The impact of board capital and board characteristics on firm performance

The British Accounting Review xxx (2013) 1–19

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The British Accounting Review journal homepage: www.elsevier.com/locate/bar

The impact of board capital and board characteristics on firm performance Johnny Jermias a, *, Lindawati Gani b,1 a b

Beedie School of Business, Simon Fraser University, Burnaby, British Columbia V5A 1S6, Canada Faculty of Economics, University of Indonesia, Jakarta, Indonesia

a b s t r a c t JEL classification: D21 G32 L1 M41 Keywords: Board capital Managerial incentives Board dependence CEO duality Resource dependence theory

The purpose of this study is to investigate the effects of board capital on the relationship between CEO duality, board dependence, managerial share ownership and performance. We argue that board capital (the ability of board members to perform manager-monitoring activities and to provide advice and counsel to management) varies across board members. Highly qualified board members will be better at monitoring management and constitute a more valuable resource for firms. Based on a sample of U.S. companies listed in the Compustat S&P 500 and using both resource dependence and agency theories, we predict and find that CEO duality and board dependence negatively affect performance and that board capital mitigates the negative effects. We also predict and find that managerial share ownership positively affects performance and that board capital strengthens this positive relationship. The results are consistent with the view that firms benefit from board capital in terms of outside directors’ ability to monitor managers and provide advice and counsel to managers. Ó 2013 Elsevier Ltd. All rights reserved.

1. Introduction Agency theory has been the most dominant approach used to examine the effects of boards of directors and managerial share ownership on firm performance. According to this theory, information asymmetry causes managers to behave opportunistically in order to maximize their own interest at the expense of shareholders. Jensen and Meckling (1976) suggest that monitoring and incentives mitigate managers’ opportunistic behavior. In large organizations, corporate governance mechanisms, particularly boards of directors, serve to ensure that firm assets are managed efficiently and in the interests of shareholders and to mitigate the consumption of perquisite and other non-pecuniary benefits by managers or any other parties (Fama & Jensen, 1983). Jensen and Meckling (1976) propose that owning shares gives managers an incentive to invest in value-maximizing activities since they will share the proceeds of those activities. They argue that as the share ownership increases, managers’ share of the cost of perquisite consumption increases, which will discourage them from engaging in opportunistic activities. Although agency theory has been a very popular approach for previous empirical studies which examines the impact of various board characteristics and managerial share ownership on performance, these studies have reported mixed and often

* Corresponding author. Tel.: þ1 778 782 4257; fax: þ1 778 782 4920. E-mail addresses: [email protected] (J. Jermias), [email protected] (L. Gani). 1 Tel.: þ62 21 31907848; fax: þ62 21 3900703. 0890-8389/$ – see front matter Ó 2013 Elsevier Ltd. All rights reserved. http://dx.doi.org/10.1016/j.bar.2013.12.001

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contradictory results (e.g., Garen, 1994; Hutchinson & Gul, 2004; Jensen & Murphy, 2004). One plausible explanation for these inconclusive results is that agency-based studies have focused only on the monitoring function of the boards. Although this stream of research is informative, it has ignored the resources which boards of directors provide to firms. Resource dependence theory (Pfeffer & Salancik, 1978) argues that when a firm appoints a member to a board of directors, it expects the directors to use their expertise, skills, and experiences to provide the firm with helpful advice and counsel (Pfeffer & Salancik, 1978; Westphal, 1999; Zahra & Pearce, 1989); enhance its legitimacy and reputation (Daily & Schwenk, 1996; Pfeffer, 1972); facilitate linkages to external organizations (Hillman, 2005; Pfeffer & Salancik, 1978); and support the firm’s capacities for manager-monitoring, evaluation (Baysinger & Hoskisson, 1990), and strategic implementation (Dallas, 2001). The purpose of this study is to investigate the effects of board capital on the relationship between corporate governance, managerial share ownership and firm performance, using a sample of U.S. companies listed in the Compustat S&P 500. We define board capital as outside directors’ ability to use their skills, reputation, experience, expertise and knowledge to perform both manager-monitoring activities and provide advice and counsel to management (Chen, 2008; Hillman, 2005). We argue that the effects of corporate governance (i.e., board dependence and CEO duality) and managerial share ownership on performance will be affected by board capital. Further, we contend that while good governance and managerial incentives are necessary conditions for superior performance, they are not on their own sufficient to ensure superior performance – we also need to consider the capacity of the directors on the board to perform their duties because their ability to provide resources and monitor managers varies. For example, companies A and B have the same governance structure and managerial share ownership, but the members of company’s A’s board of directors have better skills and expertise than the members of company B. All else being equal, it is logical to expect that company A’s board of directors will perform better at helping managers to perform their duties and conducting manager-monitoring activities than company B’s board. Consistent with previous studies (e.g., Gul & Leung, 2004; Hutchinson & Gul, 2004; Jermias, 2007; Tsui, Jaggi, & Gul, 2001; Weisbach, 1988), we predict that CEO duality and board dependence will have a negative effect on performance while managerial share ownership will have a positive effect on performance. However, the negative effects of CEO duality and board dependence will be mitigated by board capital. Furthermore, the positive effect of managerial share ownership will be strengthened by board capital. We find that board capital mitigates the negative effects of both CEO duality and board dependence. With regard to managerial share ownership, the results indicate that board capital strengthens the positive relationship between managerial share ownership and performance. This study contributes to the existing literature on corporate governance in three ways. First, we use both resource dependence theory and agency theory to develop and test the hypotheses. The results increase our understanding of the relationship between board characteristics and firm performance. That is, good governance and managerial incentives alone are not sufficient for superior performance and should be supported by boards which capably perform their duties. Second, the findings suggest that both CEO duality and board dependence have a negative impact on performance. However, the negative effects are mitigated by board capital. Third, and with regard to managerial share ownership, our results is consistent with the view of agency theory in indicating that managerial share ownership provides an incentive for managers to engage in value-maximizing activities since they will share the proceeds of these activities. Furthermore, the results indicate that higher quality outside directors strengthen the positive relationship between managerial share ownership and performance. Our results are important given that CEO duality remains a common practice in the US firms. Despite the recommendations of various recent corporate governance guidelines that the role of the CEO and the chairman of the board be kept separate (e.g., Business Roundtable, Principles of Corporate Governance, 2012; OECD Principles of Corporate Governance, 2004; Sarbanes-Oxley Act, 2002; The U.K. Corporate Governance Code, 2010; Toronto Stock Exchange Corporate Governance Guidelines, 1996), we find that the CEO is also the chairman of the board in 78% of our sampled U.S. firms. The high percentage of CEO duality is consistent with those of previous studies using a sample of large U.S. firms (e.g., Fich & Shivdasani, 2006; Rechner & Dalton, 1991). Furthermore, our results show that CEO duality is negatively and significantly associated with firm performance but the negative association is mitigated by board capital. The negative association between CEO duality and performance suggest that our findings support the corporate governance guidelines with regard to the separation of the CEO and the chairman of the board. The results also support our hypothesis that board capital will mitigate the negative effect of board dependence on performance. They support the view that inside directors are unable to objectively evaluate management and are often influenced by top management. However, the negative effect of board dependence on performance can be reduced by having prominent individuals on the board of directors, such as the director of another S&P 500 firm, the CEO of another S&P 500 firm, a university professor, or a government officer. Finally, our findings indicate that managerial share ownership has a positive and significant effect on performance and that board capital strengthens this positive relationship. These findings are consistent with those reported by previous studies (e.g., Hilman, 2005; Hilman et al., 1999; Westphal, 1999). The results of this study may have an important implication for practice. The positive effects of board capital on the relationship between CEO duality, board dependence, and performance suggest that firms need to devote greater attention to the quality of the individuals they appoint to their board of directors. This is important because many firms still appoint their CEO to the position of chairman of the board of directors. As mentioned, this was the case for the majority (78 percent) of our sampled firms. The high proportion of CEO duality, however, is consistent with the report by The Business Roundtable (an Please cite this article in press as: Jermias, J., & Gani, L., The impact of board capital and board characteristics on firm performance, The British Accounting Review (2013), http://dx.doi.org/10.1016/j.bar.2013.12.001

