𝐼𝐼 + 𝑒
(1)

Definitions of Variable

Accounting defines financial performance as total revenues minus total expenses, net income or net
profit. Sole proprietors are the owner and residual interest claimant of proprietorship audit firms and
their annual income comprises salaries received from the firms and share of operating profit of the firms.
Salaries of the sole proprietors, weekly or monthly, are a part of total expenses. The more the salaries of
the sole proprietors, the less the operating profit of the firms. It makes no difference to the sole
proprietors whether they receive salaries or not in terms of their total annual income. In addition, the
criteria for salary payments to the sole proprietors vary across firms. Based on prior studies (Chen,
Chang and Lee, 2008), this study adds their salaries back to net income to reduce such an artificial noise
and has the following operational definition. Hence, the financial performance is net profit of the audit
firms.

𝑃𝑃𝑃𝑃𝑃𝑃𝑃 = 𝑇𝑇𝑇𝑇𝑇 𝑅𝑅𝑅𝑅𝑅𝑅𝑅 𝑜𝑜 𝐴𝐴𝐴𝐴𝐴 𝐹𝐹𝐹𝐹𝐹 − 𝑇𝑇𝑡𝑎𝑎 𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸 𝑜𝑜 𝐴𝐴𝐴𝐴𝐴𝐴 𝐹𝐹𝐹𝐹𝐹

+ 𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆 𝑃𝑃𝑃𝑃 𝑡𝑡 𝑡ℎ𝑒𝑒𝑒 𝑆𝑆𝑆𝑆 𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃
(2)

One of the research variables in this study is a dummy variable of business strategy (DV_strategy). In
terms of the business strategies audit firms take, this study classifies total sample into three categories:
conventional, non-conventional, and general firms. This study defines conventional firms as audit firms
that have positive revenues from traditional practices but have no revenue from MAS. In contrast, if
audit firms have positive revenues from MAS but have no revenue from traditional practices, this study
term them as non-conventional firms. General firms refer to audit firms that have positive revenues from
both traditional practices and MAS. This study employs the dummy variable of business strategy
(DV_strategy) to distinguish among the conventional, non-conventional, and general firms.

Apart from the research variables, this study includes other influences on financial performance as
control variables. After acquiring academic qualifications in accounting, most professionals enter their
careers as assistants in audit firms. They continue to learn and gain experience and expertise through
learning by doing. The average years of experience for partners, managers, seniors, in-charge auditors,
and assistants are over 10 years, 5-10 years, 2-5 years and 0-2 years, respectively (Elder et al., 2008).
Previous studies find a positive association between employee experience and job performance (e.g.,
Schmidt, Hunter and Outerbridge, 1986), and point out that work experience relates positively to the
performance of proprietorship audit firms (Fasci and Valdez, 1998; Collins-Dodd, Gordon and Smart,
2004; Chen et al., 2008). Therefore, this study expects a positive association between work experience
of auditors and financial performance. Practitioners note that auditors older than 35 years have worked
in audit firms for more than 5 years and have accumulated much practical experience. Thus, this study
defines work experience of auditors (EXPERIENCE) as number of auditors older than 35 years as a
percent of number of total auditors. Adequate technical training and proficiency as auditors require a

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college or university education in accounting and auditing. Presumably, auditors with higher academic
education level possess more and better knowledge, and have higher intellectual potential in learning
and accumulating skills and expertise. Some prior studies report that auditors with a higher level of
education improve audit firm performance (Bröcheler et al., 2004), but some find insignificant
association between educational level of auditors and performance (Collins-Dodd et al., 2004; Fasci and
Valdez, 1998). Hence, this study does not specify a directional prediction on the relationship between
education level of auditors and financial performance. This study measures education level of auditors
(EDUCATION) by a mean number of years auditors need to obtain an academic qualification.

To remain knowledgeable about the endless stream of changes in accounting and auditing standards, tax
laws, information technology, and consulting skills, auditors must comply with a requirement of taking
part in continuing professional education. Prior researches on training for public accounting industry
indicate that professional training enhances auditors’ competency and audit performance (Bonner and
Pennington 1991; Grotelueschen, 1990; Thomas, Davis and Seaman, 1998). Further, continuing
professional education positively relates to financial performance of audit firms (Chen, Chen and Lee,
2002; Chen et al., 2008). This study expects a positive association between financial performance and
continuing professional education of auditors (CPE) which is defined as expenditures on professional
training of audit firms. Size of a company might substitute for many omitted variables and its inclusion
as a control variable enhances the accuracy of model specification (Becker, DeFond, Jiambalvo and
Subramanyam, 1998). Prior studies estimate audit firm size by either the number of full-time employees
(Collins-Dodd et al., 2004) or market share of the individual firms (Chen et al., 2002; Chen et al., 2008),
and report a positive relationship between audit firm size and performance (Chen et al., 2002; Chen et al.,
2008; Collins-Dodd et al., 2004; Rescho, 1987).

This study defines audit firm size (SIZE) as natural logarithm of total revenues of the firms and expects a
positive relationship to financial performance. The sample period of this study is 20 years and spans
over two centuries. As a professional organization, audit firms are affected by the local economy or
environment factors (e.g., Reynolds and Francis, 2001). Economic indicator, Taiwan Gross Domestic
Product, is included to control for local economy effects. However, auditors provide services to the same
clients for years and most of their practices are statutory, making the effects of environment factors on
financial performance limited. Accordingly, this study does not specify a directional prediction on the
relationship between economic indicator (INDEX) and financial performance.

RESULTS

Descriptive Statistics

Table 1 displays the descriptive statistics for variables used in regression model. Panel A of Table 1
shows descriptive statistics for non-conventional firms. Mean financial performance (PERFORM) is
$590,761. Work experience of auditors (EXPERIENCE), on average, is 0.700 which represents that 70
percent auditors are older than 35 years. Education level of auditors (EDUCATION) is 15.569, meaning
that average education level of auditors lies between junior college degree and bachelor degree. Average
expenditures on professional training of non-conventional firms (CPE) are $3,768. Mean
non-conventional firm size (SIZE) is 13.116. Panel B presents the descriptive statistics of general firms.
Mean financial performance (PERFORM) is $841,549. Work experience of auditors (EXPERIENCE)
indicates that 45.8 percent auditors are older than 35 years. Education level of auditors (EDUCATION)
of general firms is 15.539. Average expenditures on professional training of general firms (CPE) are
$21,582. Mean general firm size (SIZE) is 14.903. Panel C indicates the descriptive statistics of
conventional firms. Mean financial performance (PERFORM) is $553,822. Mean experience of auditors
(EXPERIENCE) represents that 49.8 percent auditors are older than 35 years. Average education level of
auditors (EDUCATION) is 15.187. Average expenditures on professional training of conventional firms
(CPE) are $12,556. Mean conventional firm size (SIZE) is 14.423. The untransformed figure indicates
that average total revenues of the firms are between $9,390,321 and 9,773,998.

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Table 1: Descriptive Statistics

mean std. dev. mini. maxi. q1 median q3

panel a descriptive statistics of non-conventional firms (n=123)
perform 590,761 1,522,701 -1,053,259 7,375,596 5,081 73,940 425,019
experience 0.700 0.394 0 1 0.364 1 1
education 15.569 2.983 9 34 14.333 16 17
cpe 3,768 12,225 0 76,938 0 0 275
size 13.116 1.513 8.294 16.119 12.300 13.305 14.046
index 9,547,341 2,473,120 4,974,759 13,070,681 7,536,283 9,570,584 11,612,093
panel b descriptive statistics of general firms (n=5,016)
perform 841,549 929,706 -2,926,033 16,216,676 242,007 642,899 1,213,963
experience 0.458 0.293 0 1 0.235 0.400 0.667
education 15.539 6.738 0 154 14 14.667 15.500
cpe 21,582 94,738 0 5,097,905 0 2,000 9,500
size 14.903 0.932 5.687 17.182 14.408 15.025 15.521
index 9,773,998 2,357,859 4,974,759 13,070,681 7,953,510 9,731,208 12,243,471
panel c descriptive statistics of conventional firms (n=4,081)
perform 553,822 720,160 -2,697,432 8,791,606 83,898 387,778 812,748
experience 0.498 0.325 0 1 0.250 0.429 0.750
education 15.187 4.812 7 198 14 14.667 15.500
cpe 12,556 41,804 0 862,400 0 0 6,000
size 14.423 1.127 6.234 16.968 13.845 14.615 15.202
index 9,390,321 2,398,608 4,974,759 13,070,681 7,536,283 9,570,584 11,612,093
Table 1 shows the descriptive statistics for variables used in regression model. PERFORM is equal to financial performance of audit firms. DV_
strategy is a dummy variable of business strategy. EXPERIENCE represents the work experience of auditors. EDUCATION stands for the
education level of auditors. CPE is continuing professional education of auditors. SIZE represents the audit firm size. INDEX is an economic
indicator. PERFORM, CPE, and INDEX are expressed in new Taiwan dollars.

Correlation Analysis

This study analyzes the Pearson correlation coefficients between dependent and independent variables
used in regression models. The empirical results show the high correlation coefficients between financial
performance (PERFORM) and size of audit firm (SIZE). However, the variance inflation factors (VIFs)
are less than 10 (un-tabulated), implying that no serious multi-collinearity exists among the independent
variables.

Table 2: Correlation Matrix

variables perform experience education cpe size index

perform 1
experience -0.107 1
education 0.009 0.028 1
cpe 0.207 -0.044 0.031 1
size 0.591 -0.283 -0.007 0.185 1
index 0.041 0.257 0.125 0.046 0.093 1
Table 2 shows the correlation for variables used in regression model. The number of total observations is 9,220.

Regression Results

Table 3 displays the OLS regression results of financial performance comparisons between general and
non-conventional firms, conventional and general firms, and conventional and non-conventional firms in
Columns (A), (B), and (C). The three regression models have good model specification with explanatory
power of model (adjusted R2) lying between 0.332 and 0.394. This study uses White (1980) robust
standard errors to calculate all t-statistics of coefficients to correct for heteroscedasticity. As a check on
the multi-collinearity between independent variables, this study estimates the variance inflation factors
(VIF). In econometrics, VIF greater than 10 implies serious multi-collinearity existing among
independent variables. In the regression models of Table 3, the variable VIFs are less than 1.2. In
addition, this study estimates the standardized regression coefficients (Beta) for each independent
variable to ease comparison between variables. Standardized coefficients possess attributes similar to
correlation coefficient with values lying between -1 and +1. Higher absolute value of standardized
coefficients predicts more variations in dependent variable. In the OLS standardized regression model,
no intercept exists. Column (A) shows that the coefficient on the dummy variable of business strategy
(DV_strategy) is significantly positive (t = 11.046 and p < 0.01). Consistent with expectation, this

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indicates that financial performance of non-conventional firms is better than that of general firms, which
supports H1. Column (B) displays a significantly positive coefficient on the dummy variable of business
strategy (DV_strategy) (t = 3.762 and p < 0.01), indicating that general firms financially outperform
conventional firms and H2 receives a support. Column (C) reports a significantly positive coefficient on
the dummy variable of business strategy (DV_strategy) (t = 8.273 and p < 0.01), indicating that
non-conventional firms are superior in financial performance to conventional firms and H3 receives a
support. As a differentiated and less-competitive market exists for MAS, audit firms offering MAS are
able to generate more revenues from their human resources than other firms that continue to focus on
more labor-intensive audit and assurance engagements (Banker et al., 2005). The above findings
document that audit firms adopting different business strategies lead to varied operating results.
Specifically, both the non-conventional firms and general firms providing MAS outperform the
conventional firms providing no MAS, an evidence of a natural extension of prior studies (e.g., Banker
et al., 2005).

