Impact of Corporate Governance on Bankruptcy Risk

This essay examines the impact of corporate governance mechanisms on the bankruptcy risks of business firms. It analyzes the findings of previous research studies and discusses the importance of an efficient corporate governance system in reducing the risk of corporate failure.

Managerial Finance
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Abstract
The objective of this essay is to demonstrate the need of analyzing non-financial
information in addition to financial information by the investors for analyzing the default risk of
a business firm. In this context, the paper has specifically examined the impact of corporate
governance mechanisms on bankruptcy risks of business firms. This has been carried out by the
selection of about 10 credible research journal articles on the issue and comparing their findings
to derive specific results. The views and opinions of different authors presented in previous
researches have been analyzed in detail in the essay to analyze the research issue in an adequate
manner.
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Introduction
The business corporations develop and publish the financial statements for disclosing
their financial information and facilitating the decision-making process of the investors. The
analysis of the financial statements has been largely used by the investors for predicting the
probability of bankruptcy of firms. However, the reliability of the financial statements to predict
the future growth prospects of a firm has come under criticism since the occurrence of corporate
scandals such as Enron and Worldcom. These corporate scandals have highlighted that the
information disclosed within the financial statements are not reliable for taking major investment
decisions as they can be manipulated by the business managers for the sake of depicting higher
profitability of the firms. As such, it significant researches have been done on indentifying other
non-financial information in addition with the financial information that can be used for taking
investment decisions.
This is required so that the investment decisions are not merely based on the financial
information such as accounting ratios or stock price but also consider other factors that provide a
depiction of its internal environment. In this context, the present essay undertakes a literature
review in respect of the impact of the corporate governance on the bankruptcy risk. The existing
literature tends to find the importance of developing an efficient system of corporate governance
within a firm for reducing the risk of corporate failure. Although, the existing studies offer
evidences to support the relation between corporate governance and the risk of bankruptcy, yet it
need to be analyzed in detail for understanding that an adequate governance system internally
within a firm is essential to save a firm from the verge of bankruptcy.
Impact of Corporate Governance System on the Bankruptcy Risk
Several research studies have found evidence supporting the relation between the
corporate governance system of a firm and the risk of bankruptcy. In this context, Mokarami and
Motefares (2013) have adopted the use of various corporate governance measures such as board
size, CEO replacement and CEO dual position on the bankruptcy risk of a firm. As per the study,
the corporate governance system can be stated to be an established system of rules and
procedures that are used for developing a control system over the business procedures and
protecting the interest of the shareholders. The presence of an effective corporate governance
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system is essential to attain a balance between managers and shareholders interest. As such, the
board of directors holds major responsibility of attaining balance between shareholders and
business manager’s interests as they are responsible for developing the different policies and
procedures of a company’s corporate governance system.
Therefore, it is essential that the level of board of director’s independence is very
essential to overcome the possibility of occurrence of any conflict. The research suggests that the
level of independence of board of directors can be measured on the basis of dual position of
CEO, size of Board and replacement of CEO. The dual position of the CEO refers that the CEO
and chairperson should be different from each other for increasing the control of bard on a firm
operation. The size of board should be such so that it is easily controllable by CEO and also
provides a combination of various skills and expertise to adequate addresses their various roles
and responsibilities. Also, CEO replacement has a negative impact on the activities of a firm as it
weakens the organizational effectiveness and lead to rise in uncertainty and conflict. The
research has adopted the use of survival analysis method which includes selecting a sample of 76
firms listed in Tehran Stock Exchange for testing the hypothesis by the application of regression
analysis. It has been inferred from the research carried out that there exists a positive
replacement between the CEO replacement and bankruptcy whereas there does not exist a
significant relation between the board size and CEO’ dual position on the bankruptcy of firms.
Similarly, in this context Descender (2009) has proposed a theoretical model for providing an
understanding of the board of director’s composition on the firm performance. It has been
proposed by the researcher that the presence of board having diverse skills and duality are
important for having a sportive impact on the firm performance level.
Consistent with the findings of prior studies, Hanani and Dharmastuti (2015) revealed
that there is a large influence of the corporate governance mechanisms on the potential for
bankruptcy of a firm. Similarly with the data collection and analysis method adopted in the
previous research, this study has also adopted the use of a linear regression model to analyze the
data collected of 30 listed firms from the consumer goods sector of the Indonesia Stock
Exchange during the 2010-2012 financial period. Contrary to the expectation, it has been stated
by the findings of the research that independence of the board of directors has a positive impact
on the bankruptcy risk of a firm. However, the research has also posed the finding that there is
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negative effect of other corporate governance mechanisms such as audit, remuneration or
nomination committee on the potential for bankruptcy. The researchers in this study have stated
that presence of a smaller board that can be easily controlled by the CEO reduces the possibility
of occurrence of bankruptcy within the firm. Thus, it can be stated that the findings of the
research are in contrast with the previous study findings and have proposed different measures of
the corporate governance system that impacts the potential of bankruptcy within a firm.
In this context, the research study undertaken by the Rezaee (2016) contributes to the
literature by depicting the dependence of the corporate governance mechanisms on financial
distress risk and earnings performance of a firm. It has been proposed by the research that
corporate governance has a major role in developing quality financial reports and promoting the
efficiency of the financial markets. The occurrence of the corporate scandals of Enron and
WorldCom has caused the development of new set of corporate governance measures for the
public companies. The act has provided the corporate governance measures to be adopted by
firms for overcoming the financial misconduct and scandals. The researchers has carried out
more refined test in this context by employing the use of Zscore and Oscore model to measure
the relation between the financial distress risks of selected Chinese firms with that of CGF index.