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association of CEOs U.S. leading companies) in 1997 indicating that “most American corporations are well served by a structure in which the CEO also serves as chairman of the board” (p. 13). The remainder of the paper is organized as follows. Section 2 discusses previous literature in order to develop the hypotheses. Section 3 explains the sample selection, research design and how the variables used in the study are measured. Section 4 presents the results of the statistical analyses. Section 5 discusses a number of robustness checks performed in this study. Section 6 provides general discussions of the main results the limitations of this study, and directions for future research. 2. Related literature and hypotheses There is an abundance of research investigating the effects of board characteristics and equity ownership on firm performance. Most of this research uses agency theory, which assumes that managers tend to behave opportunistically and thus need to be monitored or be given incentives that motivate them to act in the best interests of the firm (Jensen & Meckling, 1976). Agency theory proposes that the main function of boards of directors is to reduce the agency costs that result from the separation of ownership and control (Fama & Jensen, 1983). Boards of directors are formed to monitor management on behalf of shareholders and to evaluate managerial performance (Westphal & Zajac, 1995; Williamson, 1984). 2.1. CEO duality, board dependence, board capital and performance Agency theory proposes that the inclusion of outsiders on boards of directors and the separation of the CEO and the chairman of the board will allow the board to be more effectively monitor managers and therefore will be positively related to firm performance. In the U.S., while the Sarbanes-Oxley Act (SOX) of 2002 does not specifically require that the majority of board members should be independent, the Business Roundtable recommends that the majority of directors of publicly owned U.S. companies should be independent of management. Independent directors should be free of any relationship with the company or its management that may impair their ability to make independent judgments. Board independence should be considered with respect to the directors’ personal, employment, or business relationships as well as their overall attitude toward management. The Commonwealth Association for Corporate Governance (1999), the U.K. Corporate Governance Code (2010), and the OECD (2004) recommend that a sufficient number of board members should be independent of management (i.e., non-executive directors) to ensure that the boards of directors would be able to effectively monitor managerial performance, prevent conflicts of interest and balance competing demands on the firm. With respect to CEO duality, the Business Roundtable recommends that each corporation should make its own determination of what leadership structure works best for the company. The Business Roundtable indicates that in times of transition, some U.S. companies have found it useful to separate the role of CEO and chairman of the board to provide continuity of leadership. Most U.S. companies, however, do not separate the roles of CEO and the chairman of the board. The U.K. Corporate Governance Code (2010) requires that “There should be a clear division of responsibilities at the head of the company between the running of the board and the executive responsibility for the running of the company’s business” (p. 10). CEO duality is viewed as an inappropriate practice because it leads to an improper balance of power, decreases accountability, and deteriorates the boards’ capacity to make decisions independently of management. Previous studies indicate that CEO duality has a negative impact on firm performance (e.g., Bozec, 2005; Chahine & Goergen, 2011; Prevost, Rao, & Hossain, 2002; Tsui et al., 2001; Veprauskaite & Adams, 2013). For example, Chahine and Goergen (2011), find that CEO duality is negatively associated with performance of U.S. firms. Similar results were reported using data from New Zealand (Prevost et al., 2002), Canada (Bozec, 2005), and Hong Kong (Tsui et al., 2001). Although previous empirical studies using agency theory to examine the impact of board characteristics on performance are theoretically appealing, they have produced mixed and often contradictory results (e.g., Chung, Wright, & Kedia, 2003; Dalton, Daily, Certo, & Roengpitya, 2003; Hutchinson, 2002; Singh & Davidson, 2003; Young, 2003). Unlike previous studies, we take this into account by using both agency theory and resource dependence theory to investigate the mitigating effects of board capital on the effects of board characteristics and managerial ownership on firm performance. We argue that directors’ capacity to perform their duties (i.e., board capital) will moderate the relationship between CEO duality, board dependence, managerial share ownership, and performance. Previous studies using resource dependence theory have shown that the more highly capable board members are, the more effectively they can help managers to perform various duties. These individuals include the CEOs of large firm (Baysinger & Butler, 1985; Rosenstein & Wyatt, 1994), government officers (Hillman, 2005; Hillman, Zardkoohi, & Bierman, 1999), and members of influential firms’ board of directors (Haunschild & Beckman, 1998). We include university professors in this list since their profession is considered credible and many firms appoint them to their board of directors. University professors are appointed to companies’ board of directors to improve companies’ performance (Cook, 2012) and to increase shareholders’ value (Mannix, 2013). Daily (1996) contends that board members who are affiliated with influential firms may have access to valuable sources of information that is useful for performing their duties. Prominent board members can also reduce the risk of environmental uncertainty (Daily & Dalton, 1994); provide advice and counsel which enables top managers to tap into the board’s breadth of knowledge (Zahra & Pearce, 1989); help managers to formulate strategic decisions (Westphal, 1999); and assist managers in identifying strategic opportunities (Judge & Zeithaml, 1992). Hillman (2005) finds that boards which consist of more Please cite this article in press as: Jermias, J., & Gani, L., The impact of board capital and board characteristics on firm performance, The British Accounting Review (2013), http://dx.doi.org/10.1016/j.bar.2013.12.001

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government officers perform better than those with less government officers and the positive association is stronger for firms operating in heavily regulated industries. Her findings suggest that firms can deal with their external dependencies by bringing in directors who are part of the external environment on which the firm is dependent. Westphal and Zajac (1995) argue that boards of directors lack the structural power to influence management’s decisions when the CEO also serves as the chairman of the board. Gul and Leung (2004) contend that CEO duality might have a negative impact on the board’s ability to oversee managerial decisions and activities, thereby negatively affect performance. Further, previous empirical studies tend to support the view that CEO duality negatively affects various measures of firm performance (e.g., Baliga, Moyer, & Rao, 1996; Dahya & McConnell, 2007; Gul & Leung, 2004; Jermias, 2007; Tsui et al., 2001; Veprauskaite & Adams, 2013). For example, Veprauskaite and Adams (2013) find that CEO duality is negatively related to financial performance for U.K. publicly listed companies. In a similar vein, Dahya and McConnell (2007) used a sample of U.K. firms for the period of 1989–1996 to investigate the impact of board independence on firm performance. They find that firms that add outside directors to their boards exhibit a significant improvement in their performance. Using a sample of U.K. quoted companies, Weir, Laing, and McKnight (2002) find that board independence is positively associated with performance as measured by Tobin’s Q. Jermias (2007) used a sample of Canadian firms to examine the impact of CEO duality on performance in terms of Tobin’s Q. He finds that CEO duality has a significantly negative effect on Tobin’s Q. In a similar vein, Faleye, Hoitash, and Hoitash (2011) used a sample of S&P 1500 firms over the 1986–2006 period in finding that the proportion of outside directors is negatively related to excess CEO compensation and positively related to the likelihood of dismissing a CEO for poor performance. Black and Kim (2012) used Korean data in finding that board independence is positively associated with firm performance. Similar findings are reported by Dahya, Dimitrov, and McConnell (2008) who used data from twenty two countries. Tsui et al., (2001) who used the reliability of accounting information and audit fees to measure firm performance, and by Gul and Leung (2004), who used voluntary disclosure to measure firm performance. With regard to board dependence, researchers have argued that the boards of directors should function as an internal control mechanism (Ahmed & Duellman, 2007; Bushee, 1998) to discipline managers in their decision making processes (Kosnik, 1990). However, for boards to perform their duties most effectively, they should consist predominantly of outside directors (Westphal, 1999; Zahra & Pearce, 1989). As Fama and Jensen (1983) contend, inside directors do not perform manager-monitoring activities effectively and tend to collude with managers in order to expropriate residual claimants. Consistent with previous studies mentioned above, we predict that CEO duality and board dependence will have a negative effect on performance. However, we depart from previous studies by using both resource dependence and agency theories to develop the hypotheses tested in this study. We argue that board capital will moderate the negative relationship between CEO duality and performance as well as the negative relationship between board dependence and performance. Board capital represents the outside directors’ ability to monitor and to assist management in their decision making processes. Outside directors consisting of prominent and capable people such as board members or CEO of other big firms, university professors or high-rank government officers will have a better ability to perform their duties as compared to those that are inexperience and/or those with unproven track records. Studies using resource dependence theory argue that board members who work at these prestigious occupations are likely to have a positive impact on the quality of decisions made by management, and in turn, improve firm performance by using their skills, experience and expertise to perform manager-monitoring activities, give advice and counsels to management, enhance company reputation and establish contacts with external parties (e.g., Hilman & Dalziel, 2003; Hillman et al., 1999; Pfeffer & Salancik, 1978; Rosenstein & Wyatt, 1994; Zahra & Pearce, 1989). Bazerman and Schoorman (1983) argue that the ability to monitor and the credibility of advice and counsels are affected by the outside directors’ occupations. Outside board members who are CEOs or board of directors of other big firms play important roles in disseminating information across firms, reducing environmental scanning costs, serving as mechanisms for diffusions of innovations, and revealing important information regarding other firms’ agendas and operations. Hillman et al., (1999) contend that high rank government officers are often appointed to the board of directors to increase the flow of information regarding current and future rules and regulations, government agendas and operations, more open communication between the government and the firms, and increase the firms’ influence on the government’s policies. High rank government officers tend to have good negotiation skills and maintain good relationship with the societies.2 Firms appoint university professors to the board of directors often benefits from the research insights and consulting abilities brought in by the university professors.3 Although the quality of professors and civil servants may vary, companies only appoint high quality professors and civil servants to benefit from their expertise. Higher ratio of board capital indicates that the independent directors are more capable of mitigating the negative impacts of CEO duality and board dependence on performance. First, high quality independent board members will be

2 For example, when Wal Mart appointed General Claudia Kennedy to its board of directors on May 9, 2006, it stated that “We are pleased that General Kennedy has agreed to join the Employment Practice Advisory Panel and help our company continue to develop world-class employment and diversity practices”. (http://www.edubourse.com/finance/activities.php?actu¼27682, extracted on May 14, 2010). 3 For example, on March 9, 2009, Microsoft announced the appointment of Professor Maria Klawe, PhD to its board of directors. In its announcement, Bill Gates, Microsoft chairman stated that “Maria has made significant research contributions to computer science and mathematics, and we are very fortunate to have her join Microsoft’s board of directors. In particular, I think her close connection to university students and the way they shape computing trends will bring an important perspective to the board”. (http://www.microsoft.com/presspass/press/2009/mar09/03-09BODPR.mspx, extracted on May 14, 2010).

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respected more by the CEO and inside directors (Baysinger & Hoskisson, 1990) making their advice and counsels more effective. This will reduce the tendency of the management to misuse firms’ resources (Lorsch & MacIver, 1989; Zahra & Pearce, 1989). Second, higher quality independent directors are more able to aid management in the formulation of strategy and other important firm decisions (Judge & Zeithaml, 1992; Whestphal, 1999). As such, the high quality independent directors will be more effective in preventing the CEO and also the inside directors from engaging in dysfunctional behavior. Finally, prestigious independent directors will be able to effectively monitor CEO and inside directors with their ability to discern between appropriate and inappropriate course of actions taken by management (Westphal, 1999). For example, the prominent independent directors will be able to influence top management by initiating their own analyses on opportunities and suggesting alternative course of actions that are value maximizing (Zahra & Pearce, 1989). Johnson, Daily, and Ellstrand (1996) argue that top management tend to listen and follow the advice and counsels of prominent outside board members regarding administrative and other managerial issues and prominent outside directors are more actively initiating and formulating strategic course of actions to protect shareholders’ interests. Highly qualified board members will also be more effective at persuading the CEO and inside directors to refrain from misusing their power. Therefore, we expect that the negative association between board dependence and performance will be mitigated by board capital. This is because the effectiveness of boards’ manager-monitoring activities will improve and their advice and counsels will be more valuable as more high quality board members are appointed to the boards. Hence, the following hypotheses will be tested: H1: The negative relationship between CEO duality and performance will be mitigated by board capital. H2: The negative relationship between board dependence and performance will be mitigated by board capital.