Table 3: Regression Results for Comparing Financial Performance between Audit Firms Adopting
Different Business Strategies

Independent Variables Dependent Variable：PERFORM

(A) (B) (C)

(Predicted Sign) Non-Conventional v.s. General General v.s. Conventional Non-Conventional v.s.
Firms Firms Conventional Firms

Std. coef. (t-statistic) Std. coef. (t-statistic) Std. coef. (t-statistic)

*** ***
DV_strategy ( + ) 0.125 (11.046) 0.032 (3.762) 0.106 (8.273)***
EXPERIENCE ( + ) 0.099 (8.290)*** 0.069 (7.651)*** 0.055 (4.013)***
EDUCATION ( ? ) 0.006 (0.535) 0.010 (1.192) 0.022 (1.712)**
CPE ( + ) 0.084 (7.575)*** 0.102 (12.044)*** 0.114 (8.789)***
SIZE ( + ) 0.653 (54.587)*** 0.596 (65.345)*** 0.567 (40.944)***
INDEX ( ? ) -0.070 (-6.004) *** -0.042 (-4.763)*** -0.016 (-1.237)
Adjusted R2 0.394 0.373 0.332
F-value 557.86*** 904.01*** 348.72***
Number of observations 5,139 9,097 4,204
Column (A) of Table 3 displays the OLS regression results of financial performance comparisons between non-conventional and general firms.
It indicates that financial performance of non-conventional firms is better than that of general firms. Column (B) shows the empirical results of
financial performance comparisons between general and conventional firms. It demonstrates that general firms financially outperform
conventional firms. Column (c) indicates the empirical results of financial performance comparisons between non-conventional and
conventional firms. It indicates that non-conventional firms are superior in financial performance to conventional firms.*, **, *** Denote
one-tailed significance at the 10 %, 5 % and 1 % levels

Results of Control Variable and Model Fitness of Research Variables With respect to the results of
control variables shown in Tables 3, both work experience of auditors (EXPERIENCE) and size of audit
firm (SIZE) are consistent with expectation and reveal a positive relationship to financial performance in
all regression models. However, education level of auditors (EDUCATION), continuing professional
education of auditors (CPE), and economy indicator (INDEX) indicate mixed results. Further analyses
indicate that size of audit firm (SIZE) is the most important independent variable in explaining variation
of dependent variable, agreeing with prior studies (Collins-Dodd et al., 2004; Chen et al., 2008). In
addition, this study conducts hierarchical regression to verify the incrementally explanatory power
contributed by our research variables in Tables 3. The changes in the multiple squared correlation
coefficients (ΔR2) for regression models are 0.1493, 0.1262 and 0.1370 with F-statistic of 45.66, 38.60
and 41.90. All F-statistics are statistically significant at the 1 percent level. In sum, the hierarchical
regression results agree with those obtained by OLS regression model, which demonstrates that our
research variables explain dependent variable with both econometric and economic implications.

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Additional Test

In the regression results shown in Table 3, this study defines financial performance as net profit of the
audit firms. Apart from it, another kind of performance measure is net profit per employee which is
more feasible due to its consideration of firm size. Do the results in Table 3 still hold if the dependent
variable is net profit per employee? In this section, we replace the net profit of the audit firms with net
profit per employee and rerun the OLS regressions to examine our three hypotheses with results
displayed in Table 4. The dependent variable, net profit per employee (Productivity), is defined as net
profit of the audit firms divided by ending number of employees. Similar to Table 3, the comparisons
between non-conventional and general firms, general and conventional firms, and non-conventional and
conventional firms are listed in in Columns (A), (B), and (C). The three regression models have good
model specification with explanatory power of model (adjusted R2) lying between 0.121 and 0.135.
Column (A) shows that the coefficient on the dummy variable of business strategy (DV_strategy) is
significantly positive (t = 16.819 and p < 0.01). Consistent with expectation, this indicates that financial
performance of non-conventional firms is better than that of general firms, which supports H1. Column
(B) displays a significantly positive coefficient on the dummy variable of business strategy (DV_strategy)
(t = 5.491 and p < 0.01), indicating that general firms outperform conventional firms in financial
performance and H2 receives a support. Column (C) reports a significantly positive coefficient on the
dummy variable of business strategy (DV_strategy) (t = 18.234 and p < 0.01), indicating that
non-conventional firms are superior in financial performance to conventional firms and H3 is supported.
In sum, the regression results of Table 4 are similar to those in Table 3.

Table 4: Regression Results for Audit Firms Adopting Different Business Strategies

Independent Variables Dependent Variable：Productivity

(Predicted Sign)
(A) (B) (C)
Non-Conventional v.s. General General v.s. Conventional Non-Conventional v.s.
Firms Firms Conventional Firms
Std. coef. (t-statistic) Std. coef. (t-statistic) Std. coef. (t-statistic)
DV_strategy ( + ) 0.228 (16.819)*** 0.056 (5.491)*** 0.267 (18.234)***
EXPERIENCE ( + ) 0.240 (16.807)*** 0.226 (20.993)*** 0.172 (11.041)***
EDUCATION ( ? ) 0.015 (1.133) 0.014 (1.430) 0.029 (1.958)**
CPE ( + ) 0.069 (5.198)*** 0.109 (10.835)*** 0.006 (0.422)
SIZE ( + ) 0.290 (20.308)*** 0.289 (26.719)*** 0.282 (17.868) ***
INDEX ( ? ) -0.079 (-5.624) *** -0.055 (-5.272)*** -0.014 (-0.965)
Adjusted R2 0.135 0.121 0.131
F-value 134.39*** 208.80*** 106.22***
Number of observations 5,139 9,097 4,204
Column (A) of Table 4 displays the OLS regression results of productivity comparisons between non-conventional and general firms. It indicates
that productivity of non-conventional firms is better than that of general firms. Column (B) shows the empirical results of productivity
comparisons between general and conventional firms. It demonstrates that general firms financially outperform conventional firms. Column (c)
indicates the empirical results of productivity comparisons between non-conventional and conventional firms. It indicates that non-conventional
firms are superior in productivity to conventional firms. Productivity = (total revenues of audit firms-total expenses of the audit firms+ salaries
paid to their sole proprietors)/number of employees. *, **, *** Denote one-tailed significance at the 10 %, 5 % and 1 % levels.

CONCLUSION

This study first examines the financial performance differences for proprietorship audit firms taking
varied business strategies. Empirical data are from the 1989-2009 Survey Report of Audit Firms in
Taiwan, published by the Financial Supervisory Commission (FSC). One of the main results indicates
that non-conventional firms financially outperform general firms, and the latter outperforms
conventional firms. This study contributes to the resource-based view of the firm by the following
knowledge. In practice, larger audit firms render services to large companies (e.g., Francis, Maydew and
Sparks 1999). Proprietorship audit firms serve small and medium-sized enterprises and provide more
homogeneous practices due to relatively simple accounting treatments in their clients. When audit
market is less competitive, core resources of proprietorship audit firms are expertise and experience
accumulated from providing traditional practices. When audit market becomes increasingly competitive,

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such as the entry of more qualified auditors or establishment of tax agents, the preceding core resources
of proprietorship audit firms fade. Proprietorship audit firms expand service scopes into MAS and form
new core resources obtained from joint provision of traditional and non-traditional practices. As a result,
the core resources concept suggested in the resource-based view of the firm adapts in order to survive
and sustain competitiveness.

In the past three decades, traditional practice market has become increasingly competitive in the
Taiwanese auditing industry due to either an increase in the number of qualified practicing public
accountants, cancellation of the audit fee standard, or the tax agent legalization. Table 3 reports that
financial performance of proprietorship firms only providing traditional services (conventional firms) is
inferior to the other two sub-samples, non-conventional and general firms. This finding suggests that
practitioners of proprietorship audit firms, especially the conventional firms, aggressively expand their
scope of services into MAS. Banker, Chang, and Natarajan (2005) state that the profitability of audit
firms has been sustained in recent years largely by the impact that MAS has had on their productivity.
The conventional firms expanding their services to MAS enlarge their revenues, improve their
traditional practice productivity, and thereby enhance their financial performance.

For years, considerable debate rages among academics, practitioners, regulators, and legislators on the
potential conflict of interest that may arise when auditors are also a management advisor to their audit
clients. Namely, joint provision of audit service and MAS to the public company audit clients impairs
auditor independence. The U.S. Sarbanes-Oxley Act of 2002 poses more stringent restrictions on the
types of MAS auditors may perform for their public company audit clients. Proprietorship audit firms
are not allowed to provide audit services to public companies by the Taiwanese Securities and Exchange
Act. As a result, the problem of auditor independence is relatively trivial for proprietorship audit firms
offering MAS. This provides an additional justification for proprietorship audit firms to expand their
services into MAS.

This study addresses the effects of business strategy on financial performance of proprietorship audit
firms. This study uses the OLS regression to test our hypotheses. After controlling other factors affecting
financial performance, this study obtains the following main results. First, proprietorship firms only
providing MAS (non-conventional firms) financially outperform those providing both traditional
practices and MAS (general firms), and the latter financially outperforms those only offering traditional
practices (conventional firms). Due to data availability, this study employs a cross-sectional data, which
may suffer violations of the assumption of independent observations under the OLS regression model.
Additionally, practitioners argue that audit firms, especially small and medium-sized firms, establish
coalition with consulting firms to save personal income taxes for partners or sole proprietors. Future
studies may extend this study and reexamine the financial performance effects of coalition between audit
firms and consulting firms from the income tax saving perspective.

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Bonner, S.E. and N. Pennington (1991) “Cognitive Processes and Knowledge as Determinants of Auditor
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Grotelueschen, A.D. (1990) “The Effectiveness of Mandatory Continuing Education for Licensed
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Process,” The Academy of Management Review, vol. 3(3), p. 546-562.

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409-431.

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BIOGRAPHY

Yi-Fang Yang is an Assistant Professor of the Department of Accounting and Information System at the
Chang Jung Christian University. She has published scholarly articles in International Journal of Human
Resources Management, Human Systems Management, and International Research Journal of Finance
and Economics. She can be reached at No.1, Changda Rd., Gueiren Dist., Tainan City, 71101, Taiwan,

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[email protected].

Lee-Wen Yang, corresponding author, is an Assistant Professor of accounting at the Chaoyang

University of Technology. She has published scholarly articles in Human Systems Management, Middle
Eastern Finance and Economics, International Research Journal of Finance and Economics, and
International Journal of Human Resources Management. She can be reached at No. 168, Jifong E. Rd.,
Wufong Dist., Taichung City, 41349, Taiwan, [email protected].

Yahn-Shir Chen is a Professor of the Department of Accounting at the National Yunlin University of
Science and Technology. His research appears in journals such as The International Journal of Human
Resources Management, Asia-Pacific Journal of Accounting & Economics, and Economics Bulletin. He
can be reached at No. 123, Sec. 3, University Rd., Douliou, Yunlin County, 64002, Taiwan,
[email protected].

