British Journal of Interdisciplinary Research September 2024, Volume 1, Number 1, pp.

35-49
ISSN 3049-8899

THE IMPACT OF CORPORATE GOVERNANCE MECHANISMS

ON FIRM PERFORMANCE

Rezhin Dhahir FATAH,

Department of Accounting, Collage of Administration and Economics, University of
Sulaimani, Iraq
[email protected]

Abstract

This article studies the field of corporate governance and explorers its impact on firm
performance, which is one of the most arguable subjects in the literature. The objective of this
paper is to shed light on different perspectives regarding cooperate governance mechanisms
by reviewing the most recent studies in this field and to explorer its impact on firm
performance. This paper has reviewed theoretical framework such as agency theory and
stewardship theory which proposed by academics, as well as 13 empirical studies. The review
found that strong and effective corporate governance is necessary to keep firm performance
stays in improving trend, especially some important mechanisms such as (manager behaviour,
ownership structure, and board of director diversity in regards of gender). This paper
contributed to the literature by providing an argument from variety point of views achieving
different results, which can be understood that there is no a common agreement regarding the
effect of such mechanisms on performance. Hence, it provides the need of more explorations
in this field as the complexity of the relationship. This paper suggests that despite the existence
many researches in this field exploring the importance of corporate governance, the need of
additional studies required to be conducted testing a wider range of firms with different
economic situation.

Keywords: Corporate Governance Mechanisms, Company Performance, Agency Theory,

Stewardship Theory.

DOI: 10.58934/bjir.v1i1.2

1. INTRODUCTION

In the on-going global economy, corporate governance is one of the most dominant research
interests in the field of accounting and finance due to the complexity of corporate ownership
structure and variety of stakeholders with different interests (Rashid, 2023). Business
approaches have been complicated and size of corporations became larger and more complex
The impact of corporate governance mechanisms on firm performance

in the early 20th century, and then it led companies to fund themselves not by only one
individual owner, but by a huge number of owners called shareholders (Rashid, 2020;
Mahmood & Jaf, 2023; Budur, 2020). Hence, the need for effective managements to run firms
with multiple owners on behalf of shareholders became a necessary matter (Rashid, 2019;
Fatah & Sabir, 2023; Noori & Rashid, 2017). As a result of separation of ownership and
management control, a conflict appeared due to the differences in objectives and interests
between management (agents) and owners (principals); called the agency problem (Agrawal
and Knoeber, 1996)

In several circumstances managers act in their own favour at the expense of shareholder’s
wealth inside the corporation due to the freedom they have (Rashid, 2018). This misuse of
authority might occur as shareholders maintain limited ability to monitor the behaviour and
performance of managers (Kolsi & Grassa, 2017; Rashid & Sabir Jaf, 2023). In order to reduce
the agency problem and protect the rights of shareholders and other stakeholders, such
mechanisms are important to protect the interest of all parties (Rashid & Noori, 2017). Thus,
corporate governance as a system and policy can be seen as the upshot to this issue for the sake
of controlling the corporation in a way to make managers to act in advantage of the corporation
and protect the interest all stakeholders which eventually can improve the firm performance
and value (Jensen and Meckling, 1976; AlMalkawi & Pillai, 2012; Naimah, 2017; Budur et al.,
2018).

Shleifer and Vishny, 1997) describe corporate governance as being aiming to declare
confidently to investors of an organization that they will acquire a reasonable amount return on
their investments. Another definition of corporate governance with a broader insight was
revealed by Solomon (2010) who described it as a system and framework that readjusts and
monitors the internal and external affairs of enterprises, in which the system leads organizations
and management to be accountable to all stakeholders and to ensure that firms are socially and
ethically responsible in all business activities.

Managerial choices for value creation by implementing corporate governance are an interest
topic among researchers. It is supposed that practicing effective corporate governance system
reduces the conflict between shareholders and managers, information asymmetry and enhance
the efficiency of managerial practices which finally lead to improve performance of the firm.
(Johl, Khan, Subramaniam, & Muttakin, (2016); Audousset-Coulier, Jeny, & Jiang (2016;
Budur et al., 2023).

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A corporation with a very well corporate governance practice is likely to outperform others in
the market because of two main reasons. Firstly, using its resources efficiently and then
improve its profitability. Secondly, great corporate governance practices may demonstrate to
be supportive in creating good market reputation and thus, financing can be obtained at lower
costs. (Jensen and Meckling, 1976; La Porta et al., 2002; Budur et al., 2023).

The prime matter of corporate governance is to make top management accountable and provide
the authority to executives to make use of the wealth for trading opportunities simultaneously
(Braswell & Daniels, 2017). Effective corporate governance also makes the accounting
information more reliable and increase its usefulness to users which result the improvement of
the performance (Dechow et al., 1996; Rashid, 2017).