2.2. Board capital, managerial share ownership and performance Managerial share ownership affects the governance of a firm because share ownership grants managers the right to vote on the firm’s important decisions. Jensen (1993) notes that managerial share ownership aligns managers’ interests with shareholders’ interests in arguing that it makes managers less likely to behave opportunistically. Managers become more motivated to work hard when the equity that they hold in a firm increases because they will share a larger portion of the proceeds that accrue from a firm’s success (Warfield, Wild, & Wild, 1995). In addition, managerial share ownership will discourage managers from shirking their responsibilities or abusing their privileges (Cheng, Schultz, Luckett, & Booth, 2003). According to Dalton et al. (2003), managers’ motivation to serve shareholders’ interests diminishes when they do not directly benefit from the appreciation of their firm’s equity. As Jensen and Meckling (1976) suggest, when managers’ portion of a firm’s equity increases, their proportional claim on the firm’s outcomes likewise rises, which will likely reduce the perquisites they appropriate from the firm’s resources. Previous empirical studies lend support to the claim that managerial share ownership positively effects performance. One such study was conducted by Warfield et al. (1995), whose analysis of data obtained from Standard and Poor’s Compustat database finds positive associations between managerial share ownership and accounting earnings and managerial share ownership and stock returns. In addition, Hutchinson and Gul’s (2004) analysis of a sample of Australian firms finds that managerial share ownership positively impacts the relationship between investment opportunities and performance. We adopt the perspective of agency theory in predicting that there will be a positive association between managerial share ownership and firm performance. However, we argue that share ownership will have a more positive effect on managers’ performance when they are monitored and counseled by board members who are high quality as opposed to board members who are low quality. Essentially, managers who are given the reward of share ownership will perform better if high quality board members monitor them effectively and provide them with proper advice and counsel. According to Van Eerde and Thierry (1996), it is critical for firms to provide managers with share ownership because it will give them an incentive to invest in value-maximizing activities and board capital will moderate the positive relationship between share ownership and these activities. The share ownership-performance relationship will be strengthened if high-quality board members help managers to develop better strategies (Judge & Zeithaml, 1992); gain more access to scarce resources (Mizruchi & Stearns, 1988), and solidify links between companies and important stakeholders (Burt, 1980).4 Board capital will therefore strengthen the impact that managerial share ownership has on performance. Specifically, the following hypothesis will be tested: H3: The positive relationship between managerial share ownership and performance will be strengthened by board capital.

4 Consider two companies that provide the same percentage of share ownership to their managers and the same proportion of outside directors on their board. However, Company A’s board of directors consists of outside directors that are considered as word class experts such as CEO and board members of other S&P 500 firms, high-rank government officers and prominent university professors while company B’s board of directors consists of outside directors consists of inexperience local representatives. It is reasonable to expect that company A will outperform company B because of the better advice, counsels, and monitoring ability of its board of directors.

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3. Research method 3.1. Sample selection The sample consists of firms listed in the Compustat S&P 500 database for the period 1997 to 2004. Information regarding the board and ownership data was obtained from proxy statements filed by the firms found in the EDGAR database (http:// www.sec.gov/edgar.shtml). We manually searched the EDGAR database for the CEO and chairman names, ownership data, the main occupation of the board members, the number of members on the audit committee, the number of audit committee meetings, the number of outsiders on the audit committee, the number of members on the compensation committee, the number of compensation committee meetings, and the number of outsiders on the compensation committee. Information regarding number of meetings and executive tenure was obtained from the ExecuComp database. The sample is restricted to firms with complete data of all the variables needed to perform the statistical analyses. Table 1 summarizes the sample selection. We exclude 61 firms in banking, insurance and real estate industries because of their high level of industry regulations. From the remaining firms, we exclude firms that do not have at least one usable observation in Compustat S&P 500 (31 firms), EDGAR (103 firms) and ExecuCom (68 firms). Our final sample consists of 1332 firm-year observations from 237 firms. 3.2. Research design To test the hypotheses, we use the following regression model:

PERFORMit ¼ g0 þ g1 CAPit þ g2 DUALITYit þ g3 DEPit þ g4 MSOWNit þ g5 CAPit  DUALITYit þ g6 CAPit  DEPit þ g7 CAPit  MSOWNit þ g8 ASSETit þ g9 BSIZEit þ g10 INSTit þ g11 RD=Salesit þ g12 Debt=TAit þ g13 StdDevDOIit þ þg14 MTGSit þ g15 RETYRSit þ g16 Auditorit þ g17 AUDSIZEit þ g18 AUDMEETit þ þg19 AUDINDit þ g20 COMPSIZEit þ g21 COMPMEETit þ g22 COMPINDit þ g23 DEBITDAit þ g24 INDUSTRYit þ ε

(1)

Equation (1) allows us to estimate the effects of CAP, MSOWN, DEP, DUALITY, CAP*MSOWN, CAP*DEP, and CAP*DUALITY on firms’ performance (see Table 2 for the definition of the variables). We predict positive coefficients on CAP, MSOWN, CAP*DUALITY, CAP*DEP, and CAP*MSOWN, but negative coefficients for DUALITY and DEP. The variables used in this study are measured as follows: 3.2.1. Dependent variable We use Tobin’s Q as the dependent variable of this study. The main advantage of this measure of performance over accounting-based performance measures such as returns on asset or returns on equity is that Tobin’s Q is more objective Table 1 Sample selection. Panel A: Selection of firms Total number of firms listed in Compustat S&P 500 Less: Firms in financial, insurance and real estate industries Firms without data available in Compustat S&P 500 Firms without data available in EDGAR database Firms without data available in ExecuCom database Total sampled firms Panel B: Sampled firms according to their primary industry classification: Mineral industry Manufacturing industry Transportation and communication industry Trading industry Service industry Total sampled firms Panel C: Sampled firms across years: 1997 1998 1999 2000 2001 2002 2003 2004 Total firm-year observation

500 (61) (31) (103) (68) 237 14 153 12 19 39 237 122 139 157 198 205 237 138 136 1332

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Table 2 Variable definition. PERFORM: Firm performance measured by Tobin’s Q (the ratio of the market value of assets to the replacement costs of assets). CAP: The board capital as measured by the number of directors who also serve as a CEO/board of directors of S&P 500 firms/university professor/government officer divided by total numbers of directors on the board. DUALITY: An indicator of whether or not a firm’s CEO is also the chair of the board of director (CEO is equal to 1 if the CEO is also the chair of the board and 0 otherwise). DEP: The board dependence as measured by number of inside directors divided by total number of directors on the board. MSOWN: The ratio of common shares owned by management to total common shares outstanding. CAP*DUALITY: The interaction between CAP and DUALITY. CAP*DEP: The interaction between CAP and DEP. CAP*MSOWN: The interaction between CAP and MSOWN. ASSETS: The size of the firm as measured by a logarithmic function of the firm’s total assets. BSIZE: The number of directors on the board. INST: The ratio of number of shares owned by institutional shareholders to total outstanding common shares. RD/Sales: The ratio of R&D expenditures to total sales. Debt/TA: The ratio of total debt to total assets. StdDevDOI: The standard deviation of changes in operating income. MTGS: The number of board meetings held during the year. RETYRS: The number of years of credited services the named executive officers have under the firm’s pension plan. Auditor: is an indicator of whether a firm is audited by a big-four audit firm or not (Auditor is equal to 1 if the firm is audited by a big-four accounting firm and 0 otherwise). AUDSIZE: The number of members on the audit committee. AUDMEET: The number of audit committee meetings. AUDIND: The ratio of outsiders to total number of members on the audit committee COMPSIZE: The number of members on the compensation committee. COMPMEET: The number of compensation committee meetings COMPIND: The ratio of outsiders to total number of members on the compensation committee. DEBITDA: The change in earnings before interest, tax, depreciation and amortization (EBITDA).

because it is beyond the control of management. We follow Cheng’s (2008) suggestion and measure Tobin’s Q as the ratio of the market value of assets to the replacement costs of assets. We calculate the market value of assets as the sum of the market value of equity plus the difference between the book value of assets and the book value of equity. We use the book value of assets as the proxy for the replacement costs of assets. 3.2.2. Independent variables There are four independent variables in this study: board capital (CAP), managerial share ownership (MSOWN), board dependence (DEP), and CEO duality (DUALITY). CAP is measured as the ratio of the number of outside directors on the boards who also serve as the CEO/board of directors’ member for another S&P 500 firm and/or are a university professor or a government officer, to the total number of directors on the board. We manually searched for information in the EDGAR database regarding the main occupation of each member of the directors on the boards. Specifically, we searched for information as to whether an outside director on the board is also the CEO of another S&P 500 firm, a board member of another S&P 500 firm, a university professor, or a government officer.5 MSOWN is measured as the ratio of shares beneficially owned by all directors and executive officers of the firm to total number of common shares outstanding. This ratio excludes unexercised option shares which are exercisable in future periods. DEP is measured as the ratio of inside directors to total number of directors on the board. Inside directors are those whose principal positions are with the company, as indicated in the proxy statements. Retirees from the firm who are on the board of directors are also considered to be inside directors. When a director has multiple occupations, s/he is considered to be an inside director if s/he has a position with the firm. DUALITY is an indicator of whether or not a firm’s CEO is also the chairman of the board of director (DUALITY is a dummy variable equal to 1 if the CEO is also the chairman of the board and 0 otherwise). We searched for the name of the CEO and the name of the chairman of the board of directors in the proxy statements filed by the firm. When no names were available either for the CEO or for the chairman of the board, the firm was eliminated from the sample. 3.2.3. Control variables We control for firm size (ASSET), board size (BSIZE), institutional shareholders (INST), number of board meetings (MTGS), total number of years of the officers’ tenure (RETYRS) growth opportunity (RD/Sales), leverage (Debt/TA), business risk (StdDevDOI), type of auditor either big four or non-big four (Auditor), number of audit committee members (AUDSIZE), number of audit committee meeting (AUDMEET), the ratio of outsider to total number of members on the audit committee (AUDIND), number of compensation committee members (COMPSIZE), number of audit compensation committee meeting

5 We use the main occupation of the outside director as the criterion to be included in the board capital. Hence, an outside director can only be counted once in the board capital.