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THE ASSOCIATION BETWEEN FIRM

CHARACTERISTICS AND CORPORATE FINANCIAL
DISCLOSURES: EVIDENCE FROM UAE COMPANIES
Khaled Aljifri, United Arab Emirates University
Abdulkareem Alzarouni, National Bank of Abu Dhabi
Chew Ng, Griffith University
Mohammad Iqbal Tahir, The University of Faisalabad and Griffith University

ABSTRACT

This paper provides empirical evidence of the impact of firm specific characteristics on corporate
financial disclosures amongst UAE companies. A total of 153 public, joint-stock companies, listed and
unlisted, were incorporated at the time of study. Both descriptive statistics and multiple regression
analyses are used to test the relationship between the characteristics of UAE firms and the extent of their
financial disclosure. Eight hypotheses were established to examine the relationship between a number of
explanatory variables (namely, type of industry, listing status, return on equity, liquidity, market
capitalization, foreign ownership, non-executive directors, and audit committee) and the extent of
disclosure in corporate annual reports. The results of this study show that listing status, industry type,
and size of firm are found to be significantly associated with the level of disclosure. This finding not only
provides support for previous studies, but also is of relevance to those in the UAE who want to
understand corporate disclosure and should also be of interest to UAE user-groups. Conclusions drawn
from this study may be of interest to policy makers and regulators who want to improve corporate
financial disclosure in their countries.

JEL: M4, M48, M49

KEYWORDS: Corporate Financial Disclosure, Firm Characteristics, UAE Firms,

Corporate Annual Reports

INTRODUCTION

T he quality of information disclosed in corporate annual reports has received a great deal of
attention in the last four decades, mostly in developed countries. The relationship between the
extent/quality of disclosure in corporate annual reports and the characteristics of the firm has been
extensively examined in the literature. Most of the studies in this area have used an index methodology,
which is based on developing a general index and relating it to a number of explanatory variables (e.g.,
asset size, number of shareholders, profitability, listing status) in order to explain cross-sectional variation
in the extent of disclosure in such corporate annual reports.

It is essential to have high-quality standards and reporting practices to provide users of financial
information with what they need (Biobele et. al., 2013). Deficiencies in such standards and practices
cause inconsistency, incomparability, reduced transparency and a lack of trust in the information
provided, which lead to higher costs of capital and increased risks for different user-groups. As Jenkins
(2002, p. 2) stated, ‘High-quality financial reporting is essential to maintaining an efficient capital market
system. A highly liquid capital market requires the availability of transparent and complete information so
that all participants can make informed decisions as they allocate their capital among competing
alternatives’.

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The above-mentioned perceived benefits accrue to economically advanced nations. However, financial
reporting is even more essential for developing countries which seek to build a strong economy by
regulating financial practices, protecting the national economy from the control of a handful of influential
investors, and encouraging citizens to invest locally. The purpose of this study is to examine the
relationship between the extent of disclosure in corporate annual reports and selected firms’
characteristics in The United Arab Emirates (UAE). UAE, which was established in 1971, is a new
country that relies heavily on oil as its main source of income. Since its establishment, the UAE has
adopted an open economic strategy, and it is one of the fastest growing countries in the world on various
socioeconomic indicators, such as GDP per capita (Wikipedia, 2008). The country has witnessed
remarkable progress and development in different economic aspects. However, the accounting profession
is not well developed (Khasharmeh & Aljifri, 2010).

The government of the UAE has, since 1980, examined the potential benefits of establishing an official
securities market. The market was established in 2000. Different groups of participants in the UAE
securities market (investors, brokers, financial analysts and businessmen) have expressed dissatisfaction
with the practice of financial disclosure among UAE firms, and have complained about variations in
disclosure. The research problem is, therefore, related to corporate disclosure practices in corporate
annual reports. This study seeks to examine the corporate disclosure in annual reports of a sample of UAE
firms and to determine the factors responsible for the variation, if any, in financial disclosure.

There are few previous studies of UAE financial reporting. Al-Shayeb (2003a) attempted to examine
factors that influence the general level of information disclosed by UAE companies in 2000. He found
that overall compliance in the UAE was low since none of his sample companies complied with statutory
requirements on disclosure. Aljifri (2008) studied the extent of disclosure by public companies listed on
the Abu Dhabi Securities Market and the Dubai Financial Market in 2003. Using denominator-adjusted
disclosure-indices, he compared the extent of corporate disclosure between companies, sectors, and the
two financial markets. The results of his study indicate that significant differences are found between
sectors. However, the size, the debt equity ratio, and profitability of a company were found to have no
significant association with the level of disclosure. Unfortunately, the sample sizes in both these studies
were very small, and so their conclusions about the level of disclosure may not be generalisable. Also the
regulations governing disclosure were very new at the time of the studies.
Although the findings of this study are specific to the UAE, the results of this research are relevant to
other countries in the region with similar socio-economic environments. Conclusions drawn from this
study may be of interest to policy makers and regulators who want to improve corporate financial
disclosure in their countries. The findings of this study are also likely to benefit researchers and users of
annual reports in other parts of the world.

The rest of this paper is organized as follows: Section 2 presents the background of the UAE securities
market and Section 3 provides a literature review. Research hypotheses are presented in Section 4.
Section 5 reviews empirical studies which employ various index methodologies to assess and explain
disclosure variations in corporate annual reports. The empirical results are presented in Section 6, and
discussion and conclusions are provided in Section 7.

Background

In the UAE, five forces have shaped financial reporting requirements and practice in the UAE, namely,
the Ministry of Economy, the Central Bank of the UAE (CBUAE), Emirates Securities and Commodities
Authority (ESCA), Dubai International Financial Centre, and Abu Dhabi Accountability Authority. The
Ministry of Economy issued Companies Law No.8/1984 and its amendment No.13/1988, both of which
require firms to maintain records of their operations and to provide audited financial statements to the
Ministry and to other authorities concerned. The Companies Law and its amendments do not specify any

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particular standards, format, or information items that should be reported in financial statements.
However, Article 190 of the Law states that the board of directors should prepare the company balance
sheet, a profit and loss account, a report on company activities during the previous financial year, and the
proposal for net profit distribution.

The CBUAE issued Provision No.445/1988 which requires financial institutions to prepare their audited
financial statements in accordance with the format prepared by the CBUAE. Later, the CBUAE issued
Circular No.20/1999 which requires all banks and financial institutions to adopt the IAS/IFRS in their
annual reports. Since 1999, all firms reporting to the CBUAE prepare their financial statements in
accordance with the IFRS.

ESCA was established by Federal Law No. 4/2000 on the 29th January 2000. ESCA requires all listed
firms to report their reviewed interim financial statements quarterly as well as their audited financial
statements at the end of their financial year. Articles Nos. 29, 31, and 36 of Regulation No. 3/2000
stipulate that listed firms and those applying to be listed have to report to ESCA and to make their
financial statements public.

Although there is an accounting body in the UAE called the UAE Accountants and Auditors Association
(AAA), this association has not issued any national standards and it has no official role in regulating the
profession. Hence, the accounting profession is not well-organized and there are no specific professional
standards with which UAE firms and auditors must comply. It can therefore be concluded that the legal
and regulatory frameworks for financial reporting in the UAE are imprecise and limited in scope.

LITERATURE REVIEW

Previous Studies and Disclosure Index Methodology

Historically, Cerf (1961) was the first researcher who conducted an empirical study using a quantifiable
measure of disclosure and relating it to certain financial and non-financial corporate variables. Cerf’s
study was based on a sample of 527 US firms listed on the New York Stock Exchange (NYSE), on other
exchanges or traded over the counter (OTC). He developed an index consisting of 31 items, each of
which was scored on a scale of 1 to 4 on the basis of interviews with financial analysts. The index was
then related to four corporate variables. He found a significant positive correlation between the level of
disclosure and a firm’s asset size for firms that were not listed on the NYSE, and between the level of
profitability and disclosure for firms listed on the NYSE and those traded OTC. He also found that firms
listed on the NYSE disclosed more information than other firms.

Cerf’s (1961) approach, with extensions and modifications, has been used widely in many other studies to
examine the adequacy of corporate financial disclosure in different countries. Studies using disclosure
index methodology can be classified into three groups: those in developed countries, those in developing
countries, and international studies where data from several countries was included. However, the present
literature survey in the present study is restricted to developing countries and especially to those countries
that have similar socio-economic environments.

Studies in Developing Countries

Using a general disclosure index, previous studies suggest that the extent of corporate financial
disclosures is a function of financial and non-financial characteristics of firms (Imhoff, 1992; Malone et
al., 1993; Lang & Lundholm, 1993; Wallace et al., 1994; Inchausti, 1997; Cooke, 1989a, 1989b, 1989c;
Patton & Zelenka, 1997; Priebjrivat, 1991; Abu-Nassar, 1993; Suwaidan, 1997; Hooks et al., 2002; Naser
& Nuseibeh, 2003; Prencipe, 2004; Alsaeed, 2006; Aljifri, 2008, Hossain and Hammami, 2009; Bhayani,

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2012; Ahmed, 2012). While some studies found that firm size, listing status, leverage, and industry type
were significantly associated with higher disclosure levels, results for other variables (profitability, size of
audit firm, and liquidity) were inconclusive. These findings could be attributed to differences in socio-
economic and political environments between countries, organizational structure, construction of
disclosure indices, and sampling error (Cooke & Wallace, 1990; Ahmed & Courtis, 1999).

In Saudi Arabia, Abdel-Salam (1985) investigated the relationship between the extent of disclosure and
some specific corporate variables. He found a negative results with respect to size of firm measured by
either capital or assets. For the other variables (growth, government subsidy, government ownership,
audit firm size) the results were not clear.

In Jordan, in a study of 45 Jordanian firms, Solas (1994) found that firm size, number of shareholders,
rate of return, and earnings margin had no significant relationship with the quality of financial reporting.
These results contradict Abu Nassar’s (1993) study, which investigated the relationship between the level
of disclosure of 96 firms listed on the Amman Stock Exchange and seven corporate variables. He used
five models of regression analysis to overcome the problem of multicollinearity between the independent
variables. The results revealed that among the independent variables, total dividends were found to be the
most important influence on disclosure. However no relationship was found with equity ratio or the
number of shareholders.

In Bangladesh, Ahmed and Nicholls (1994) investigated the extent of corporate compliance with local
disclosure requirements. By developing an index and applying it to 63 firms listed on the Bangladesh
Stock Exchange, the researchers found no significant association between firm size and the level of
disclosure. However, they reported a positive and significant relationship with the status of firms as
subsidiaries of multinational firms.

Hannifa and Cooke (2002) examined whether the extent of voluntary disclosure in annual reports of 167
Malaysian listed firms was associated with 31 corporate characteristics, divided into three groups of
variables: corporate governance, cultural and firm specific (control) variables. A scoring sheet of 65
voluntary disclosure items, selected on the basis of previous research, was developed and applied to the
annual reports of the selected sample. Using regression analysis, the results indicated a significant
association between the extent of voluntary disclosure and two corporate governance variables (chair who
is a non-executive director and domination of family members on boards) and with one cultural variable
(proportion of Malay directors on the board).

Naser et al. (2002) investigated changes in corporate disclosure in Jordan after the introduction of the
International Accounting Standards (IAS). The results, applying regression analysis, indicated a slight
improvement in the depth of disclosure after the introduction of IAS. In addition, the depth of disclosure
was found to be associated with corporate size, audit firm status, liquidity, gearing, and profitability. In
another study, Naser and Nuseibeh (2003) tried to assess the quality of information disclosed, in the years
1992-1999, by a sample of non-financial Saudi firms listed on the Saudi Stock Exchange. The researchers
used two indices (weighted and un-weighted). The results indicated a relatively high level of compliance
with mandatory requirements in all industries except the electricity sector. However, the level of
voluntary disclosure was relatively low. Alsaeed (2005) also examined the effect of specific
characteristics on the extent of voluntary disclosure by a sample of 40 Saudi firms. He reported that while
large firms tend to present more voluntary information than small firms, the other characteristics (debt
ratio, ownership dispersion, firm age, profit margin, return on equity, liquidity, industry type, and audit
firm size) were found not to be significantly associated with the level of disclosure.