The research method adopted is similar to the previous research studies discussed of developing
research hypothesis to determine the impact of corporate governance on the performance of a
firm. While most studies adopt to gather data with the use of sampling research instruments, the
researcher in this study have gathered the data from CGF index of the Corporate Governance
Research Center having the index of Chinese firm’s corporate governance in finance. The
financial data is collected from the China Stock Market Accounting Research Database. It has
been revealed from the research carried out that firms having high CGF index are associated with
lower financial distress risk and thereby delivering better financial and market performance. The
findings have been further supported by the secondary data finings of the research which has
stated that good corporate governance ensures the accountability of the board of directors and
management to the stakeholders. Thus, it leads to establishment of ethical framework within a
firm which managers holds the responsibility of maximizing the interest of the stakeholders.
Several studies have provided direct evidence of the specific corporative governance measures
that impacts a firm performance while the research has paid less attention to identifying the
influence of difference corporate governance factors on the performance of a firm.
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Consistent with the findings of prior studies, Mathew and Archbold (2016) has revealed
that board attributes have a significant impact on the credit risk level of a firm. The research
study intends to find the impact of board size, percentage of non-executive directors, a powerful
CEO, equity ownership and institutional ownership on the risk level of a firm. However, unlike
the previous research studies discussed in the literature this research study has not adopted the
use of collecting primary data for analyzing the research issue in the context. The study on the
contrary has adopted the use of secondary data accessed from Bloomberg and Morningstar
databases of the companies listed on FTSE 350 index of the UK from the financial period 2005
to 2010. The data collected has been analyzed statistically for developing the research findings.
The research has also depicted that the composition of Board has a significant impact on the risk
level of a firm. Unlike to the findings of the Hanani and Dharmastuti (2015), it has been
proposed by the researcher that a decrease in the size of board tends to increase the firm risk
level. The presence of a higher board executive equity ownership and the institutional investors
holding the equity of a firm tend to increase the total risk of a firm. Thus, the research has also
validated that there is an effect of the corporate governance measures on the risk level of a firm.
Okiro, Aduda and Omoro (2015) have also conducted a research in this context to
examine the relation between the effects of corporate governance on the performance of firms.
The research has developed a secondary analysis by adopting the use of agency theory
framework for examining in detail the impact of good corporate governance on the firm
performance. The primary data has been gathered through the use of survey method similarly
with that of the research of Mokarami and Motefares (2013) and Hanani and Dharmastuti (2015)
by selecting the 98 listed companies and carrying out a census survey on them between the
financial periods of 2009-2013. The data collected has been analyzed with the use of multiple
regression analysis to test the research hypothesis developed. It has been inferred from the
research as similar to the previous research findings that there does exist a positive significant
impact of corporate governance on firm performance level. In addition, the results suggest that
there is a positive significant effect of capital structure that is amount of debt financing, on the
corporate governance and the financial performance of a firm. The research has provided a new
perspective of the relation between capital structure, firm performance and the corporate
governance system. The corporate governance systems in addition with the capital structure
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decisions have an effect on the value of a firm by having an influence on the management
operations and performance level.
In contrast, Erkens, Hung, Matos (2012) have argued that corporate governance measures
adopted by a firm could result in increasing the risk of occurrence of financial crisis within a
firm. This has been analyzed by investigating the influence of corporate governance on financial
firm’s performance during the period of financial crisis of the year 2007-2008. In this context,
the research has accessed the database of about 300 financial firms from 30 countries that have
experienced a major impact of the financial crisis. It has been inferred from the research that the
firms having independent boards and institutional ownership have poor returns of stock during
the period of financial crisis. This is largely on account of the increasing use of equity capital by
the firms during the period of financial crisis that leads to negatively impact the firm
performance. The evidence in favor of the above findings has also been proposed by the research
study of the Wang and Lin (2010) that has examined the dataset of about 201 bankrupt and 2,751
non-bankrupt firms of the US for the financial period between the years 1990-2006. The mixed
evidence has been proposed by the research that has stated that firms having strong governance
reduce the probability of financial distress but at a decreasing rate.
The fact has been further supported by the research carried out by the Postnova (2012)
and it has been proposed in the study that presence of a more shareholder oriented corporate
governance system can lead to taking wrong decisions that could negatively impact the value of
a firm. The fact has been examined by the use of statistical measures that has evaluated the effect
of governance on the credit risk by the use of CGQ score model. It has been concluded by the
research findings that the quality of corporate governance does not have impact on the credit
risk. However, this fact has been contradicted by the research carried out by Eling and Marek
(2011) there exist a negative relation between corporate governance and risk taking behavior of
the business managers. This is because higher level of compensation and increased monitoring
reduces the risk taking activities within a firm. The research has adopted the use of developing a
structural equation model to analyze the different governance factors impact on the risk taking on
specific insurance firms.
Conclusion
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The overall literature findings derived from the analysis of the recent studies has raised
doubt on the impact of corporate governance system on the potential for bankruptcy of a firm.
The currents state of literature can be said to be deficient in inferring the significant impact of the
corporate governance system on the firm risk taking behavior and its long-term value. Some
studies have identified positive relation whereas some have stated that there is no significant
influence of the corporate governance factors on the potential risk of bankruptcy of a fir. As
such, there is present a need for future studies to be carried out in his context for determining the
factors of corporate governance system that can reduce the potential of bankruptcy within a firm
so as to protect the interests of the stakeholders of a firm.
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References
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Rezaee, Z. 2016. Does Corporate Governance Matter? Evidence from New Chinese Corporate
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