Please cite this article in press as: Jermias, J., & Gani, L., The impact of board capital and board characteristics on firm performance, The British Accounting Review (2013), http://dx.doi.org/10.1016/j.bar.2013.12.001

Tobin’s Q 1 0.09 (0.00) 0.14 (0.03) 0.12 (0.00) 0.17 (0.00) 0.11 (0.01) 0.03 (0.17) 0.06 (0.45) 0.18 (0.00) 0.23 (0.00) 0.11 (0.00) 0.22 (0.00) 0.20 (0.00) 0.09 (0.01) 0.04 (0.42) 0.09 (0.06) 0.018 (0.44) 0.25 (0.00) 0.13 (0.00) 0.01 (0.02) 0.21 (0.01) 0.18 (0.16) 0.01 (0.961) 0.09 (0.00)

DUALITY DEP MSOWN CAP*DUALITY CAP*DEP CAP*MSOWN ASSETS BSIZE INST RD/Sales Debt/TA StdDevDOI MTGS RETYRS Auditor AUDSIZE AUDMEET AUDIND COMPSIZE COMPMEET COMPIND

DEBITDA

CAP

DUALITY

DEP

MSOWN

CAP*DUALITY

CAP*DEP

CAP*MSOWN

ASSETS

BSIZE

INST

RD/Sales

Debt/Ta

StdDevDOI

MTGS

RETYRS

1 0.15 (0.00) 0.27 (0.00) 0.14 (0.00) 0.81 (0.00) 0.66 (0.00) 0.14 (0.00) 0.48 (0.00) 0.30 (0.00) 0.16 (0.00) 0.12 (0.00) 0.07 (0.01) 0.02 (0.12) 0.06 (0.09) 0.04 (0.15) 0.10 (0.00) 0.34 (0.00) 0.08 (0.00) 0.03 (0.21) 0.29 (0.00) 0.13 (0.00) 0.04 (0.10) 0.01 (0.05)

1 0.13 (0.00) 0.10 (0.00) 0.61 (0.00) 0.02 (0.00) 0.03 (0.17) 0.11 (0.00) 0.06 (0.01) 0.01 (0.74) 0.14 (0.00) 0.11 (0.00) 0.03 (0.09) 0.17 (0.00) 0.02 (0.24) 0.06 (0.01) 0.15 (0.00) 0.02 (0.43) 0.01 (0.64) 0.15 (0.00) 0.04 (0.15) 0.01 (0.62) 0.01 (0.58)

1 0.23 (0.00) 0.19 (0.00) 0.22 (0.00) 0.11 (0.00) 0.13 (0.00) 0.09 (0.00) 0.02 (0.65) 0.10 (0.01) 0.13 (0.00) 0.07 (0.05) 0.19 (0.00) 0.08 (0.03) 0.05 (0.03) 0.31 (0.00) 0.14 (0.00) 0.17 (0.00) 0.31 (0.00) 0.13 (0.00) 0.12 (0.00) 0.02 (0.42)

1 0.14 (0.00) 0.05 (0.04) 0.86 (0.00) 0.21 (0.00) 0.13 (0.00) 0.19 (0.00) 0.12 (0.00) 0.15 (0.00) 0.02 (0.76) 0.06 (0.16) 0.13 (0.01) 0.01 (0.92) 0.22 (0.00) 0.06 (0.01) 0.22 (0.00) 0.18 (0.00) 0.05 (0.04) 0.20 (0.00) 0.01 (0.58)

1 0.45 (0.00) 0.08 (0.00) 0.40 (0.00) 0.25 (0.00) 0.10 (0.00) 0.18 (0.00) 0.09 (0.01) 0.02 (0.24) 0.07 (0.08) 0.11 (0.00) 0.04 (0.09) 0.33 (0.00) 0.04 (0.10) 0.03 (0.18) 0.29 (0.00) 0.11 (0.00) 0.03 (0.23) 0.01 (0.81)

1 0.24 (0.00) 0.37 (0.00) 0.23 (0.00) 0.13 (0.00) 0.02 (0.33) 0.03 (0.35) 0.03 (0.44) 0.05 (0.12) 0.11 (0.01) 0.05 (0.02) 0.12 (0.00) 0.01 (0.83) 0.04 (0.09) 0.07 (0.00) 0.06 (0.01) 0.03 (0.23) 0.02 (0.49)

1 0.09 (0.00) 0.02 (0.40) 0.16 (0.00) 0.02 (0.38) 0.09 (0.01) 0.18 (0.00) 0.03 (0.41) 0.04 (0.22) 0.03 (0.22) 0.01 (0.66) 0.01 (0.66) 0.24 (0.00) 0.09 (0.00) 0.05 (0.04) 0.21 (0.00) 0.01 (0.62)

1 0.55 (0.00) 0.31 (0.00) 0.12 (0.00) 0.17 (0.00) 0.11 (0.01) 0.25 (0.00) 0.41 (0.00) 0.06 (0.00) 0.44 (0.00) 0.18 (0.00) 0.02 (0.38) 0.36 (0.00) 0.29 (0.00) 0.01 (0.84) 0.03 (0.23)

1 0.14 (0.00) 0.29 (0.00) 0.22 (0.00) 0.11 (0.06) 0.03 (0.23) 0.17 (0.01) 0.01 (0.82) 0.53 (0.00) 0.02 (0.51) 0.06 (0.02) 0.47 (0.00) 0.12 (0.00) 0.02 (0.32) 0.01 (0.83)

1 0.02 (0.61) 0.05 (0.17) 0.01 (0.84) 0.05 (0.31) 0.05 (0.13) 0.02 (0.368) 0.06 (0.01) 0.01 (0.87) 0.06 (0.02) 0.06 (0.02) 0.05 (0.04) 0.05 (0.04) 0.03 (0.27)

1 0.31 (0.00) 0.06 (0.08) 0.21 (0.00) 0.03 (0.41) 0.01 (0.80) 0.26 (0.00) 0.05 (0.04) 0.02 (0.54) 0.22 (0.00) 0.06 (0.01) 0.15 (0.00) 0.01 (0.81)

1 0.13 (0.00) 0.03 (0.45) 0.08 (0.03) 0.05 (0.04) 0.26 (0.000) 0.01 (0.77) 0.02 (0.42) 0.24 (0.00) 0.09 (0.00) 0.03 (0.21) 0.03 (0.25)

1 0.08 (0.03) 0.06 (0.09) 0.04 (0.34) 0.160 (0.16) 0.04 (0.36) 0.04 (0.33) 0.11 (0.34) 0.03 (0.46) 0.08 (0.06) 0.07 (0.02)

1 0.03 (0.32) 0.03 (0.22) 0.06 (0.35) 0.24 (0.01) 0.11 (0.12) 0.02 (0.35) 0.14 (0.09) 0.09 (0.19) 0.01 (0.37)

1 0.05 (0.56) 0.09 (0.11) 0.02 (0.53) 0.06 (0.32) 0.01 (0.75) 0.06 (0.06) 0.07 (0.11) 0.09 (0.13)

J. Jermias, L. Gani / The British Accounting Review xxx (2013) 1–19

Variable Tobin’s Q CAP

8

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Table 3 Pearson correlations among variables (n ¼ 1332) (P-values in parenthesis).

Auditor

AUDSIZE

AUDMEET

AUDIND

COMPSIZE

COMPMEET

COMPIND

DEBITDA

Tobin’s Q CAP DUALITY DEP MSOWN CAP*DUALITY CAP*DEP CAP*MSOWN ASSETS BSIZE INST RD/Sales Debt/TA StdDevDOI MTGS RETYRS Auditor AUDSIZE AUDMEET AUDIND COMPSIZE COMPMEET COMPIND DEBITDA

1 0.01 (0.78) 0.15 (0.00) 0.04 (0.09) 0.02 (0.47) 0.06 (0.03) 0.04 (0.09) 0.01 (0.73)

1 0.03 0.09 0.66 0.12 0.04 0.01

1 0.04 (0.13) 0.05 (0.04) 0.36 (0.00) 0.01 (0.90) 0.01 (0.73)

1 0.09 (0.00) 0.07 (0.00) 0.45 (0.00) 0.01 (0.91)

1 0.15 (0.00) 0.06 (0.02) 0.01 (0.92)

1 0.07 (0.00) 0.03 (0.17)

1 0.01 (0.92)

1

(0.15) (0.00) (0.00) (0.00) (0.11) (0.85)

Tobin’s Q is the ratio of the market value of assets to the replacement costs of assets. CAP is the board capital as measured by the number of directors who also serve as a CEO/board of directors of S&P 500 firms/ university professor/government officer divided by total numbers of directors on the board; DUALITY is an indicator of whether or not a firm’s CEO is also the chair of the board of director (CEO is equal to 1 if the CEO is also the chair of the board and 0 otherwise); DEP is the board dependence as measured by number of inside directors divided by total number of directors on the board; MSOWN is the ratio of common shares owned by management to total common shares outstanding; CAP*DUALITY is the interaction between CAP and CEO; CAP*DEP is the interaction between CAP and DEP; CAP*MSOWN is the interaction between CAP and MSOWN; ASSETS is the size of the firm as measured by a logarithmic function of the firm’s total assets; BSIZE is the number of directors on the board; INST is the ratio of number of shares owned by institutional shareholders to total outstanding common shares. RD/Sales is the ratio of R&D expenditures to total sales. Debt/TA is the ratio of total debt to total assets. StdDevDOI is the standard deviation of changes in operating income. MTGS is the number of board meetings held during the year. RETYRS ¼ number of years of credited services the named executive officers have under the firm’s pension plan; Auditor is an indicator of whether a firm is audited by a big-four audit firm or not (Auditor is equal to 1 if the firm is audited by a big-four accounting firm and 0 otherwise); AUDSIZE is the number of members on the audit committee; AUDMEET is the number of audit committee meetings; AUDIND is the ratio of outsiders to total number of members on the audit committee; COMPSIZE is the number of members on the compensation committee; COMPMEET is the number of compensation committee meetings; COMPIND is the ratio of outsiders to total number of members on the compensation committee; DEBITDA is the change in earnings before interest, tax, depreciation and amortization (EBITDA).

J. Jermias, L. Gani / The British Accounting Review xxx (2013) 1–19

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Variable

9

10

J. Jermias, L. Gani / The British Accounting Review xxx (2013) 1–19

(COMPMEET), the ratio of outsider to total number of members on the compensation committee (COMPIND), change in EBITDA (DEBITDA), and the four-digit primary industry classification (INDUSTRY). ASSET was measured as the logarithmic function of total assets.6 As previous research has reported that firm size affects performance (e.g., Ramaswamy, 2001; Westphal & Zajac, 1995), we include firm size to ensure that our findings are not confounded by the effect of size on performance. BSIZE is measured by the total number of directors on the boards. The size of the board of directors is expected to be associated with firm performance through the relative influence of the CEO on boards of various sizes. On one hand, Yermack (1996) and Guest (2009) argue that larger boards are less effective and more susceptible to the influence of the CEO. In addition, Cheng (2008) argues that larger boards encounter more problems with directors’ free-riding than smaller boards. On the other hand, Pfeffer and Salancik (1978) contend that a larger board size might indicate that a firm is attempting to form links with its environment and, therefore, be expected to positively affect performance. Hence, we cannot predict the direction of the relationship between board size and performance. We measure institutional shareholders (INST) as the ratio of stock owned by institutions, including mutual funds, pension funds, banks, and loan companies to total number of common shares outstanding. Institutional shareholders affect performance through their effective monitoring of the CEO (e.g., Core, Holthausen, & Larker, 1999; Cyert, Kang, & Kumar, 2002) and institutional ownership might also affect performance through institutions’ active involvement in monitoring activities (Bushee, 1990). More frequent board meetings mean boards have more opportunity to scrutinize management decisions (Adams & Ferreira, 2009; Masulis, Wang, & Xie, 2012).7 Core et al., (1999) found that more effective monitoring activities by the boards increase firm performance. Hence, we expect that MTGS will have a positive relationship with performance. Directors’ tenure represents the stability of the board. Crutchley, Garner, and Marshall (2002) found that greater board stability is associated with improved performance. Therefore, we predict that RETYRS will have a positive relationship with performance. Following previous studies (e.g., Cheng, 2008; Gompers, Ishii, & Metrick, 2003; Mehran, 1995) we also control for growth opportunity (measured by the ratio of R&D expenditure to total sales), leverage (measured by the ratio of total debt to total assets), business risk (measured by the standard deviation of changes in operating income and change in EBITDA), audit quality (measured by the type of auditor used by the company: big four vs. non-big four) and various committees’ characteristics (AUDSIZE as measured by the number of members on the audit committee; AUDMEET as measured by the number of audit committee meetings; AUDIND as measured by the ratio of outsiders to total number of members on the audit committee; COMPSIZE as measured by the number of members on the compensation committee; COMPMEET as measured by the number of compensation committee meetings; and COMPIND as measured by the ratio of outsiders to total number of members on the compensation committee). Finally, we control for the types of industry in which the company operates.