The compliance and implementation of corporate governance at the supreme levels of the
organization is the only way to make sure that an ethical culture exists inside the firms. In this
sense, it can be said that an effective and efficient structure of corporate governance is
necessary in order to improve performance and reduce the agency problem (Jensen and
Meckling, 1976; Mutlu et al., 2018; Fatah et al., 2021).

The objective of this paper is to review the theoretical framework regarding the corporate
governance and the most recent studies conducted to investigate the relationship between
corporate governance and firm performance.

The remainder of this paper is structured as follows. Section two shows several relevant
reviews of previous theoretical and empirical frameworks in the literature. Section three and
the final chapter include a conclusion of this study and suggestions for future research.

2. LITERATURE REVIEW

2.1. Theoretical Framework

Typically, managers of corporations are not the owners of firms, although sometimes they hold
a small proportion of shares inside corporations they manage. The real owners of firms are the
body of shareholders who appoint the board of directors (Rashid, 2023). Hence, the board of
directors is authorized to hire and fire managers (agents) who carry out daily activities of the
firms. Thus, it can be questioned whether these managers run the corporation’s activities
effectively and whether they are trustworthy; whether they pay attention to shareholder wealth

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The impact of corporate governance mechanisms on firm performance

or look after their own interests (Rashid, 2021). Addressing these questions, there are some
theories trying to explain these relationships and deal with them. Furthermore, it is important
to mention that this study will focus only on principal-agent theory, stewardship theory, and
leadership life cycle theory regarding CEO characteristics. However, there are some other areas
that deal with corporate governance which may have effects on firm performance, such as
stakeholder theory (Rashid, 2023). This theory takes a wider view of corporate governance
than only shareholder wealth maximization, considering the interests of employee welfare and
health, and those of customers, and suppliers (Keasey et al., 1997). Also, corporate social
responsibility is considered one way to improve firm performance in ways which are not
investigated in this study. According to Innovest Strategic Value Advisors, those companies
ranked as the most socially and environmentally responsible have demonstrated better financial
performance (Solomon, 2010, 257).

2.1.1. Agency Theory

In the field of corporate governance, agency theory plays a significant role in explaining the
relationship between the owners and managers of firms. The root of agency theory comes from
an article by Alchian and Demsetz (1972), developed by Jensen and Meckling (1976) and
further studied by Fama and Jensen (1983). Jensen and Meckling (1976) describe the
relationship of agency and principal as an agreement in which a person or a group of persons
(principals) occupy another person (the agent) to provide a number of services on their behalf
that gives the authority to the agent to make some decisions. This theory explains the primary
conflict between shareholders of a company and agents due to the utility maximization that
each of them seeks. Sometimes, managers have some self-interested objectives and try to
achieve these objectives at the expense of owners. Jensen and Meckling (1976) illustrate that
managers will increase the non-pecuniary spending if their stake in the firm is low. Thus, this
problem leads to agency cost as well as the cost of monitoring the agents in aligning managers
to act in the interests of shareholders. This cost arises as a result of the separation of owners of
a company from control of it. Hence, Jensen and Meckling (1976) claim that strong and
effective corporate governance structures are necessary to reduce and solve this problem that
arises between shareholders and managers. Furthermore, Shliefer and Vishny (1997) stress that
the main and primary task of corporate governance is to manage the agency problem that arises
as a result of diverse interests among stakeholders. Thus, if a weak corporate governance
structure is implemented in the firm, then it would be an opportunity for managers to act in

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Fatah

their own interests due to weak and ineffective corporate governance mechanisms and this may
lead to a diminution in shareholder wealth as well as firm performance. Furthermore, agency
theory suggests that the roles of CEO and chairperson should be separated. Accordingly, the
CEOs have the right to make decisions, and the chairmen have the right of control over
decisions. According to agency theory if the two roles are given to one person, then CEOs may
control the firm and makes some decisions in favour of personal interests (Jensen and
Meckling, 1976; Jensen, 1986). Belkhir (2009) postulates that the separation of roles of CEO
and chairman will lead to a reduction in agency cost (Fama and Jensen 1983). Hence, separating
the role of CEO and chairperson will result in an increase in shareholder wealth and
improvement in firm performance, because this separation generates better transparency and
accountability (i.e. Finkelstein and D’Aveni, 1994; Adams, Almeida, and Ferreira, 2005).