Al Zoubi and Al Zoubi (2012) examined the opinions of accounting academics and investors on the
adequacy of the quality and quantity of information disclosed by Jordanian listed companies in the

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circumstances of the global financial crisis. They used a sample of the two groups of respondents (i.e.,
academics and investors), consisting of 90 respondents from each category. The analysis of the data
gathered by questionnaire revealed that while accounting academics perceived the quantity of disclosed
information to be sufficient, investors perceived the quantity of accounting disclosure to be inadequate.

Research Hypotheses

There has been a great deal of empirical work regarding the relationship between firm-specific
characteristics and the extent of corporate disclosure. This research has used a variety of theoretical
frameworks, such as agency theory, signalling theory, capital market theory and cost-benefit theory
(Haniffa & Cooke, 2002). While the characteristics examined may be classified into various categories,
they are not mutually exclusive. In this study, the characteristics of a company were divided into four
categories (market-related, performance-related, structure-related, and corporate governance variables,
see Table 1) to explain the relationship between company characteristics and their disclosure in the UAE.
These characteristics (i.e., the variables) were selected on the basis that they met the following three
preconditions: (1) the variable encompasses sound theoretical reasons for explaining the association
between the variable and corporate disclosure, (2) the variable is relevant to the socio-economic
environment of the UAE; and (3) sufficient data about the variable was available. Based on these criteria,
eight firm-specific variables were selected for this research: (1) industry type, (2) listing status, (3)
profitability, represented by return on equity ratio (ROE), (4) liquidity, (5) firm size, (6) foreign
ownership, (7) composition of board of directors, and (8) audit committee. The theoretical and empirical
support for these variables are discussed in the following subsections.

Industry Type

Accounting policies and techniques may vary between firms because of their industry-specific
characteristics. Firms from a particular industry may adopt disclosure practices that differ from firms in
other industries (Wallace 1989; Dye & Sridhar 1995). Some industries are highly regulated because of
their overall contribution to a country’s national income. These industries are subject to more rigorous
control, which may affect the level of disclosure (Owsus-Ansah, 1998b). A disclosure differential may
also be associated with the scope of business operations. Firms with multi-production lines may have
more information to disclose than those with small or single line production (Owsus-Ansah, 1998b).
Finally, a dominant firm with a high level of disclosure within a particular industry may lead other firms
to “follow the leader” (Belkaoui & Kahl, 1978) in that industry to adopt the same level of disclosure
(Wallace & Naser, 1995). Therefore a positive association can be assumed between the industry type and
the extent of disclosure:

H1: There is a significant association between the type of industry and the extent of disclosure.
Listing Status

The level of disclosure may vary between listed and unlisted firms. Not only do firms have to comply
with the listing rules imposed by the securities market in which they are listed (e.g., Leftwich et al., 1981;
Cooke 1989a; Wallace et al. 1994), but they also seek funds and hope to reduce the cost of capital by
disclosing more information (Cooke 1989a). Moreover, listed firms are much more in the public eye (Al-
Mulhem, 1997) than unlisted ones, so they tend to disclose more information. It can be assumed that there
is an association between listing status and increased disclosure:

H2: Firms listed in the UAE securities market disclose more information than unlisted firms.

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Profitability

Profitability has been used to explain the variation of disclosure between firms. When profitability is
high, management is more willing to disclose detailed information (Inchausti, 1997; Lang & Lundholm,
1993; Wallace & Naser, 1995; Suwaidan, 1997). Unprofitable firms will be less inclined to release more
information to hide their poor performance. There are different measures of profitability such as net
income, profit margin, return on assets, and return on equity. In this study return on equity was chosen as
a proxy for profitability. Hence, it is hypothesised that return on equity is associated with the extent of
disclosure:

H3: Firms in the UAE securities market with a higher return on equity disclose more information than
firms with lower return on equity.

Liquidity

The assessment of a firm’s liquidity is an important issue for those who use financial statements to judge
a firm’s solvency. Liquidity is of interest to regulatory bodies as well as to investors and lenders. The
inability of a firm to meet its current obligations may mean a default in payment of interest and principal
to the lenders and may lead to bankruptcy. To alleviate these fears, firms are willing to disclose more
information (Wallace & Naser, 1995). Also, liquidity is perceived to be associated with a strong financial
position and firms with high liquidity ratios are expected to disclose more information (Belkaoui & Kahl,
1978; Cooke, 1989a, 1989b; Wallace et al., 1994). Therefore, an association between liquidity, as
measured by current assets divided by current liabilities, and the extent of financial disclosure is
hypothesised as follows:

H4: Firms in the UAE securities market with high liquidity tend to disclose more information than firms
with low liquidity.

Firm Size

In the literature, size has been found to be an influential variable in explaining differences in disclosure
practices among firms (Cerf 1961; Singhvi & Desai, 1971; Buzby 1974a; Lang & Lundholm, 1993;
Wallace et al., 1994; Zarzeski 1996; Naser, 1998; Archambault & Archambault, 2003). There are several
reasons for a positive association between firm size and the extent of disclosure. Disclosing detailed
information is costly, and thus may not be affordable for small firms. Large firms are usually diverse in
the scope of their business, the types of products and geographical coverage. A considerable amount of
information is required for management purposes and can be generated internally. Consequently, the
marginal cost of disclosing the information publicly is low (Cooke 1989c). Also, large firms go to
financial markets to raise funds more often than small ones. These large firms are aware that selling new
securities and a low cost of capital depend on disclosing more information to users (Choi, 1973a, 1973b;
Spero, 1979; Dhaliwal, 1979, 1980b; Barry & Brown, 1985). On the other hand, disclosure of detailed
information may place small firms at a competitive disadvantage with other large firms in the same
industry (Buzby, 1975).

Different variables have been used in previous studies as proxies for firm size, including total assets,
market capitalization, and net sales. (Wallace & Naser, 1995; Naser et al., 2002; Hanifa & Cooke, 2002).
In this research, market capitalization is chosen as it is more objective than other variables and is an
externally determined measure, set by choices that are made by the investing public (Wallace & Naser,
1995). A positive association is expected between a firm’s size (measured by market capitalisation) and
the extent of disclosure:

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H5: Firms in the UAE securities market with a large market capitalization tend to disclose more
information than firms with small market capitalization.

Foreign Ownership

Based on agency theory, where there is a separation between owners (shareholders) and management of a
firm, the potential for agency costs arise because of conflicts of interest between the principal and the
agent (Jensen & Meckling, 1976; Watts, 1977; Fama & Jensen, 1983; Chau & Gray, 2002). Shareholders
will be more inclined to increase monitoring of management behaviour in order to alleviate the agency
problems. Monitoring costs affect both profitability and management remuneration, and consequently
management can reduce monitoring costs by providing more information to shareholders.

Shareholders, according to Wallace (1989), also vary in their information needs. Some shareholders could
be interested in profitability, others might be looking for forecast information, while others want
information about social responsibility. Accordingly, corporate financial disclosure is likely to be higher
in widely-held firms and in this sense the demand for information is expected to be higher from foreign
investors due to the geographical separation between management and owners (Bradbury, 1992; Craswell
& Taylor, 1992). Diffusion of ownership has been empirically found to be an important variable in
explaining the variability of corporate financial disclosure (Leftwich et al., 1981; Craswell & Taylor,
1992; Hossain et al., 1994), and the demand for information is expected to be greater when a high
proportion of shares is held by foreign investors. Therefore, it is hypothesized that:

H6: UAE firms with a higher proportion of foreign ownership disclose more information than those
without such ownership.

Composition of Board of Directors

Board composition is defined by Shamser and Annuar (1993, p. 44) as ‘the proportion of outside directors
to the total number of directors’. The role of the board of directors in monitoring management behaviour
and corporate financial disclosure may be a function of the composition of the board (Gibbins et al.,
1990). Having a higher proportion of outside non-executive directors on the board may result in better
monitoring of the behaviour of management by the board and limit managerial opportunism (Fama, 1980;
Fama & Jensen, 1983).

Also, non-executive board members are less aligned with management, and they may be more inclined to
encourage and support more disclosure to the users of financial reporting (Mak & Eng, 2003). A positive
relationship between the proportion of independent directors and disclosure has been found empirically in
other capital market settings (Chen & Jaggi, 2000). Therefore, it is hypothesised that:

H7: There is a positive association between the proportion of outside directors and the level of disclosure
made by UAE firms.

Audit Committee

Recent high-profile accounting scandals, such as that involving Enron, have shed light on the
effectiveness of audit committees. Such problems have led some countries to impose more regulations on
audit committee functions, including independence, composition, expertise and disclosure activities (e.g.,
Sarbane-Oxely Act 2002). The structure of the audit committee determines the level of monitoring and
thereby the level of financial disclosure. It has been argued that an effective and independent audit
committee has an influential role in the financial reporting process (Kreutzfeldt & Wallace, 1986; Abbott

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et al., 2004). An independent audit committee provides greater monitoring of the financial discretion of
management and ensures the credibility of corporate financial disclosure (The Blue Ribbon Committee,
1999).

The level of expertise is another factor which enhances the effectiveness of the audit committee. This
expertise should be based on members of the audit committee who possess knowledge and experience in
accounting and finance (Beasley & Salterio, 2001; Abbott et al., 2004). The US (Sarbane-Oxely Act
2002) and Malaysia (Bursa Malaysia listing requirements 2001) require that at least one member of the
audit committee possesses a background in accounting and finance. Hence, it is assumed that having
independent and qualified audit committee members enhances the quality of a firm’s financial disclosure.
In this research, since information on the independence and qualifications of audit committee members is
not available in the UAE, the effect of the existence of an audit committee on the extent of corporate
disclosure is assessed by testing whether a firm has an audit committee or not. Therefore, it is
hypothesized that:

H8: There is a positive association between the existence of an audit committee and the level of financial
disclosure made by UAE firms.

Table 1 presents the research hypotheses and the predicted signs for each explanatory variable associated
with each hypothesis.

Table 1: Research Hypotheses and Predicted Signs of the Coefficients

Independent Variable Hypothesis Expected Sign

Market Variables:
Industry Type H1 +/-
Listing Status H2 +
Performance Variables:
Profitability (ROE) H3 +
Liquidity H4 +
Structure Variables:
Firm Size (Market Capitalization) H5 +
Foreign Ownership H6 +
Corporate Governance Variables:
Composition of B.O.D. H7 +
Audit Committee H8 +
This table lists the hypotheses with their expected signs. It shows that market variables (with an exception for industry type), performance
variables, structure variables, and corporate governance variables are predicted to have a positive relationship with the level of financial
disclosure made by UAE firms.

METHODOLOGY

Selection of Information Items

The most important step in constructing a disclosure index is the selection of information items that could
be found in corporate annual reports. It should be noted that there is no consensus on the number or
selection of items to be included in a disclosure index (Wallace et al., 1994; Al-Hussaini, 2001). Also, the
number of information items used in previous studies has varied considerably, which may reflect
differences in the settings where the studies were conducted (Wallace, 1993; Patel, 2003; Ngangan et al.,
2005).

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As Marston and Shrives (1991) noted, the number of items that could be disclosed by a company is very
large, if not infinite. Wallace (1988) argued that there was no agreed criterion on which to select an item
of information, and that to overcome the selection bias, an extensive list of disclosure items be developed.
The number of items included in the scoring sheet in previous studies varied from a minimum of 17 items
(Barrett, 1976) to a maximum of 530 (Craig & Diga, 1998).