4. Data analysis and result Table 3 reveals the Pearson’s correlations for all the variables used in this study. Consistent with our prediction, the relationship between board capital and performance is positive and significant (r ¼ 0.09, p < 0.00), indicating that firms benefit from having high quality directors on their boards. DUALITY has a negative and significant correlation with performance (r ¼ 0.14, p ¼ 0.03), suggesting that firms in which the CEO is also the chairman of the board perform poorer than those in which the CEO is not the chairman of the board. Board dependence has a negative and significant relationship with performance (r ¼ 0.12, p < 0.00), while managerial share ownership has a positive and significant relationship with performance (r ¼ 0.17; p < 0.00). It is interesting to note that board capital is positively and significantly associated with firm size, which suggests that large firms can afford to appoint high quality individuals to their boards of directors.8 Table 4 presents the descriptive statistics of the variables used in this study. The average Tobin’s Q is 1.23, with a minimum of 0.08 and a maximum of 5.12. The average percentage of board capital (CAP) is 48%, with a minimum of 0% and a maximum of 89%. This indicates that a relatively high proportion of directors on boards are prominent individuals who also serve as a CEO in other S&P 500 firms, are on the board of directors in other S&P 500 firms, and/or are a university professor or a government official.

6 We also use total sales and number of employees as alternative measures of firm size. The results (not reported in this paper) are qualitatively similar to those reported in this paper. 7 Some empirical studies have reported that board meeting frequency is inversely related to performance (e.g., Fich & Shivdasani, 2006;Vafeas, 1999). Vafeas (1999) argues that the negative relation between board meeting frequency and firm performance is the limited time outside directors spent together is not used for the meaningful exchange of ideas among themselves and with management. Despite this opposing view, our study follows the theoretical and most empirical works in accounting and finance literature suggesting that the frequency of board meetings has a positive impact on performance (e.g., Adams & Ferreira, 2009; Core et al., 1999; Masulis et al., 2012). 8 A question that may arise from this result is whether the correlation between CAP and performance interacted with firm size is spurious. More specifically, is it possible that both CAP and firm size are caused by good performance? A further investigation seems to indicate that this is not the case. Table 2 shows that firm size is negatively related to performance suggesting that good performing firms are not clustered among large firms only.

Please cite this article in press as: Jermias, J., & Gani, L., The impact of board capital and board characteristics on firm performance, The British Accounting Review (2013), http://dx.doi.org/10.1016/j.bar.2013.12.001

J. Jermias, L. Gani / The British Accounting Review xxx (2013) 1–19

11

Table 4 Descriptive statistics. Variable

Mean

SD

Median

Minimum

Maximum

Tobin’s Q CAP DUALITY DEP MSOWN CAP*DUALITY CAP*DEP CAP*MSOWN ASSETS BSIZE INST RD/Sales Debt/TA StdDevDOI MTGS RETYRS Auditor AUDSIZE AUDMEET AUDIND COMPSIZE COMPMEET COMPIND DEBITDA CEO of S&P 500 BOD of S&P 500 University Professor Government Officer

1.23 0.48 0.78 0.21 0.06 0.39 0.09 0.02 8.38 10.19 0.17 0.03 0.23 1.68 6.97 48.22 0.88 4.13 5.62 0.99 3.97 4.78 0.99 0.07 0.05 0.30 0.08 0.05

2.34 0.30 0.41 0.11 0.10 0.34 0.07 0.05 1.44 2.59 0.14 0.07 0.18 11.78 4.23 32.18 0.32 1.19 3.20 0.05 1.23 2.34 0.07 1.91 0.08 0.22 0.93 0.90

1.18 0.45 1.00 0.18 0.02 0.31 0.08 0.06 8.37 10.00 0.15 0.04 0.19 1.79 5.53 41.54 1.00 4.00 5.00 1.00 4.00 5.00 1.00 0.13 0.00 0.29 0.07 0.00

0.08 0.00 0.00 0.07 0.00 0.00 0.03 0.00 1.75 4.00 0.00 0.00 0.01 0.01 2.00 3.00 0.00 2.00 1.00 0.33 2.00 1.00 0.33 25.36 0.00 0.00 0.00 0.00

5.12 0.89 1.00 0.91 0.82 0.84 0.91 0.38 12.48 19.00 0.91 0.41 0.76 65.21 9.00 176.00 1.00 9.00 18.00 1.00 12.00 14.00 1.00 19.20 0.55 0.80 0.50 0.67

Tobin’s Q is the ratio of the market value of assets to the replacement costs of assets. CAP is the board capital as measured by the number of directors who also serve as a CEO/board of directors of S&P 500 firms/university professor/government officer divided by total numbers of directors on the board; DUALITY is an indicator of whether or not a firm’s CEO is also the chair of the board of director (CEO is equal to 1 if the CEO is also the chair of the board and 0 otherwise); DEP is the board dependence as measured by number of inside directors divided by total number of directors on the board; MSOWN is the ratio of common shares owned by management to total common shares outstanding; CAP*DUALITY is the interaction between CAP and CEO; CAP*DEP is the interaction between CAP and DEP; CAP*MSOWN is the interaction between CAP and MSOWN; ASSETS is the size of the firm as measured by a logarithmic function of the firm’s total assets; BSIZE is the number of directors on the board; INST is the ratio of number of shares owned by institutional shareholders to total outstanding common shares. RD/Sales is the ratio of R&D expenditures to total sales. Debt/TA is the ratio of total debt to total assets. StdDevDOI is the standard deviation of changes in operating income. MTGS is the number of board meetings held during the year. RETYRS is the number of years of credited services the named executive officers have under the firm’s pension plan; Auditor is an indicator of whether a firm is audited by a big-four audit firm or not (Auditor is equal to 1 if the firm is audited by a big-four accounting firm and 0 otherwise); AUDSIZE is the number of members on the audit committee; AUDMEET is the number of audit committee meetings; AUDIND is the ratio of outsiders to total number of members on the audit committee; COMPSIZE is the number of members on the compensation committee; COMPMEET is the number of compensation committee meetings; COMPIND is the ratio of outsiders to total number of members on the compensation committee; DEBITDA is the change in earnings before interest, tax, depreciation and amortization (EBITDA). CEO of S&P 500 is the number of directors who also serve as a CEO of S&P 500 firms divided by board size; BOD of S&P 500 is the number of directors who also serve as board of directors of S&P 500 firms divided by board size; University Professor is the number of directors who are university professors divided by board size; Government Officer is the number of directors who are/government officers divided by board size.

As indicated in the previous sections, the U.S. corporate governance guidelines (i.e., SOX and the Principle of Corporate Governance) do not specifically require that that the roles of the CEO and the chairman of the board should be kept separate, Table 4 indicates that on average, the CEO also the chairman of the board in 78% of our sample firms.9 The average ratio of inside directors to total number of directors is 21%, with a minimum of 7% and a maximum of 91%. These results also show that the boards of most of the firms we sampled are dominated by outside directors. The average percentage of shares owned by directors and other executives is 6%, with a minimum of 0% and a maximum of 82%.10

9 The high percentage of CEO duality might be due to the fact that the corporate governance guidelines in the U.S. (i.e., SOX) do not specifically require the separation of CEO and chairman of the board of directors. Furthermore, the Principle of Corporate Governance issued by The Business Round Table states that “most American corporations are well served by a structure in which the CEO also serves as chairman of the board and each corporation should make its own determination of what leadership structure work best for the company (p. 13). Rechner and Dalton (1991) found that almost 80 percent of the CEOs of U.S. large firms are also the chairman of the boards of directors. 10 The results are comparable with those reported by previous studies that use a sample of large U.S. firms. For example, the average percentage of shares owned by directors and other executives is 6% which is comparable to those reported by previous studies such as 6.97 (Fich & Shivdasani, 2006) and 7.1 (Vafeas, 1999). Similarly, the average percentage of CEO duality is 78% which is comparable to 80% reported by Rechner and Dalton (1991) and 85% reported by Fich and Shivdasani (2006). With respect to the ratio of inside directors to total number of directors, the result indicates that the mean is 21% which is comparable to 28.2% reported by Vafeas (1999).

Please cite this article in press as: Jermias, J., & Gani, L., The impact of board capital and board characteristics on firm performance, The British Accounting Review (2013), http://dx.doi.org/10.1016/j.bar.2013.12.001