2.1.2. Stewardship Theory

In contrast to agency theory, stewardship theory suggests managers do not attempt to achieve
self-interested goals. In fact, they try to improve firm value and shareholder wealth because
shareholders can invest in other firms and leave any particular firm whenever they want,
whereas it is more difficult for managers to change their job. Thus, managers are concerned
more about the long-term progression of a company, while shareholders pay more attention to
short-term returns (Monks and Minow, 2004). Furthermore, stewardship theory also
emphasizes that if the roles of CEO and chairman are combined, it will lead to progress in
corporate performance. As Fama and Jensen (1983) state, managers serve corporations in a
reliable manner in favor of firms. Hence, it can be argued that managers are useful stewards
for firms and they try to maximize firm value (Davis et al., 1997). Additionally, Dahya et al.,
(1996) claim that if the role duality of CEO exists, board interference will be minimized and
this will give CEOs the opportunity to determine the future goals and visions of a firm with a
strategic view. Thus, it contributes to a better, unbound, leadership and to improvement in a
firm’s performance.

2.3. Manager Behaviour

In attempting to test the agency problem, Zhang, et al., (2020) examined corporate governance
tools with shareholder’s monitoring to shed light on directors and Chief Executive Officers
(CEO) behaviour in relation to agency cost and firm value. This study conducted on 16926
firms in China along with 165287 directors during 2005-2015. The study concludes that CEO

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The impact of corporate governance mechanisms on firm performance

surname ties increases agency cost. However, this cost will be reduced when there is a strong
monitoring by shareholders. Additionally, directors and supervisors behave in favour of the
firm if they have a parallel interest with the value of the company. In the same direction, Alam,
et al., (2020) tested the characteristics, power, and supervision of directors and managers in
Islamic banks in comparison with conventional banks to figure out their effect on Earning
Management among the two different banking systems. The study examined 97 conventional
banks and 39 Islamic Banks from ten top Islamic countries from 2006-2016 applying
Generalized Least Square (GLS). The study concludes that there is not a significant difference
between Islamic and conventional banks in regards of earning management. In contrary to the
general opinion that argues the value of religion and ethic will be promoted if supervision based
on Sharia implemented, such implementation do not limit the director’s attempts in such
opportunistic behaviors. Thus, there are some other factors affect earning management
according to this study such as board size, company size and leverage, which negatively affect
the exercise of earning management. Moreover, Nazir & Afza (2018) also paid attention to the
relationship between the behavior of management and earning management and the role of
corporate governance in reducing this phenomenon. In doing this, this paper examined 1944
non-financial firms in Pakistan stock exchange. It achieved the result consistent with agency
theory which indicates that effective corporate governance will mitigate agency problem and
then enhance the performance. The argument behind this is managers are opportunistic in their
behaviour when making decisions and sometimes report unreliable earning which finally
affects the performance negatively. Thus, the study confirmed that such mechanisms of
corporate governance are important to mitigate this behaviour by managers in manipulating
reported earnings in order to improve the value and performance of the firm.

2.3. Ownership Structure

One of the most influential mechanisms of corporate governance is the ownership structure of
firms. Hence there are several studies in the literature attempted to examine the effect of this
mechanisms on performance. In term of board size and leverage as corporate governance
mechanisms, Pillai & Al-Malkawi (2017) attempted to test the effect of these mechanisms on
firm performance along with three other mechanisms (government shareholding, audit type,
and Corporate Social Responsibility). The researchers examined 349 companies during the
period 2005-2012 in Gulf Cooperation Council countries using Generalized Least Square
(GLS). The result confirmed that all internal mechanisms have a positive impact on

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performance and hence, stating that the exercise of a good corporate governance is important
to improve the future of the business financially.

The most recent study by Bhagat & Bolton (2019) conducted in this regard to find the impact
of manager stock ownership on firm performance. This study examined different samples of
U.S. firms throughout (2003-2016) particularly the 100 biggest financial firms applying
multinomial logistic regressions. They used director stock ownership as corporate governance
measurement and tested its effect on future performances. The result of this study confirmed
that there are a positive relationship between director stock ownership and financial institution
performance with reduction in firm financial risk. In the same line but with different result,
Paniagua et al., (2018), conducted a research on 1207 firms from 2013-2015 to test the effect
of ownership structure on company performance across 59 countries utilizing linear and non-
linear multiple regression. This study concludes that there are a negative relationship between
the number of board of directors and firm performance. Additionally, according to the finding,
the structure of ownership suggests that the higher the debt, will lead to the higher Return on
Equity (ROE). Similarly but not quite the same, Calero, et al., (2019), examined the effect of
different types of ownership structure in common as well as civil law countries using a meta-
analysis of 127 studies conducted in this field with a sample of 70010 firms. The result showed
that ownership types and the independence of director negatively affect the performance in
common law countries, while it has a positive impact on performance in civil law countries.
This study concludes that the regulations and the environment of firms play important role in
improving the performance. Uncommonly Akbar et al., (2016) argue that, the compliance of
corporate governance has not effect on performance either positively or negatively. This
research applied Generalized Method of Moment on 435 publicly listed UK firms throughout
1999-2009. They suggest that those studies which argue the effect of corporate governance on
firm performance ignored the endogeneity that occur between variables with error. This means
that the researchers may have taken advantage of this problem in their studies to find a link
between corporate governance and firm performance.