The disclosure index may include both mandatory and voluntary information items since both forms of
disclosure result from social-system processes (Archambault & Archambault, 2003). Mandatory
disclosure is required by statute, professional regulations and listing requirements of stock exchanges.
The extent to which firms comply with legal and regulatory requirements depends on the strictness or
laxity of the government, professional and other regulatory bodies (Marston & Shivers, 1991; Salawu,
2012). Voluntary disclosure on the other hand, in excess of the minimum, may arise where corporate
perceptions of the benefits arising outweigh the costs (Gray & Roberts, 1989; Chakroun & Matoussi,
2012).

In this research, the focus is on mandatory items because financial reporting and disclosure practice in the
UAE are not well-organized and free-market mechanisms are immature (Owsus-Ansah, 1998a). In order
to avoid penalizing a firm for not disclosing an item that does not apply to it, the list of items was based
on the limited and specific requirements set by the UAE regulators, in addition to IFRS, to which all firms
in the UAE claim to comply. The initial list of information items (index) consisted of 405 items, of which
only six items were related to ESCA requirements. To ensure that a complete, relevant and applicable list
of information items was included in the index, two control measures were adopted. First, the list was
cross-checked with the disclosure checklists of three of the big-four accounting firms: KPMG, Ernst and
Young and Deloitte. Second, the list was discussed with three senior external auditors working for three
big auditing firms in the UAE (Deloitte, KPMG, and Talal Abu Ghazala). The purpose of this step was to
refine the list and to determine the suitability of the items for firms operating in different sectors in the
UAE.

Based on these measures, 88 items were excluded as they related to 9 standards that were irrelevant or
inapplicable to the UAE or the dates when they came into effect were after 2005 (see Table 2). These
standards were: IFRS 1 First-time Adoption of IFRS; IFRS 6 Exploration for and Evaluation of Mineral
Assets; IFRS 7 Financial Instruments Disclosure; IFRS 8 Operating Segments; IAS 12 Income Taxes;
IAS 26 Accounting and Reporting by Retirement Benefit Plan; IAS 29 Financial Reporting in
Hyperinflationary Economies; IAS 34 Interim Financial Reporting; and IAS 39 Financial Instruments
Recognition and Measurement (see Table 2 for the reasons for exclusion).

Table 2: Excluded IAS & IFRS Items

IFRS/IAS Title Reasons for Exclusion

IFRS 1 First-time Adoption of IFRS All firms claimed adoption of IFRS before 2004
IFRS 6 Exploration for and Evaluation of Mineral Assets It is effective on January 2006 onward
IFRS 7 Financial Instruments: Disclosures It is effective on January 2007 onward
IFRS 8 Operating Segments It is effective on January 2009 onward
IAS 12 Income Taxes UAE firms pay no income tax
IAS 26 Accounting and Reporting by Retirement Benefit Plan The UAE has its own benefits and retirement plan

IAS 29 Financial Reporting in Hyperinflationary Economies Inflation has been relatively low (1.5% to 4%) over the past ten
years (GCC 2003)
IAS 34 Interim Financial Reporting The objective of this research is to assess disclosure in
corporate annual reports
IAS 39 Financial Instruments: Recognition and Measurement All disclosure requirements in IAS 39 were covered in IAS 32
This table reports the excluded IFRS/IAS with the reason of exclusion. These standards were excluded as they that were irrelevant or
inapplicable to the UAE or the dates when they came into effect were after 2005.

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The final list included a total of 317 items of information. This final list was then pilot tested on 20
companies from different sectors to ensure that items peculiar to each selected sector were taken into
account.

Sample Selection, Data Collection, and Variables Measurements

Based on the constitution of the UAE, the Ministry of Economy is responsible for the orderly operation of
the country’s economy. Companies Law No. 8/1984 is the main act which governs the incorporation,
control, and management of different types of firms. There are seven types of firms that may be
incorporated in the UAE: general partnership, simple limited partnership, joint participation (venture);
public joint stock company, private joint stock company, limited liability company, and partnership
united with shares. All public joint stock firms have to lodge their annual reports with the Ministry.
Therefore, the Companies Department at the Ministry of Economy was approached to provide copies of
the 2005 annual reports of all public joint stock companies as this was the best and quickest way to obtain
the required data.

The year 2005 was selected as it was the most recent data available at the time of the request. A total of
153 public joint stock companies, listed and unlisted, were incorporated at the time of study. Seven firms
were excluded from the sample as they were incorporated in either 2005 or later and had very little
information in their annual reports. Another 33 firms were excluded because their annual reports were not
available. Twenty of these 33 companies were solely owned by the UAE government, and while they had
been registered as joint stock companies, their annual reports were not accessible. For the other 11
companies, annual reports were not available to the researchers, despite numerous efforts to obtain them.
Hence, they were also excluded from the sample. Consequently, only 113 corporate annual reports were
collected representing approximately 75% of the total population. Table 3 provides a summary of the total
sample.

The dependent variable, total disclosure index (TDI), for each firm was the disclosure made by the firm
through its annual report and it was measured by the total disclosure index (TDI) as explained in in the
next subsection. Data for these variables was obtained from the annual reports of the selected firms, and
from the annual guide of firms published by ESCA. Table 4 summarises data collection and variables
measurement.

Table 3: Population and the Sample of Public Joint Stock Companies in the UAE

Sector Companies Annual Reports Available/Not Available Total %

Listed Unlisted Total Listed Unlisted Available
Available Established Not Available Established Not
late 2005 Available Late 2005 Available

Banking 22 3 25 22 0 0 3 0 0 25 100%
Insurance 23 1 24 23 0 0 1 0 0 24 100%
Services 36 32 68 34 2 0 0 4 28 34 50%
Industries 27 9 36 27 0 0 3 1 5 30 83%
Total 108 45 153 106 2 0 7 5 33 113 74%
This table presents a summary of the population and the sample of Public Joint Stock Companies in the UAE. A total of 153 public joint stock
companies, listed and unlisted, were incorporated at the time of study, however, only 113 corporate annual reports were collected representing
approximately 75% of the total population

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Table 4: Data Collection and Measurement of Variables

Independent Variable Proxy Sources of

Information
Market Variables:
Industry Type Dummy variable coded: Industry 1(Banking) = 1, otherwise = 0 ESCA
Industry 2 (Insurance) = 1, otherwise = 0
Industry 3 (Services) = 1, otherwise = 0
Industry 4 (Industrial) = 1, otherwise = 0
Listing Status Dummy variable coded 1 = listed, ESCA
0 = unlisted
Performance Variables:
Profitability (ROE) Return on Equity = earnings/total shareholders' equity Firms’ Annual
reports

Liquidity Current assets/ current liabilities Firms’ Annual

reports
Structure Variables:
Firm Size Number of shares at year-end date X market value per share ESCA
(Market Capitalization)
Foreign Ownership Percentage of non-UAE national investors’ ownership ESCA
Corporate Governance Variables:
Composition of B.O.D. Proportion of outside directors to the total number of directors ESCA
Audit Committee Dummy variables coded: 1 = if a company has an audit committee, 0 = otherwise ESCA
This table reports data collection of the independent variables and their proxies. Data for these variables was obtained from the annual reports
of the selected firms, and from the annual guide of firms published by ESCA.

Statistical Procedures

One of the methodological problems associated with the scoring procedures of the disclosure index is
whether or not an item is applicable to a particular firm (Owsus-Ansah, 1998a). To overcome this
problem, following Cooke’s (1989a) recommendation, the entire annual report of every company was
read first by the researcher to understand clearly the scope of the disclosure practice and to determine
whether an undisclosed item was in fact applicable to that particular company. This procedure led to the
creation of a relative index for each sample firm. The relative index, which includes information items a
firm was expected to disclose, was adopted by several previous studies (Buzby, 1975; Wallace, 1987;
Firth, 1980; Babbie, 1994; Ahmed & Nicholls, 1994; Inchausti, 1997; Owsus-Ansah, 1998a, Aljifri,
2008). Consequently, the risk of penalising a firm for not disclosing an item, inapplicable to that firm,
was significantly reduced.

The next step was to apply the index to each firm using the dichotomous procedure of matching the firm’s
annual report disclosures to the index. Following the unweighted index scoring scheme, an item scored
one if it was disclosed and zero if it was not. Based on the calculated scores for each firm, the descriptive
statistics were calculated to form a judgement about the current level of disclosure in the UAE. The scores
of the disclosure index for each firm were calculated by dividing the total scores by the maximum score
(M) (based on the relative index of the firm), as follows:
n
M = ∑ di (1)
i =1

where,
di = expected item of disclosure
n = the number of items applicable to a firm, i.e. n ≤ 317
The total disclosure score (TD) for a firm was calculated as follows:

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M
TD = ∑ di (2)
i =1

where:
di = 1 if the item di is disclosed

0 if the item di is not disclosed

M ≤n
The total disclosure index (TDI) for each firm was therefore calculated as:
TDI = TD (3)

Statistical Tests

Different statistical approaches and methodologies have been adopted in previous studies to test the
relationship between the extent of disclosure and various firm-specific variables. Earlier studies (Singhvi
& Desai, 1971; Buzby, 1975; Stanga, 1976; Belkaoui & Kahl, 1978; Buckland et al., 1998) used a
matched-pair statistical procedure to test for difference between the mean disclosure indexes of two or
more groups of sample firms. More recent studies, starting with Chow and Wong-Boren (1987), have
used a variation of a multiple regression procedure.

For example, some researchers use dummy variable manipulation procedures within a stepwise multiple
Ordinary Least Squares (OLS) regression analysis (Cooke, 1989a, 1989b; Haniffa & Cooke, 2002), while
others use rank regression procedures (Land and Lundholm, 1993; Wallace et al., 1994; Naser, 1998;
Chen & Jaggi, 2000; Chau & Gray, 2002) or a meta-analysis technique (Ahmed & Courtis, 1999).
Wallace et al. (1994), Haniffa and Cooke (2002), and Archambault and Archambault (2003) used two
regression models, reduced regression and full regression, to deal with the possibility of collinearity. In
this research, both descriptive statistics and multiple regression analyses are used to test the relationship
between the characteristics of UAE firms and the extent of their disclosure.

Descriptive Statistics

Two types of descriptive statistics were conducted. The first was a descriptive analysis which includes the
mean and standard deviation. The second test was a correlation test which highlights the relationship
between a single explanatory variable and the extent of disclosure by UAE firms.

Multiple Regression Analysis

One of the main problems that confronts researchers using the OLS regression is when the dependent
variable is constrained to range between zero and one. The estimation of the regression model can,
however, lie outside this range. This is because the standard OLS presumes an unconstrained dependent
variable. Hence, the standard OLS estimates may be unreliable (Hanushek & Jackson, 1977; Ahmed &
Nicholls, 1994; Greene, 2003). Consequently, the suggestion to transform the dependent variable was
adopted (Hanushek & Jackson, 1977; Wallace e. al., 1994; Ahmed & Nicholls, 1994; Fox, 1997;
Inchausti 1997; Naser & Al-Khatib, 2000; Greene, 2003; Makhija & Patton, 2004; Al-Shaimmari 2005).