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With respect to the control variables, the average size as measured by the logarithm of total assets is 8.38, with a minimum of 1.75 and a maximum of 12.48. The average number of directors on the boards is 10, with a minimum of 4 and a maximum of 19. The average percentage of shares owned by institutional shareholders is 17%, with a minimum of 0% and a maximum of 91%. The average RD/Sales ratio is 3% with the minimum of 0% and a maximum of 41%. The average Debt/TA ratio is 23% with a minimum of 1% and a maximum of 76%. The average StdDevDOI is 1.68 with a minimum of 0.01 and a maximum of 65.21. The average number of meeting is about 7 times during the period with a minimum of 2 and a maximum of 9. The average number of years credited to the named executive officers have under the firm’s pension plan is 48.22 years with a minimum of 3 years and a maximum of 176 years.11 88% of the sampled firms used big four audit firms. The average number of members on the audit committee is 4.13 with a minimum of 2 and a maximum of 9. The average number of audit committee meeting is about 6 times during the period with a minimum of 1 and a maximum of 18. 99% of the audit committee members are outsiders. The average number of members on the compensation committee is 3.97 with a minimum of 2 and a maximum of 12. The average number of compensation committee meeting is about 5 times during the period with a minimum of 1 and a maximum of 14. 99% of the compensation committee members are outsiders. The average DEBITDA is 0.07 with a minimum of 25.36 and a maximum of 19.20.12 The results also show that 30% of board capital (CAP) is outside directors who also serve as board of directors of S&P 500 firms, followed by outside directors who are also university professors (8%), outside directors who also serve as a CEO of S&P 500 firms (5%), and outside directors who are also government officers (5%). Table 5 presents the results of the panel-data regression analyses for Tobin’s Q as the dependent variable.13 Since there are multiple companies for different years, we use the robust cluster option proposed by Petersen (2009) to account for lack of independence across the observations of each firm. Regression 1 (with the interaction terms) reports the interactive effects of board capital on the relationship between CEO duality, board dependence, and managerial share ownership on firm performance. Regression 2 (without the interaction terms) shows the main effects of the independent variables on performance.14 We performed collinearity diagnostic tests simultaneously with the regression analyses. Table 5 reports the variance inflation factor (VIF) for each variable to indicate the stability of the regression model. The stability of the model decreases as the VIF increases. Although Column (5) of Table 5 shows that there is one variable (CAP) with a VIF larger than 10, Column (8) of Table 5 indicates that all the variables used in this study have VIFs around one.15 The results indicate that multi-collinearity does not impede our interpretation of the results of the regression analyses.16 Hypothesis H1 predicts that board capital will mitigate the negative effect of CEO duality on firm performance. This hypothesis concerns the incremental effect of CAP on the relationship between DUALITY and PERFORM. Consistent with our prediction, the results indicate that board capital has a positive effect on the relationship between CEO duality and performance. That is, the coefficient on CAP*DUALITY is significantly positive (t ¼ 2.01, p < 0.05). These results support hypothesis H1. Hypothesis H2 expects that board capital will mitigate the negative effect of board dependence on performance. This hypothesis relates to the incremental effect of CAP on the relationship between DEP and PERFORM. Consistent with our hypothesis, the results suggest that board capital has a positive influence on the relationship between board dependence and performance. That is, the coefficient on CAP*DEP is positive and significant (t ¼ 2.47, p < 0.05). These results confirm hypothesis H2. Hypothesis H3 posits that board capital will have a positive impact on the relationship between managerial share ownership and performance. This hypothesis concerns the incremental effect of CAP on the relationship between MSOWN and PERFORM. The results reveal that the coefficient on CAP*MSOWN is positive and statistically significant (t ¼ 3.63; p < 0.01), which supports hypothesis H3.

11

These figures represents the total number of years credited to all the named executive officers (usually the top five executives officers). We also investigate the distribution of CAP, CEO, DEP, and MSOWN by years. The results (not reported in this paper) indicate that board characteristics are similar across the eight year periods. This similarity is expected given that our period of study occurs before the full implementation of SOX. The consistent figures suggest that the results of the statistical analyses are robust across different periods. 13 The analyses were performed using the xtreg command with the re option in STATA. We use the random effect (re) option to allow for the time invariant and slow changing variables such as CEO duality, types of auditors and industry classifications, to play a role as explanatory variables (Stock & Watson, 2007). 14 We also partitioned our sample into pre-SOX (1997–2002) and post-SOX (2003–2004). The results (not reported in the paper) are qualitatively similar. 15 Multi-collinearity may affect the least squares estimates of the regression coefficients when the VIF is larger than 10 (Dielman (2001). Column (5) of Table 5 reveals that CAP has a VIF value of 11.71. However, column (8) of Table 5 shows that the maximum value of VIF for all the independent variables (without the interaction terms) is 2.14. It seems that the high VIF values for CAP is due to the interaction terms included in regression 1. Hartmann and Moers (1999) suggest that multi-collinearity between the independent variables and their interaction terms should not be a concern when applying moderated regression analyses (MRA) because the coefficients of the interaction terms in MRA is insensitive to changes in scale origins of the lower-order effect. 16 In order to avoid the problem with multi-colinearity because of too many predictors used in the multiple regression analyses, we follow HudekKnezevic, Kardum, and Maglica’s (2005) suggestion to perform separate analyses for each interaction. The results (not reported in this paper) are qualitatively similar to those reported in Table 6. Pedhazur and Pedhazur-Schmelkin (1991) argue that in the moderated regression analyses, the coefficients should be interpreted when all the variables included in the model since the inclusion of interaction effects do change the coefficients of the bi-variate correlation. 12

Please cite this article in press as: Jermias, J., & Gani, L., The impact of board capital and board characteristics on firm performance, The British Accounting Review (2013), http://dx.doi.org/10.1016/j.bar.2013.12.001

J. Jermias, L. Gani / The British Accounting Review xxx (2013) 1–19

13

Table 5 Panel data regression results of Tobin’s Q on board capital, managerial share ownership, board dependence, CEO duality, and control variables. Variable (1)

Prediction (2)

Results Regression 1 (with interaction terms)

Intercept CAP DUALITY DEP MSOWN CAP*DUALITY CAP*DEP CAP*MSOWN ASSETS BSIZE INST RD/Sales Debt/TA StdDevDOI MTGS RETYRS Auditor AUDSIZE AUDMEET AUDIND COMPSIZE COMPMEET COMPIND DEBITDA INDUSTRYc R2 Wald Chi2 N

? þ   þ þ þ þ  ? þ þ   þ þ þ ? ? þ ? ? þ þ ?

Coefficienta B (3)

T-values (p-values)b(4)

13.48 0.20 0.39 1.78 0.11 0.73 0.80 0.16 0.56 0.14 0.04 2.04 4.53 0.03 0.01 0.04 0.32 0.21 0.09 0.80 0.07 0.10 1.61 0.11

5.15 (0.00)*** 3.21 (0.00)*** 2.09 (0.01)** 1.73 (0.08)* 5.18 (0.00)*** 2.01 (0.04)** 2.47 (0.01)** 3.63 (0.00)*** 5.21 (0.00)*** 2.95 (0.00)*** 3.24 (0.00)*** 3.64 (0.00)*** 6.12 (0.00)*** 2.75 (0.00)*** 0.91 (0.36) 1.89 (0.06)* 2.18 (0.03)** 2.12 (0.03)** 3.39 (0.00)*** 0.36 (0.72) 0.73 (0.46) 2.51 (0.01)** 1.35 (0.17) 2.63 (0.00)*** 0.28 260.77*** 1332

Regression 2 (without interaction terms) VIF (5) 11.71 3.47 3.02 4.38 9.74 4.97 4.36 2.14 1.84 1.28 3.22 1.25 1.54 1.15 1.68 1.05 2.15 1.21 1.23 2.00 1.22 1.20 1.02

Coefficienta B (6)

T-values (p-values)b(7)

VIF (8)

11.94 0.49 0.29 1.10 0.05

4.80 (0.00)*** 3.30 (0.00)*** 1.99 (0.04)** 1.81 (0.07)* 3.84 (0.00)***

1.46 1.12 1.20 1.14

0.51 0.16 0.03 2.13 4.53 0.04 0.02 0.03 0.31 0.18 0.10 0.19 0.08 0.10 1.64 0.11

4.84 (0.00)*** 2.01 (0.04)** 3.13 (0.00)*** 3.59 (0.00)*** 6.11 (0.00)*** 2.89 (0.00)*** 1.18 (0.23) 2.32 (0.02)** 2.14 (0.03)** 1.88 (0.06)* 3.61 (0.00)*** 0.39 (0.69) 0.81 (0.42) 2.56 (0.01)** 1.37 (0.17) 2.65 (0.01)**

2.06 1.81 1.25 1.20 1.23 1.67 1.54 1.34 1.05 2.14 1.20 1.17 2.00 1.22 1.20 1.01

0.27 243.51*** 1332

The dependent variable is Tobin’s Q. Tobin’s Q is the ratio of the market value of assets to the replacement costs of assets. CAP is the board capital as measured by the number of directors who also serve as a CEO/board of directors of S&P 500 firms/university professor/government officer divided by total numbers of directors on the board; DUALITY is an indicator of whether or not a firm’s CEO is also the chair of the board of director (CEO is equal to 1 if the CEO is also the chair of the board and 0 otherwise); DEP is the board dependence as measured by number of inside directors divided by total number of directors on the board; MSOWN is the ratio of common shares owned by management to total common shares outstanding; CAP*DULITY is the interaction between CAP and CEO; CAP*DEP is the interaction between CAP and DEP; CAP*MSOWN is the interaction between CAP and MSOWN; ASSETS is the size of the firm as measured by a logarithmic function of the firm’s total assets; BSIZE is the number of directors on the board; INST is the ratio of number of shares owned by institutional shareholders to total outstanding common shares. RD/Sales is the ratio of R&D expenditures to total sales. Debt/TA is the ratio of total debt to total assets. StdDevDOI is the standard deviation of changes in operating income. MTGS is the number of board meetings held during the year. RETYRS ¼ number of years of credited services the named executive officers have under the firm’s pension plan; Auditor is an indicator of whether a firm is audited by a big-four audit firm or not (Auditor is equal to 1 if the firm is audited by a big-four accounting firm and 0 otherwise); AUDSIZE is the number of members on the audit committee; AUDMEET is the number of audit committee meetings; AUDIND is the ratio of outsiders to total number of members on the audit committee; COMPSIZE is the number of members on the compensation committee; COMPMEET is the number of compensation committee meetings; COMPIND is the ratio of outsiders to total number of members on the compensation committee; DEBITDA is the change in earnings before interest, tax, depreciation and amortization (EBITDA), INDUSTRY is the four-digit primary industry classification. a The coefficients are reported in the unstandardized form. b The p-values are based on two-tailed tests, except in cases of directional prediction, where we use a one-tailed test.*,**, and***, denote significance levels at 0.10, 0.05, and 0.01 respectively. c None of the industry variables were significant (not reported in this table).