2.4. Board Diversity

The gender of board also plays an important role in affecting firm value and performance,
which attracted many researchers’ attention to empirically test this relationship. Byron & Post
(2016) investigate the role of female directors and its influence on firm social performance and
reputation by reviewing several studies in this field from 20 different countries using Meta-

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The impact of corporate governance mechanisms on firm performance

Analysis. They find that the presence of women in board of director positively affect firm social
performance, especially when the firm has a motivation to rely on the resources that women
shift to the board with keeping balance in power between women and men directors. Hence,
this study suggests that the availability of female directors is an important element to enhance
corporate social performance. Meanwhile, Nadeem, et al., (2017), attempt to test the effect of
gender diversity on sustainability of listed companies in Australia after the change of regulation
regarding gender diversity among directors. The study conducted on 374 Security exchange
companies listed on stock exchange during the year of 2010-2014 using General Method of
Moment. This study revealed that the female directors are crucially and positively affect the
corporate sustainability as well as corporate performance. Hence, suggesting policy makers to
promote the diversity of directors in respect of gender. Additionally, Song, et al., (2020)
examined the relationship between board diversity and U.S. firm performance during a wide
range of period 1993-2018 in Hospitality sector employing panel regression models. The result
stated that gender diversity significantly improve the performance of firms, while age of board
of directors does not have a significant effect on performance. Đặng, et al., (2020) reached the
same result applying different approach (control function method) to test S&P 500 firms during
the period of 2004-2015. The finding of this paper is consistent with previous empirical
researches that argue the presence of female in board of director leads to increase performance
and profitability. This study concludes that the increase of female percentage in directors will
increase return on asset (profitability measurement). However, it can be said that it is still a
debatable issue researchers should investigate this issue more in the field of corporate
governance.

To summarize, it can be argued that different mechanisms of corporate governance affect firm
performance collaboratively or independently as the majority of the above studies confirmed,
in spite of little contrast studies which show no significant effect. Also, Rose (2016) in his
study found that the compliance of corporate governance is an effective factor to enhance the
performance in Denmark. However, it discussed that the measurement of corporate governance
compliance is quite difficult or there is not a proper way to measure it, but instead regulatory
and policy makers should penalize those firms which claiming they comply corporate
governance.

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There is many more authors support this argument (Akbar et al., 2016; Nazir & Afsa, 2018,
Zhang et al., 2020; Tang & Cheng, 2020). However, the issue of corporate governance and
firm performance is still a controversial issue in the field of accounting and finance.

3. CONCLUSION

This paper has reviewed several theoretical as well as empirical studies regarding the impact
of corporate governance mechanisms on company performance in order to get a better insight
into the complex relationship between the two factors. To do so, this paper selected several
studies from different countries to review them. The results of the selected studies in this paper
are somehow mixed relating to each group of mechanisms chosen by researchers. Firstly,
studies conducted in regarding the field of managers behaviour confirmed on such monitoring
mechanisms on their behaviour. Overall, there is an argument stating that managers are
opportunistic in their behaviour when making decisions and sometimes report unreliable
financial reports which finally affects the performance negatively. Thus, they confirmed that
such mechanisms of corporate governance are important to mitigate this behaviour by
managers in manipulating reported earnings in order to improve the value and performance of
the firm.

Secondly, ownership structure of a firm has negotiable impact on performance, but the majority
of studies suggest that directors with stock ownership in the firm will lead to better performance
as the stake between the directors and the firm will be in the same direction. Hence, decisions
made by director will be in favour of the firm and consequently improve performance.

Finally, board diversity paid attention in this review as a crucial mechanism, which many
studies explorer the influence of this mechanism on performance as well. All the studies have
been reviewed in this paper found that the female directors positively affecting the performance
of firms in respect of profitability. Hence, the suggestion toward policy makers is to promote
the diversity of directors in respect of gender inside board of directors.

In summary, results from studies in literature suggest that an effective and efficient corporate
governance structure leads to an improvement in firm performance, market performance as
well as financial performance. Although it can be argued that not all the studies support the
above statement, this review provides an insight into the complex relationship between
corporate governance and company performance by reviewing different studies conducted in
this regards. It indicates that some corporate governance strategies are effective and others,

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The impact of corporate governance mechanisms on firm performance

despite being popular among academics and businesses alike, do not make a statistically
significant contribute to firm performance. Finally, it is important to mention that agency
theory and stewardship theory provide a good insight into explaining the relationship between
corporate governance and company performance. However, there is not a common agreement
among financiers and analysts that can be completely relied upon to conceptualize it regarding
the impact of corporate governance mechanisms on company performance.

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