This approach also has the advantage that such transformation might result in normally distributed errors
(Cooke, 1998). The transformation was done by taking the logarithm of the total disclosure index for each

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firm. Then, the transformed total disclosure index (TTDI) was regressed against the eight specified
variables by applying OLS regression procedures. The regression model is expressed as follows:
TTDI = ∝ + β1 indtypei + β2 indtypei + β3 indtypei + β4 indtype + β5 listingi + β6 ROEi + β7 liquidi + β8
marcapi + β9 foriegni + β10 boardi + β11 auditi + ε (4)
where:

TTDI = Transformed Total disclosure index (actual score awarded to each

firm/maximum score)
∝ = Intercept
indtype = Industry type (indtype1 = Banking; indtype2 = Insurance; indtype3 = Services; indtype4 =
Industrial)
listing = Listing status
ROE = Return on equity
liquid = Liquidity
marcap = Market capitalization
foreign = Foreign ownership
board = Board composition
Audit = Audit committee.
ε = Error term
β1, β2, β3, β4, β5, β6, β7, β8, β9, β10, β11, β12, = slope coefficients of the model.

RESULTS

Descriptive Analysis

Table 5 provides descriptive analysis for the dependent variable and the explanatory variables. In general,
the extent of corporate disclosure varies from 23% to 70%. The overall mean value of disclosure is 57%
with standard deviation of 9%, reflecting a low to moderate level of disclosure among the 113 sample
firms.

Table 5: Descriptive analysis of the Dependent and Independent Variables

Variables N Mean Std. Deviation Minimum Maximum

Total Disclosure 113 0.57 0.09 0.23 0.70
Listing Status 113 0.94 0.24 0.00 1
Net Income/Equity (ROE) 113 0.21 0.13 - 0.01 0.55
Liquidity 113 3.85 8.66 0.39 86.33
Market Capitalization (million dirham) 113 7,894 17,836 20 133,811
Foreign Ownership 113 0.26 0.32 0.00 100.00
% of outside directors 113 0.93 0.10 0.60 100.00
Audit Committee 113 0.53 0 1
Banks 25 0.22 0 1
Industrial 30 0.27 0 1
Insurance 24 0.21 0 1
Services 34 0.30 0 1
This table provides a descriptive statistics of the dependent and independent variables. It shows the extent of corporate disclosure varies from
23% to 70%. The overall mean value of disclosure is 57%.

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An examination of Table 5 shows that 94% of the sample companies are listed on the UAE securities
market and the mean value of return on equity (ROE) for the 113 companies is 21%. The overall liquidity
(current ratio) is 3.85 which is well above the rule of thumb of 2:1. The mean value of foreign ownership
among the firms is 26% while non-executive directors constitute about 93% of the sampled boards. Fifty-
three percent of the firms have audit committees, which indicates that good corporate governance is not
widely practised and that further enforcement is needed from the UAE authorities.

Correlation Analysis

To assess the relationship between the total disclosure index (TDI) and the characteristics of the firms, a
Pearson Product-Moment correlation matrix was used to examine the correlation between the dependent
variable (TDI) and each of the independent variables used in this study. The Pearson Product-Moment
correlation matrix for the dependent and independent variables is presented in Table 6. The statistical
results show that significant positive relationships were found to exist between the extent of disclosure
and banking industry (r = 0.347) and listing status variables (r = 0.288) at the P < 0.01 level. These
results support hypotheses H1, which states that there is a significant relationship between corporate
disclosure and industry type, and H2, which states that there is a significant relationship between
corporate disclosure and listing status. However, no significant correlation was found between other
industry types and the extent of disclosure.

No other statistically significant correlations were found. Return-On-Equity (r = -0.074, P = 0.434) and
liquidity (r = -0.001, P = 0.992) appear to be negative but not influentially correlated with the extent of
disclosure. The most interesting result is that size measured by market capitalization was found to be
negative but not significantly correlated with corporate disclosure (r = -0.028, P = 0.772). On the other
hand, the relationship between the extent of disclosure and foreign ownership (r = 0.079, P = 0.408),
composition of board of directors (r = 0.107, P = 0.258), and audit committee (r = 0.111, P = 0.241) was
found to be positive but also not significantly correlated. These results do not appear to support
hypotheses H3, H4, H5, H6, H7, and H8.

Multiple Regression Analysis

This subsection describes the results of running the ordinary least square (OLS) regression with log
transformation analysis with all company variables using SPSS. All variables were entered into the model
simultaneously. The purpose is to test whether the specified independent variables contribute significantly
to the prediction of the disclosure level of firms in the UAE. The results of the multiple regression
analysis are presented in Table 7. Results of the multiple regression analysis of the association between
company variables and the extent of disclosure in the annual reports of the sample companies are shown
in Table 7. As can be seen, the coefficient of determination R2 is equal to 33% and the adjusted R2 is
equal to 26% where the P–value < 0 .01 and the F test statistics (10, 102) = 4.95.

Table 6: Correlation Analysis

Listing Status

Capitalization

% of outside

Committee
Ownership
Disclosure

Insurance
Industrial
Liquidity

directors
Foreign

Service
Market

Banks
Audit
Total

ROE

Total Person
Disclosure Correlation 1 0.288* -0.074 -0.001 -0.028 0.079 0.107 0.111 0.347* -0.115 -0.091 -0.122
Sig. (2 tailed) 0.002 0.434 0.992 0.772 0.408 0.258 0.241 0.000 0.224 0.339 0.200
N 113 113 113 113 113 113 113 113 113 113 113 113

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Listing Person
Status Correlation 0.288 1 0.198* 0.042 0.110 0.143 0.053 0.053 -0.128 -0.095 0.044 0.169
Sig. (2 tailed) 0.002 0.035 0.661 0.245 0.130 0.578 0.579 0.175 0.317 0.646 0.074
N 113 113 113 113 113 113 113 113 113 113 113 113
Person
ROE Correlation -0.074 0.198* 1 -0.142 0.056 -0.064 -0.139 0.107 -0.03 -0.184 .291* -0.055
Sig. (2 tailed) 0.434 0.035 0.132 0.559 0.499 0.142 0.259 0.751 0.051 0.002 0.565
N 113 113 113 113 113 113 113 113 113 113 113 113
Person
Liquidity Correlation -0.001 0.042 -0.142 1 -0.044 0.090 -0.002 -0.015 -0.136 -0.020 -0.049 0.186*
Sig.(2 tailed) 0.992 0.661 0.132 0.643 0.343 0.982 0.877 0.152 0.837 0.605 0.049
N 113 113 113 113 113 113 113 113 113 113 113 113
Market Person
* * *
Capitalization Correlation -0.028 0.110 0.056 -0.044 1 0.019 -0.033 0.282 0.197 -0.169 0.186 0.150
Sig. (2 tailed) 0.772 0.245 0.559 0.643 0.839 0.729 0.003 0.036 0.074 0.048 0.113
N 113 113 113 113 113 113 113 113 113 113 113 0.113
Foreign Person
-0.270*
Ownership Correlation 0.079 0.143 -0.064 0.090 0.019 1 -0.127 -0.044 -0.183 0.103 0.306*
Sig. (2 tailed) 0.408 0.130 0.499 0.343 0.839 0.179 0.647 0.053 0.276 0.004 0.001
N 113 113 113 113 113 113 113 113 113 113 113 113
% of outside Person
directors Correlation 0.107 0.053 -0.139 -0.002 -0.033 -0.127 1 0.067 0.082 0.000 0.087 -0.152
Sig. (2 tailed) 0.258 0.578 0.142 0.982 0.729 0.179 0.484 0.387 0.999 0.359 0.108
N 113 113 113 113 113 113 113 113 113 113 113 113
Audit Person
Committee Correlation 0.111 0.053 0.107 -0.015 0.282** -0.044 0.067 1 0.287** -0.238 -0.119 0.075
Sig. (2 tailed) 0.241 0.579 0.259 0.877 0.003 0.647 0.484 0.002 0.011 0.210 0.428
N 113 113 113 113 113 113 113 113 113 113 113 113
Person *
-0.277 -0.350*
Banks Correlation 0.347** -0.128 -0.03 -0.136 0.197* -0.183 0.082 0.287* 1 -0.320*
Sig. (2 tailed) 0.000 0.175 0.751 0.152 0.036 0.053 0.387 0.002 0.001 0.003 0.000
N 113 113 113 113 113 113 113 113 113 113 113 113
Person * -
-0.238
Industrial Correlation -0.115 -0.095 -0.184 -0.020 -0.169 0.103 0.000 0.320* 1 -0.312* 0.394*
Sig. (2 tailed) 0.224 0.317 0.051 0.837 0.074 0.276 0.999 0.011 0.001 0.001 0.000
N 113 113 113 113 113 113 113 113 113 113 113 113
Person -
Insurance Correlation -0.091 0.044 0.291* -0.049 -0.186 -0.270* 0.087 -0.119 -0.277* -0.312* 1 0.341*
Sig. (2 tailed) 0.339 0.646 0.002 0.605 0.048 0.004 0.359 0.210 0.003 0.001 0.000
N 113 113 113 113 113 113 113 113 113 113 113 113
Person
Service Correlation -0.122 0.169 -0.055 0.186* 0.150 0.306* -0.152 0.075 -0.350* -0.394* -0.341* 1
Sig. (2 tailed) 0.200 0.074 0.565 0.049 0.113 0.001 0.108 0.428 0.000 0.000 0.000
N 113 113 113 113 113 113 113 113 113 113 113 113
This table presents the Pearson Product-Moment correlation matrix for the dependent and independent variables. The statistical results show
that significant positive relationships were found to exist between the extent of disclosure and banking industry (r = 0.347) and listing status
variables (r = 0.288) at the P < 0.01 level. The correlations are for selected variables used in the analysis. *, ** indicate significance at the 1
and 5 percent. levels respectively.

These results show that approximately 26% of the variation in disclosure level scores between the
companies can be explained by the eight independent variables included in the model. According to
Anderson et al. (1993) and Abd-Elsalam and Weetman (2003), an explanatory y power of 20% is
considered useful in social science research.

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The results show that listing and industry type (banking sector) variables were positively and significantly
associated with the extent of disclosure of the sample companies at the 1% level. Also, market
capitalization was significant but with a negative coefficient at the 5% level. The model indicated that the
other variables did not seem to be the main determinants of variations in the extent of disclosure of the
sample companies.

Table 7: Summary of the Results of OLS Regression with Log Transformation

Variable β t Sig. t VIF

Listing 0.3268 5.03 0.000 1.13
ROE -0.1650 -1.34 0.183 1.24
Liquidity 0.0004 0.23 0.820 1.07
Market Capitalization -1.8500 -2.06 0.042 1.17
Foreign Ownership 0.0850 1.65 0.102 1.21
Non-Executive Directors 0.0622 0.41 0.685 1.09
Audit Committee 0.0174 0.53 0.594 1.21
Banks 0.1939 4.28 0.000 1.62
Industrial 0.0055 0.13 0.896 1.56
Insurance 0.0502 1.04 0.299 1.78
Constant -0.9863 -6.43 0.000 -
2
R = 0.3268 F (10, 102) = 4.95 Mean VIF = 1.31
Adj. R2 = 0.2608 Sig. F = 0.0000
This table summarizes the results of OLS regression with Log Transformation. It shows that listing and industry type (banking sector) variables
were positively and significantly associated with the extent of disclosure of the sample companies at the 1% level.

DISCUSSIONS AND CONCLUSIONS

This paper analyses the possible impacts of eight specific company variables on the extent of disclosure
by UAE firms. The descriptive analysis revealed that the overall mean value of disclosure in the UAE is
57%, reflecting a low to moderate level of disclosure. The major conclusion that can be drawn from the
regression analysis is that the industry type, listing status and the size of firm (market capitalization) are
the most powerful explanatory variables when related to the variation in compliance with regulations that
specify mandatory disclosure on the part of UAE firms. With regard to the other variables, the model
showed that these variables did not seem to be the main determinants of variations in the extent of
disclosure of the sample companies.