With respect to the control variables, our findings suggest that firm size is negatively and significantly correlated with performance (t ¼ 5.21, p < 0.01). This result is consistent with the findings of previous studies (e.g., Jermias, 2007; Westphal, 1999). Furthermore, our results indicate that institutional ownership (INT) is positive and significant (t ¼ 3.24; p < 0.01), which suggests that firms benefit from the monitoring activities of institutional shareholders. With respect to board size (BSIZE), the results indicate that board size has a negative and marginally significant relationship with performance (t ¼ ¼ 2.95; p < 0.01), which is consistent with the findings of Weisbach (1988). The negative association between board size and performance is also consistent with the argument that a larger board takes more time and effort to reach consensus, and encounters more free-riding problems among directors (Cheng, 2008), than does a smaller board. The results also show that growth opportunity (RD/Sales) is positive and significant (t ¼ 3.64; p < 0.01), the change in EBITDA (DEBITDA) is also positive and significant (t ¼ 2.63; p < 0.01), and executive tenure (RETYRS) is positive and marginally significant (t ¼ 1.89; p < 0.10). With respect to risk the standard deviation of change in operating income (StdDevDOI) is negative and significant (t ¼ 2.75; p < 0.01). The results also indicate that audit committee size (AUDITSIZE), number of audit committee meeting (AUDMEET) and number of compensation committee meeting are negative and significant (t ¼ 2.12; p < 0.05, t ¼ 3.39; p < 0.01, and t ¼ 2.51; p < 0.05, respectively). Please cite this article in press as: Jermias, J., & Gani, L., The impact of board capital and board characteristics on firm performance, The British Accounting Review (2013), http://dx.doi.org/10.1016/j.bar.2013.12.001

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J. Jermias, L. Gani / The British Accounting Review xxx (2013) 1–19

Table 6 shows the results of the panel-data regression of Tobin’s Q on the individual element of the board capital, CEO duality, board dependence, managerial share ownership and the control variables. The results indicate that the components of board capital are positively and significantly correlated to Tobin’s Q, except for that of the government officer component which is positive but not significant. 5. Robustness checks We performed two additional analyses to check the robustness of our results reported in the previous section. First, we address the endogeneity concern regarding the possibility that both board capital and board related variables might be endogenously determined. For example, one of the key arguments in this paper is that outside directors with lots of board capital will have a positive effect on firm performance. However, it may be that good performing firms attract high quality outside directors so that the causality is reversed. Adams, Hermalin, and Weisbach (2010) argue that endogeneity is a serious problem since companies choose certain governance structures in response to the governance issues they face. We address this concern in two ways. First, we use extensive control variables to capture the variation between firms that could affect optimal governance structure (Black, Jang, & Kim, 2006). Second, we perform two-stage least square regression (2SLS in STATA) in which we use total equity, total sales, capital intensity, operating margin (sales minus cost of goods sold, divided by sales), length of operating cycle (average receivables divided by sales plus average inventory divided by cost of goods sold),

Table 6 OLS results of Tobin’s Q on the individual element of board capital, managerial share ownership, board dependence, CEO duality and control variables. Variable (1)

Prediction (2)

Coefficienta B (3)

T-values (p-values)b (4)

Intercept CEO of S&P 500 BOD of S&P 500 University Professor Government Officer DUALITY DEP MSOWN ASSETS BSIZE INST RD/Sales Debt/TA StdDevDOI MTGS RETYRS Auditor AUDSIZE AUDMEET AUDIND COMPSIZE COMPMEET COMPIND DEBITDA INDUSTRYc R2 Wald Chi2 N

? þ þ þ þ   þ  ? þ þ   þ þ þ ? ? þ ? ? þ þ ?

11.77 1.63 2.45 0.65 1.27 0.21 1.26 0.04 0.48 0.16 0.04 2.12 4.65 0.03 0.01 0.04 0.32 0.16 0.09 0.83 0.06 0.11 1.59 0.10

4.77 (0.00)*** 1.91 (0.06)* 2.77 (0.00)*** 2.39 (0.01)** 1.03 (0.30) 1.85 (0.07)* 1.93 (0.05)* 3.84 (0.00)*** 4.50 (0.00)*** 3.31 (0.00)*** 3.22 (0.00)*** 3.74 (0.00)*** 6.30 (0.00)*** 1.97 (0.04)** 0.76 (0.44) 1.83 (0.06)* 2.16 (0.03)** 1.66 (0.09)* 3.37 (0.00)*** 0.33 (0.74) 0.64 (0.52) 2.83 (0.00)*** 1.33 (0.18) 2.06 (0.03)** 0.22 251.18*** 1332

The dependent variable is Tobin’s Q. Tobin’s Q is the ratio of the market value of assets to the replacement costs of assets. CEO of S&P 500 is the number of directors who also serve as a CEO of S&P 500 firms divided by board size; BOD of S&P 500 is the number of directors who also serve as board of directors of S&P 500 firms divided by board size; University Professor is the number of directors who are university professors divided by board size; Government Officer is the number of directors who are/government officers divided by board size; DULITY is an indicator of whether or not a firm’s CEO is also the chair of the board of director (CEO is equal to 1 if the CEO is also the chair of the board and 0 otherwise); DEP is the board dependence as measured by number of inside directors divided by total number of directors on the board; MSOWN is the ratio of common shares owned by management to total common shares outstanding; ASSETS is the size of the firm as measured by a logarithmic function of the firm’s total assets; BSIZE is the number of directors on the board; INST is the ratio of number of shares owned by institutional shareholders to total outstanding common shares. RD/Sales is the ratio of R&D expenditures to total sales. Debt/TA is the ratio of total debt to total assets. StdDevDOI is the standard deviation of changes in operating income. MTGS is the number of board meetings held during the year. RETYRS ¼ number of years of credited services the named executive officers have under the firm’s pension plan; Auditor is an indicator of whether a firm is audited by a big-four audit firm or not (Auditor is equal to 1 if the firm is audited by a big-four accounting firm and 0 otherwise); AUDSIZE is the number of members on the audit committee; AUDMEET is the number of audit committee meetings; AUDIND is the ratio of outsiders to total number of members on the audit committee; COMPSIZE is the number of members on the compensation committee; COMPMEET is the number of compensation committee meetings; COMPIND is the ratio of outsiders to total number of members on the compensation committee; DEBITDA is the change in earnings before interest, tax, depreciation and amortization (EBITDA), INDUSTRY is the four-digit primary industry classification. a The coefficients are reported in the unstandardized form. b The p-values are based on two-tailed tests, except in cases of directional prediction, where we use a one-tailed test.*,**, and***, denote significance levels at 0.10, 0.05, and 0.01 respectively.

Please cite this article in press as: Jermias, J., & Gani, L., The impact of board capital and board characteristics on firm performance, The British Accounting Review (2013), http://dx.doi.org/10.1016/j.bar.2013.12.001

J. Jermias, L. Gani / The British Accounting Review xxx (2013) 1–19

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Table 7 2SLS results of Tobin’s Q on board capital, managerial share ownership, board dependence, CEO duality, and control variables. Variable (1)

Prediction (2)

Results Regression 1 (with interaction terms) a

Coefficient B (3)

Regression 2 (without interaction terms) b

T-values (p-values) (4)

Intercept ? 12.46 5.88 (0.00)*** CAP þ 0.97 4.11 (0.00)*** DUALITY  0.86 2.78 (0.01)** DEP  1.97 1.80 (0.07)* MSOWN þ 0.26 5.42 (0.00)*** CAP*DUALITY þ 0.98 2.48 (0.01)** CAP*DEP þ 0.69 2.56 (0.01)** CAP*MSOWN þ 0.11 3.02 (0.00)*** ASSETS  0.43 4.97 (0.00)*** BSIZE ? 0.14 3.15 (0.00)*** INST þ 0.04 2.36 (0.02)** RD/Sales þ 0.17 3.39 (0.00)*** Debt/TA  4.29 6.27 (0.00)*** StdDevDOI  0.03 0.71 (0.48) MTGS þ 0.03 1.14 (0.25) RETYRS þ 0.05 2.04 (0.04)** Auditor þ 0.22 2.97 (0.00)*** AUDSIZE ? 0.19 2.16 (0.03)** AUDMEET ? 0.10 3.59 (0.00)*** AUDIND þ 0.42 0.21 (0.83) COMPSIZE ? 0.02 0.26 (0.79) COMPMEET ? 0.11 3.15 (0.00)*** COMPIND þ 1.78 1.72 (0.09)* DEBITDA þ 0.12 2.71 (0.00)*** INDUSTRYc ? 2 R 0.23 F 16.21*** N 1332 Test of validity of instruments: Sargan Statistics: Chi-square (6) ¼ 8.02, p-value ¼ 0.237 Wald C-Statistics: Chi-square (6) ¼ 6.65, p-value ¼ 0.354

VIF (5) 11.71 3.47 3.02 4.38 9.74 4.97 4.36 2.14 1.84 1.28 3.22 1.25 1.54 1.15 1.68 1.05 2.15 1.21 1.23 2.00 1.22 1.20 1.02

Coefficienta B (6)

T-values (p-values)b (7)

VIF (8)

10.47 0.68 0.49 0.59 0.04

4.73 (0.00)*** 4.14 (0.00)*** 3.98 (0.00)*** 2.42 (0.02)** 4.34 (0.00)***

1.46 1.12 1.20 1.14

0.39 0.06 0.02 0.21 4.45 0.02 0.03 0.03 0.15 0.20 0.10 0.81 0.03 0.13 1.65 0.13

4.15 (0.00)*** 3.47 (0.00)*** 3.74 (0.00)*** 3.18 (0.00)*** 6.83 (0.00)*** 0.73 (0.47) 1.21 (0.23) 2.11 (0.03)* 1.84 (0.07)* 2.08 (0.04)** 3.38 (0.00)*** 0.49 (0.62) 0.34 (0.73) 3.26 (0.00)*** 1.35 (0.18) 2.93 (0.00)***

2.06 1.81 1.25 1.20 1.23 1.67 1.54 1.34 1.05 2.14 1.20 1.17 2.00 1.22 1.20 1.01

0.21 18.24*** 1332 Test of validity of instruments: Sargan Statistics: Chi-square (3) ¼ 2.28, p-value ¼ 0.516 Wald C-Statistics: Chi-square (3) ¼ 2.82, p-value ¼ 0.421

The dependent variable is Tobin’s Q. Tobin’s Q is the ratio of the market value of assets to the replacement costs of assets. CAP is the board capital as measured by the number of directors officer divided by total numbers of directors on the board; DUALITY is an indicator of whether or not a firm’s CEO is also the chair of the board of director (CEO is equal to 1 if the CEO is also the chair of the board and 0 otherwise); DEP is the board dependence as measured by number of inside directors divided by total number of directors on the board; MSOWN is the ratio of common shares owned by management to total common shares outstanding; CAP*DUALITY is the interaction between CAP and CEO; CAP*DEP is the interaction between CAP and DEP; CAP*MSOWN is the interaction between CAP and MSOWN; ASSETS is the size of the firm as measured by a logarithmic function of the firm’s total assets; BSIZE is the number of directors on the board; INST is the ratio of number of shares owned by institutional shareholders to total outstanding common shares. RD/Sales is the ratio of R&D expenditures to total sales. Debt/TA is the ratio of total debt to total assets. StdDevDOI is the standard deviation of changes in operating income. MTGS is the number of board meetings held during the year. RETYRS ¼ number of years of credited services the named executive officers have under the firm’s pension plan; Auditor is an indicator of whether a firm is audited by a big-four audit firm or not (Auditor is equal to 1 if the firm is audited by a big-four accounting firm and 0 otherwise); AUDSIZE is the number of members on the audit committee; AUDMEET is the number of audit committee meetings; AUDIND is the ratio of outsiders to total number of members on the audit committee; COMPSIZE is the number of members on the compensation committee; COMPMEET is the number of compensation committee meetings; COMPIND is the ratio of outsiders to total number of members on the compensation committee; DEBITDA is the change in earnings before interest, tax, depreciation and amortization (EBITDA); INDUSTRY is the four-digit primary industry classification.. a The coefficients are reported in the unstandardized form. b The p-values are based on two-tailed tests, except in cases of directional prediction, where we use a one-tailed test.*,**, and***, denote significance levels at 0.10, 0.05, and 0.01 respectively. c None of the industry variables were significant (not reported in this table).

and sales growth as instrumental variables.17 Previous research (e.g., Black et al., 2006; Ittner & Larcker, 2001) suggest that these six variables are plausible instruments for corporate governance since there is no a priori reason for these variables to be endogenous to corporate governance or firm performance.18 The results are reported in Table 7. The results are qualitatively similar to those reported in Table 5.

17 The analyses were performed using the ivreg2 command with the re option in STATA. We use the endogenous covariates and instrumental variable regression procedures with the re option. We test the validity of our instruments using the endogtest option. 18 We use the Sargan test to investigate whether the instrumental variables are uncorrelated with the error term. The results indicate that the null hypothesis of zero correlation between the instruments and the error term cannot be rejected (Chi-square (6) ¼ 8.02, p ¼ 0.237). Furthermore, we use the Wald C-statistics to test whether the instrumental variables are sufficiently correlated with the endogenous variables (test for under-identification). The results indicate that the null hypothesis of sufficient correlation between the instruments and the endogenous variables cannot be rejected (Chi-square (6) ¼ 6.65, p ¼ 0.354).

Please cite this article in press as: Jermias, J., & Gani, L., The impact of board capital and board characteristics on firm performance, The British Accounting Review (2013), http://dx.doi.org/10.1016/j.bar.2013.12.001

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Table 8 2SLS results of ROA on board capital, managerial share ownership, board dependence, CEO duality, and control variables. Variable (1)

Prediction (2)

Results Regression 1 (with interaction terms) Coefficienta B (3)

T-values (p-values)b (4)

Intercept ? 9.85 2.34 (0.02)** CAP þ 2.39 3.26 (0.00)*** DUALITY  4.41 2.93 (0.00)*** DEP  1.74 2.19 (0.03)** MSOWN þ 0.09 3.32 (0.00)*** CAP*DUALITY þ 6.67 2.30 (0.02)** CAP*DEP þ 5.92 2.34 (0.02)** CAP*MSOWN þ 0.20 2.73 (0.01)** ASSETS  1.78 2.57 (0.01)** BSIZE ? 0.37 2.21 (0.03)** INST þ 0.05 2.76 (0.01)** RD/Sales þ 28.80 6.06 (0.00)*** Debt/TA  15.17 3.22 (0.00)*** StdDevDOI  0.14 2.04 (0.04)** MTGS þ 0.16 1.22 (0.22) RETYRS þ 0.02 1.73 (0.08)* Auditor þ 1.77 1.92 (0.05)* AUDSIZE ? 0.52 2.74 (0.01)** AUDMEET ? 0.14 1.67 (0.09)* AUDIND þ 3.49 1.30 (0.19) COMPSIZE ? 0.67 0.98 (0.34) COMPMEET ? 0.65 2.36 (0.02)** COMPIND þ 2.35 1.72 (0.09)* DEBITDA þ 0.51 1.94 (0.05)* INDUSTRYc ? R2 0.19 F 8.69*** N 1332 Test of validity of instruments: Sargan Statistics: Chi-square (6) ¼ 9.10, p-value ¼ 0.168 Wald C-Statistics: Chi-square (5) ¼ 6.96, p-value ¼ 0.224

Regression 2 (without interaction terms) VIF (5) 11.71 3.47 3.02 4.38 9.74 4.97 4.36 2.14 1.84 1.28 3.22 1.25 1.54 1.15 1.68 1.05 2.15 1.21 1.23 2.00 1.22 1.20 1.02

Coefficienta B (6)

T-values (p-values)b (7)

VIF (8)

14.65 2.27 1.93 0.83 0.10

3.24 (0.00)*** 3.26 (0.00)*** 2.40 (0.02)** 2.14 (0.03)** 2.90 (0.00)***

1.46 1.12 1.20 1.14

1.72 0.34 0.06 25.61 15.27 0.11 0.17 0.07 1.75 0.42 0.21 0.30 0.10 0.64 2.36 0.56

2.61 (0.00)*** 2.15 (0.03)** 3.27 (0.00)*** 6.06 (0.00)*** 3.35 (0.00)*** 1.73 (0.08)* 1.13 (0.26) 1.16 (0.25) 1.93 (0.05)* 1.61 (0.11) 2.03 (0.04)** 1.02 (0.31) 1.07 (0.29) 2.34 (0.02)** 1.36 (0.17) 2.67 (0.00)***

2.06 1.81 1.25 1.20 1.23 1.67 1.54 1.34 1.05 2.14 1.20 1.17 2.00 1.22 1.20 1.01

0.18 9.91*** 1332 Test of validity of instruments: Sargan Statistics: Chi-square (3) ¼ 2.97, p-value ¼ 0.396 Wald C-Statistics: Chi-square (3) ¼ 2.89, p-value ¼ 0.409

The dependent variable is ROA. ROA is measured as income before extraordinary items divided by total assets; CAP is the board capital as measured by the number of directors who also serve as a CEO/board of directors of S&P 500 firms/university professor/government officer divided by total numbers of directors on the board; DUALITY is an indicator of whether or not a firm’s CEO is also the chair of the board of director (CEO is equal to 1 if the CEO is also the chair of the board and 0 otherwise); DEP is the board dependence as measured by number of inside directors divided by total number of directors on the board; MSOWN is the ratio of common shares owned by management to total common shares outstanding; CAP*DUALITY is the interaction between CAP and CEO; CAP*DEP is the interaction between CAP and DEP; CAP*MSOWN is the interaction between CAP and MSOWN; ASSETS is the size of the firm as measured by a logarithmic function of the firm’s total assets; BSIZE is the number of directors on the board; INST is the ratio of number of shares owned by institutional shareholders to total outstanding common shares. RD/Sales is the ratio of R&D expenditures to total sales. Debt/TA is the ratio of total debt to total assets. StdDevDOI is the standard deviation of changes in operating income. MTGS is the number of board meetings held during the year. RETYRS ¼ number of years of credited services the named executive officers have under the firm’s pension plan; Auditor is an indicator of whether a firm is audited by a big-four audit firm or not (Auditor is equal to 1 if the firm is audited by a big-four accounting firm and 0 otherwise); AUDSIZE is the number of members on the audit committee; AUDMEET is the number of audit committee meetings; AUDIND is the ratio of outsiders to total number of members on the audit committee; COMPSIZE is the number of members on the compensation committee; COMPMEET is the number of compensation committee meetings; COMPIND is the ratio of outsiders to total number of members on the compensation committee; DEBITDA is the change in earnings before interest, tax, depreciation and amortization (EBITDA); INDUSTRY is the four-digit primary industry classification. a The coefficients are reported in the unstandardized form. b The p-values are based on two-tailed tests, except in cases of directional prediction, where we use a one-tailed test.*,**, and***, denote significance levels at 0.10, 0.05, and 0.01 respectively. c None of the industry variables were significant (not reported in this table).

Second, we use ROA as the dependent variable to investigate the robustness of our study to a different specification of firm performance.19 The results are reported in Table 8. As shown in Table 8, the results are consistent with those reported in Table 4 (based on Tobin’s Q as a measure of performance). 6. Conclusions, limitations, and implications for future research This paper has investigated the influence of board capital on the relationship between CEO duality, board dependence, managerial share ownership and performance. Consistent with our prediction, board capital mitigates the negative effects of

19 We also performed additional analyses using Market to Book ratio and return on equity (not reported in this paper) as measures of performance. The results are qualitatively similar to those reported in this paper.

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both CEO duality and board dependence on performance. Further, the results show that firms in which the CEO is also the chairman of the board perform poorer than those in which the CEO is not the chairman of the board. However, the performance disadvantage decreases as the level of board capital increases. This suggests that if there are more capable individuals serving on the board of directions, a CEO who is also the chairman of the board might be discouraged to misuse his/her power. Prominent and capable board members might also effectively limit opportunities for the CEO/chairman of the board to engage in opportunistic behavior. It is interesting to note that board capital has a direct and positive impact on performance. As shown in Table 7, column (7), the main effect of board capital on performance is positive and significant (t ¼ 3.30, p < 0.01). This result supports the resource dependence theory proposition that a high quality board of directors will support the firm by providing it with advice and counsel, legitimacy, channels of communications with external organizations, and access to outside resources (Pfeffer & Salancik, 1978). This result is also consistent with results reported by previous empirical studies (e.g., Dalton et al., 2003; Hillman et al., 1999). The results of this study, however, should be interpreted in light of four limitations. First, we measure board capital indirectly, as based on our perception of what constitutes highly capable board director. This proxy might not represent board member’s actual quality in terms of how they perform their duties. Future studies might use more direct measures of board capital, such as the accuracy and quality of the advice given by the board. However, such direct measures are difficult to obtain. Moreover, our measurement of board capital is supported by previous studies (e.g., Baysinger & Butler, 1985; Hillman et al., 1999; Rosenstein & Wyatt, 1994) which suggest that the quality of decisions made by the board of directors is positively associated with directors’ membership in other influential organizations. Second, although the findings of this study suggests that a disproportionately high number of inside directors has a negative association with firm performance, some authors argue that it might not be necessary to divide boards into insiders and outsiders in order to evaluate the impact of board directors on firm performance. For example, Westphal (1999) argues that firms benefit from both insider and outsider directors. He proposes that rather than dividing the two groups of directors, firms might benefits from employing a team development approach that unifies the two groups into a single, cohesive group and maximizes their different expertise and skills set. Third, our sample firms consist of large U.S firms with international operations and tend to be the dominant players in their respective industries for the period of 1997–2004. Therefore, the results of our study might not be generalizable to small firms which tend to have different characteristics as those of our sampled firms or other periods with different governance regulations. Finally, we assume that outside directors are in a better position than inside directors to protect shareholder interests from managerial opportunism because they are independent of management’s influence and do not have any business connections with the firms (Fama & Jensen, 1983). However, in reality, it is extremely difficult, if not impossible, to observe that the outside directors are, in fact, completely independent of the firms. Therefore, the results of this study should be interpreted by considering this limitation. 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