This finding can be explained on the grounds that listed firms are exposed to more disclosure
requirements stipulated by the UAE securities market. Similarly, unlike the other sectors, the banking
sector is the most regulated sector by the Central Bank of the UAE. The results also showed that market
capitalization was significant at the 5% level, but with a negative coefficient. This result provides
unexpected evidence and is inconsistent with H5, which states that big firms tend to disclose more
information than firms with small firms. This can be attributed to the fact that big firms have more social
and political influence to avoid compliance with mandatory disclosure requirements.
The results of this study have extended the understanding of how characteristics of a firm help to explain
the variability in disclosure. The extent of disclosure was found to be significantly associated with listing
status, industry type, and size of firm. This finding not only provides support for previous studies, but is
also of relevance to those in the UAE who want to understand corporate disclosure. A possible policy
implication of this finding is that unlisted large firms need closer scrutiny by the regulatory authorities.

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The International Journal of Business and Finance Research ♦ VOLUME 8 ♦ NUMBER 2 ♦ 2014

The UAE authorities need to evaluate the efficacy of the regulatory requirements and also to introduce
more effective monitoring and enforcement mechanisms.

The findings of the study should also be of interest to UAE user-groups. As firms with small market
capitalization, banking sector firms, and listed firms on the UAE securities market disclose more
information in their annual reports, users should be cautious when dealing with large and unlisted firms
and may have to consider different sources of information in addition to annual reports. This study also
reveals that external auditors in the UAE provide unqualified reports without mentioning any departure
from compliance with mandatory requirements of the UAE securities market or IFRS. This raises a
question about the quality of auditing practices in this country and requires more attention from the
authorities concerned.

Currently the UAE Accountants and Auditors Association (AAA) has no authority to regulate the
profession. Cooperation between government authorities and this accounting body is crucial in order to
regulate financial reporting effectively (Craig & Diga, 1996). Consequently, UAE authorities should give
more responsibility and support to the AAA, which can play an important role in increasing awareness
among its members about disclosure requirements, as well as ensuring that only qualified auditors are
licensed.

This study provides some insights into the determinants of disclosure level in the UAE. However, the
findings of this study should be interpreted with care as several limitations are associated with this kind of
research. The first limitation relates to the use of the chosen index to measure the extent of disclosure.
Although the disclosure index is considered the most suitable methodology to test the extent of disclosure
(Marston & Shrives, 1991; Botosan, 1997; Prencipe, 2004), the interpretation of these results is
constrained by the validity and reliability of the disclosure index used in the study. The level of corporate
disclosure may be affected by the subjective selection of items for information disclosure. While the
disclosure items included in the index were carefully selected, they may not fully encompass all possible
items that need to be included in the assessment of corporate reporting practices. Wallace and Naser
(1995) pointed out that the results of using a disclosure index may be different if the number or nature of
items was changed. Also, the evaluation process was limited to mandatory items only as it was not
possible to include voluntary disclosure items. Consequently, using a disclosure index with non-
mandatory items may reveal quite different results from the present study. The subjectivity problem
inherent in scoring the annual reports of the sample companies may not have been completely eliminated
and hence, there is an unavoidable subjectivity in the scoring process (Owsus-Ansah, 1998b).
Consequently, the comprehensiveness of corporate disclosures may not have been fully and/or properly
captured by the disclosure index used in the study.

As the economy of the UAE advances through time, more research will be needed in the future in order to
gain further understanding of corporate disclosure. The current study examined the relationship between
mandatory disclosure and certain company characteristics in a single period. Further research might
attempt to extend this examination to include two or more periods, such as before and after the
establishment of the official securities market, or a comparative study of firms before and after they are
listed.

In examining the explanatory power of company characteristics, it is possible that other variables, which
have an impact on the extent of disclosure in the UAE, have not been included in the present study.
Consequently, future research should investigate the effect of other variables, such as the qualifications of
audit committee members and cultural factors, on the level of disclosure. Moreover, as the government
moves towards the privatization of government-owned companies, a future research project could
examine the impact of privatization on the disclosure behaviour of such companies.

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K. Aljifri et al | IJBFR ♦ Vol. 8 ♦ No. 2 ♦ 2014

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ACKNOWLEDGMENT

The authors wish to thank the two anonymous reviewers for their valuable comments and suggestions.
Biography

Dr. Khaled Aljifri is an Associate Professor of Accounting at United Arab Emirates University. He can be
contacted at: College of Business and Economics, Accounting Department, UAEU, P.O. Box 15551, Al
Ain, United Arab Emirates. Email: [email protected].

Dr. Abdulkarim Alzarouni is the Deputy General Manager of Group Internal Audit in the National Bank
of Abu Dhabi. He can be contacted via email: [email protected].

Dr. Chew Ng is Professor of Financial Accounting at the Griffith Business School, Griffith University.
She can be contacted at: Department of Accounting, Finance and Economics, Griffith Business School,
Griffith University, Nathan Campus, Queensland, Australia 4111. E-mail: [email protected].

Dr. Mohammad Iqbal Tahir. He can be contacted at: School of Management Studies, the University of
Faisalabad, Pakistan, and Department of Accounting, Finance and Economics Griffith University, Nathan
Campus, Queensland, Australia 4111. Email: [email protected].

123
 REVIEWERS
The IBFR would like to thank the following members of the academic community and industry for their much appreciated
contribution as reviewers.

Hisham Abdelbaki, University of Mansoura - Egypt Peter Geczy, AIST

Isaac Oluwajoba Abereijo, Obafemi Awolowo University Lucia Gibilaro, University of Bergamo
Naser Abughazaleh, Gulf University For Science And Hongtao Guo, Salem State University
Technology Danyelle Guyatt, University of Bath
Nsiah Acheampong, University of Phoenix Zulkifli Hasan, Islamic University College of Malaysia
Vera Adamchik, University of Houston-Victoria Shahriar Hasan, Thompson Rivers University
Iyabo Adeoye, National Horticultural Research Instittute, Peng He, Investment Technology Group
Ibadan, Nigeria.
Niall Hegarty, St. Johns University
Michael Adusei, Kwame Nkrumah University of Science
Paulin Houanye, University of International Business and
And Technology
Education, School of Law
Mohd Ajlouni, Yarmouk University
Daniel Hsiao, University of Minnesota Duluth
Sylvester Akinbuli, University of Lagos
Xiaochu Hu, School of Public Policy, George Mason
Anthony Akinlo, Obafemi Awolowo University University
Yousuf Al-Busaidi, Sultan Qaboos University Jui-ying Hung, Chatoyang University of Technology
Khaled Aljaaidi, Universiti Utara Malaysia Fazeena Hussain, University of the South Pacific
Hussein Al-tamimi, University of Sharjah Shilpa Iyanna, Abu Dhabi University
Paulo Alves, CMVM, ISCAL and Lusofona University Sakshi Jain, University of Delhi
Ghazi Al-weshah, Albalqa Applied University Raja Saquib Yusaf Janjua, CIIT
Glyn Atwal, Groupe Ecole Supérieure de Commerce de Yu Junye, Louisiana State University
Rennes
Tejendra N. Kalia, Worcester State College
Samar Baqer, Kuwait University College of Business
Gary Keller, Eastern Oregon University
Administration
Ann Galligan Kelley, Providence College
Susan C. Baxter, Bethune-Cookman College
Ann Kelley, Providence college
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Ifraz Khan, University of the South Pacific
Ahmet Bayraktar, Rutgers University
Halil Kiymaz, Rollins College
Kyle Brink, Western Michigan University
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Giovanni Bronzetti, University of Calabria
Bamini Kpd Balakrishnan, Universiti Malaysia Sabah
Karel Bruna, University of Economics-Prague
Bohumil Král, University of Economics-Prague
Priyashni Chand, University of the South Pacific
Jan Kruger, Unisa School for Business Leadership
Wan-Ju Chen, Diwan College of Management
Christopher B. Kummer, Webster University-Vienna
Yahn-shir Chen, National Yunlin University of Science and
Techology, Taiwan Mei-mei Kuo, JinWen University of Science & Technology
Bea Chiang, The College of New Jersey Mary Layfield Ledbetter, Nova Southeastern University
Te-kuang Chou, Southern Taiwan University John Ledgerwood, Embry-Riddle Aeronautical University
Shih Yung Chou, University of the Incarnate Word Yen-hsien Lee, Chung Yuan Christian University
Caryn Coatney, University of Southern Queensland Shulin Lin, Hsiuping University of Science and
Technology
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Yingchou Lin, Missouri Univ. of Science and Technology
Michael Conyette, Okanagan College
Melissa Lotter, Tshwane University of Technology
Huang Department of Accounting, Economics & Finance,
Xin (Robert) Luo, Virginia State University
Rajni Devi, The University of the South Pacific
Andy Lynch, Southern New Hampshire University
Leonel Di Camillo, Universidad Austral
Abeer Mahrous, Cairo university
Steven Dunn, University of Wisconsin Oshkosh
Gladys Marquez-Navarro, Saint Louis University
Mahmoud Elgamal, Kuwait University
Cheryl G. Max, IBM
Ernesto Escobedo, Business Offices of Dr. Escobedo
Romilda Mazzotta, University of Calabria
Zaifeng Fan, University of Wisconsin whitewater
Perrine Ferauge University of Mons Mary Beth Mccabe, National University
Olga Ferraro, University of Calabria Avi Messica, Holon Institute of Technology
William Francisco, Austin Peay State University Scott Miller, Pepperdine University
Cameron Montgomery, Delta State University Vijay Vishwakarma, St. Francis Xavier University
Sandip Mukherji, Howard University Ya-fang Wang, Providence University
Tony Mutsue, Iowa Wesleyan College Richard Zhe Wang, Eastern Illinois University
Cheedradevi Narayanasamy, Graduate School of Business, Jon Webber, University of Phoenix
National University of Malaysia Jason West, Griffith University
Dennis Olson, Thompson Rivers University Wannapa Wichitchanya, Burapha University
Godwin Onyeaso, Shorter University Veronda Willis, The University of Texas at San Antonio
Bilge Kagan Ozdemir, Anadolu University Bingqing Yin, University of Kansas
Dawn H. Pearcy, Eastern Michigan University Fabiola Baltar, Universidad Nacional de Mar del Plata
Pina Puntillo, University of Calabria (Italy) Myrna Berrios, Modern Hairstyling Institute
Rahim Quazi, Prairie View A&M University Monica Clavel San Emeterio, University of La Rioja
Anitha Ramachander, New Horizon College of Engineering Esther Enriquez, Instituto Tecnologico de Ciudad Juarez
Charles Rambo, University Of Nairobi, Kenya Carmen Galve-górriz, Universidad de Zaragoza
Prena Rani, University of the South Pacific Blanca Rosa Garcia Rivera, Universidad Autónoma De
Kathleen Reddick, College of St. Elizabeth Baja California
Maurizio Rija, University of Calabria. Carlos Alberto González Camargo, Universidad Jorge
Matthew T. Royle, Valdosta State University Tadeo Lozano
Tatsiana N. Rybak, Belarusian State Economic University Hector Alfonso Gonzalez Guerra, Universidad Autonoma
De Coahuila
Rafiu Oyesola Salawu, Obafemi Awolowo University
Claudia Soledad Herrera Oliva, Universidad Autónoma De
Paul Allen Salisbury, York College, City University of
Baja California
New York
Eduardo Macias-Negrete, Instituto Tecnologico De Ciudad
Leire San Jose, University of Basque Country
Juarez
I Putu Sugiartha Sanjaya, Atma Jaya Yogyakarta
Jesús Apolinar Martínez Puebla, Universidad Autónoma
University, Indonesia
De Tamaulipas
Sunando Sengupta, Bowie State University
Francisco Jose May Hernandez, Universidad Del Caribe
Brian W. Sloboda, University of Phoenix
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Smita Mayuresh Sovani, Pune University De Ciudad Juarez
Alexandru Stancu, University of Geneva and IATA Linda Margarita Medina Herrera, Tecnológico De
(International Air Transport Association) Monterrey. Campus Ciudad De México
Jiří Strouhal, University of Economics-Prague Erwin Eduardo Navarrete Andrade, Universidad Central
Vichet Sum, University of Maryland -- Eastern Shore De Chile
Qian Sun, Kutztown University Gloria Alicia Nieves Bernal, Universidad Autónoma Del
Diah Suryaningrum, Universitas Pembangunan Nasional Estado De Baja California
Veteran Jatim Julian Pando, University Of The Basque Country
Andree Swanson, Ashford University Eloisa Perez, Macewan University
James Tanoos, Saint Mary-of-the-Woods College Iñaki Periáñez, Universidad Del Pais Vasco (Spain)
Jeannemarie Thorpe, Southern NH University Alma Ruth Rebolledo Mendoza, Universidad De Colima
Ramona Toma, Lucian Blaga University of Sibiu-Romania Carmen Rios, Universidad del Este
Alejandro Torres Mussatto Senado de la Republica & Celsa G. Sánchez, CETYS Universidad
Universidad de Valparaíso
Adriana Patricia Soto Aguilar, Benemerita Universidad
Jorge Torres-Zorrilla, Pontificia Universidad Católica del Autonoma De Puebla
Perú Amy Yeo, Tunku Abdul Rahman College
William Trainor, East Tennessee State University Vera Palea, University of Turin
Md Hamid Uddin, University Of Sharjah Fabrizio Rossi,University of Cassino and Southern Lazio
Ozge Uygur, Rowan University Intiyas Utami , Satya Wacana Christian University
K.W. VanVuren, The University of Tennessee – Martin Ertambang Nahartyo, UGM
 REVIEWERS
The IBFR would like to thank the following members of the academic community and industry for their much appreciated
contribution as reviewers.

Haydeé Aguilar, Universidad Autónoma De Aguascalientes Ernesto Geovani Figueroa González, Universidad Juárez
Bustamante Valenzuela Ana Cecilia, Universidad Del Estado De Durango
Autonoma De Baja California Carlos Fong Reynoso, Universidad De Guadalajara
María Antonieta Andrade Vallejo, Instituto Politécnico Ana Karen Fraire, Universidad De Gualdalajara
Nacional Teresa García López, Instituto De Investigaciones Y
Olga Lucía Anzola Morales, Universidad Externado De Estudios Superiores De Las Ciencias Administrativas
Colombia Helbert Eli Gazca Santos, Instituto Tecnológico De Mérida
Antonio Arbelo Alvarez, Universidad De La Laguna Denisse Gómez Bañuelos, Cesues
Hector Luis Avila Baray, Instituto Tecnologico De Cd. María Brenda González Herrera, Universidad Juárez Del
Cuauhtemoc Estado De Durango
Graciela Ayala Jiménez, Universidad Autónoma De Ana Ma. Guillén Jiménez, Universidad Autónoma De Baja
Querétaro California
Albanelis Campos Coa, Universidad De Oriente Araceli Gutierrez, Universidad Autonoma De
Carlos Alberto Cano Plata, Universidad De Bogotá Jorge Aguascalientes
Tadeo Lozano Andreina Hernandez, Universidad Central De Venezuela
Alberto Cardenas, Instituto Tecnologico De Cd. Juarez Arturo Hernández, Universidad Tecnológica
Edyamira Cardozo, Universidad Nacional Experimental De Centroamericana
Guayana Alejandro Hernández Trasobares, Universidad De Zaragoza
Sheila Nora Katia Carrillo Incháustegui, Universidad Alma Delia Inda, Universidad Autonoma Del Estado De
Peruana Cayetano Heredia Baja California
Emma Casas Medina, Centro De Estudios Superiores Del Carmen Leticia Jiménez González, Université De Montréal
Estado De Sonora Montréal Qc Canadá.
Benjamin Castillo Osorio, Universidad Del Sinú-Sede Gaspar Alonso Jiménez Rentería, Instituto Tecnológico De
Monteria Chihuahua
Benjamín Castillo Osorio, Universidad Cooperativa De Lourdes Jordán Sales, Universidad De Las Palmas De Gran
Colombia Y Universidad De Córdoba Canaria
María Antonia Cervilla De Olivieri, Universidad Simón Santiago León Ch., Universidad Marítima Del Caribe
Bolívar
Graciela López Méndez, Universidad De Guadalajara-
Cipriano Domigo Coronado García, Universidad Autónoma Jalisco
De Baja California
Virginia Guadalupe López Torres, Universidad Autónoma
Semei Leopoldo Coronado Ramírez, Universidad De De Baja California
Guadalajara
Angel Machorro Rodríguez, Instituto Tecnológico De
Esther Eduviges Corral Quintero, Universidad Autónoma Orizaba
De Baja California
Cruz Elda Macias Teran, Universidad Autonoma De Baja
Dorie Cruz Ramirez, Universidad Autonoma Del Estado California
De Hidalgo /Esc. Superior De Cd. Sahagún
Aracely Madrid, ITESM, Campus Chihuahua
Tomás J. Cuevas-Contreras, Universidad Autónoma De
Deneb Magaña Medina, Universidad Juárez Autónoma De
Ciudad Juárez
Tabasco
Edna Isabel De La Garza Martinez, Universidad Autónoma
Carlos Manosalvas, Universidad Estatal Amazónica
De Coahuila
Gladys Yaneth Mariño Becerra, Universidad Pedagogica Y
Hilario De Latorre Perez, Universidad Autonoma De Baja
Tecnológica De Colombia
California
Omaira Cecilia Martínez Moreno, Universidad Autónoma
Javier De León Ledesma, Universidad De Las Palmas De
De Baja California-México
Gran Canaria - Campus Universitario De Tafira
Jesus Carlos Martinez Ruiz, Universidad Autonoma De
Hilario Díaz Guzmán, Universidad Popular Autónoma Del
Chihuahua
Estado De Puebla
Alaitz Mendizabal, Universidad Del País Vasco
Cesar Amador Díaz Pelayo, Universidad De Guadalajara,
Centro Universitario Costa Sur Alaitz Mendizabal Zubeldia, Universidad Del País Vasco/
Euskal Herriko Unibertsitatea
Avilés Elizabeth, Cicese
Fidel Antonio Mendoza Shaw, Universidad Estatal De
Ernesto Geovani Figueroa González, Universidad Juárez
Sonora
Del Estado De Durango
Juan Nicolás Montoya Monsalve, Universidad Nacional De María Dolores Sánchez-fernández, Universidade da Coruña
Colombia-Manizales
Luis Eduardo Sandoval Garrido, Universidad Militar de
Jennifer Mul Encalada, Universidad Autónoma De Yucatán Nueva Granada
Gloria Muñoz Del Real, Universidad Autonoma De Baja Pol Santandreu i Gràcia, Universitat de Barcelona,
California Santandreu Consultors
Alberto Elías Muñoz Santiago, Fundación Universidad Del Victor Gustavo Sarasqueta, Universidad Argentina de la
Norte Empresa UADE
Bertha Guadalupe Ojeda García, Universidad Estatal De Jaime Andrés Sarmiento Espinel, Universidad Militar de
Sonora Nueva Granada
Erika Olivas, Universidad Estatal De Sonora Jesus Otoniel Sosa Rodriguez, Universidad De Colima
Erick Orozco, Universidad Simon Bolivar Edith Georgina Surdez Pérez, Universidad Juárez
Rosa Martha Ortega Martínez, Universidad Juárez Del Autónoma De Tabasco
Estado De Durango Jesús María Martín Terán Gastélum, Centro De Estudios
José Manuel Osorio Atondo, Centro De Estudios Superiores Del Estado De Sonora
Superiores Del Estado De Sonora Jesus María Martín Terán Terán Gastélum, Centro De
Luz Stella Pemberthy Gallo, Universidad Del Cauca Estudios Superiores Del Estado De Sonora
Andres Pereyra Chan, Instituto Tecnologico De Merida Jesús María Martín Terán Gastélum, Centro De Estudios
Andres Pereyra Chan, Instituto Tecnologico De Merida Superiores Del Estado De Sonora
Adrialy Perez, Universidad Estatal De Sonora Maria De La Paz Toldos Romero, Tecnologico De
Monterrey, Campus Guadalajara
Hector Priego Huertas, Universidad De Colima
Abraham Vásquez Cruz, Universidad Veracruzana
Juan Carlos Robledo Fernández, Universidad EAFIT-
Medellin/Universidad Tecnologica De Bolivar-Cartagena Angel Wilhelm Vazquez, Universidad Autonoma Del
Estado De Morelos
Natalia G. Romero Vivar, Universidad Estatal De Sonora
Lorena Vélez García, Universidad Autónoma De Baja
Humberto Rosso, Universidad Mayor De San Andres
California
José Gabriel Ruiz Andrade, Universidad Autónoma De
Alejandro Villafañez Zamudio, Instituto Tecnologico de
Baja California-México
Matamoros
Antonio Salas, Universidad Autonoma De Chihuahua
Hector Rosendo Villanueva Zamora, Universidad
Claudia Nora Salcido, Universidad Juarez Del Estado De Mesoamericana
Durango
Oskar Villarreal Larrinaga, Universidad del País
Juan Manuel San Martín Reyna, Universidad Autónoma De Vasco/Euskal Herriko Universitatea
Tamaulipas-México
Delimiro Alberto Visbal Cadavid, Universidad del
Francisco Sanches Tomé, Instituto Politécnico da Guarda Magdalena
Edelmira Sánchez, Universidad Autónoma de Ciudad Rosalva Diamantina Vásquez Mireles, Universidad
Juárez Autónoma de Coahuila
Deycy Janeth Sánchez Preciado, Universidad del Cauca Oscar Bernardo Reyes Real, Universidad de Colima
María Cristina Sánchez Romero, Instituto Tecnológico de
Orizaba
 HOW TO PUBLISH

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submission are available at the Journal website www.theIBFR.com/journal.htm. Papers may be submitted
for initial review in any format. However, authors should take special care to address spelling and grammar
issues prior to submission. Authors of accepted papers are required to precisely format their document
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There is no charge for standard paper reviews. The normal review time for submissions is 90-120 days.
However, authors desiring a quicker review may elect to pay an expedited review fee, which guarantees an
inditial review within two weeks. Authors of accepted papers are required to pay a publication fee based on
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the original work of the authors, has not been published elsewhere, and is not under publication consideration
elsewhere. In addition, submission of a manuscript implies that the author is prepared to pay the publication
fee should the manuscript be accepted.

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The IBFR
P.O. Box 4908
Hilo, HI 96720
[email protected]

Website

www.theIBFR.org or www.theIBFR.com
 PUBLICATION OPPORTUNITIES

Business Education
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Review of Business & Finance Studies (ISSN: 2150- Business Education & Accreditation publishes high-quality
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