The relationship between electricity consumption, electricity prices and GDP in Pakistan

Corporate Ownership & Control / Volume 10, Issue 4, 2013, Continued - 4 КОРПОРАТИВНАЯ СОБСТВЕННОСТЬ И КОНТРОЛЬ CORPORATE OWNERSHIP & CONTROL Postal Address: Почтовый адрес редакции: Postal Box 36 Sumy 40014 Ukraine Почтовый ящик 36 г. Сумы, 40014 Украина Tel: +380-542-611025 Fax: +380-542-611025 e-mail: alex_kostyuk@mail.ru alex_kostyuk@virtusinterpress.org www.virtusinterpress.org Тел.: 38-542-611025 Факс: 38-542-611025 эл. почта: alex_kostyuk@mail.ru alex_kostyuk@virtusinterpress.org www.virtusinterpress.org Journal Corporate Ownership & Control is published four times a year, in September-November, December-February, March-May and June-August, by Publishing House “Virtus Interpress”, Kirova Str. 146/1, office 20, Sumy, 40021, Ukraine. Журнал "Корпоративная собственность и контроль" издается четыре раза в год в сентябре, декабре, марте, июне издательским домом Виртус Интерпресс, ул. Кирова 146/1, г. Сумы, 40021, Украина. 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Corporate Ownership & Control Корпоративная собственность и контроль ISSN 1727-9232 (printed version) 1810-0368 (CD version) 1810-3057 (online version) ISSN 1727-9232 (печатная версия) 1810-0368 (версия на компакт-диске) 1810-3057 (электронная версия) Certificate № 7881 Свидетельство КВ 7881 от 11.09.2003 г. Virtus Interpress. All rights reserved. Виртус Интерпресс. Права защищены. 377 за информацией Corporate Ownership & Control / Volume 10, Issue 4, 2013, Continued - 4 CORPORATE OWNERSHIP & CONTROL Volume 10, Issue 4, 2013, Continued - 4 CONTENTS THE RELATIONSHIP BETWEEN EARNINGS QUALITY, CONTROL MECHANISMS OF CORPORATE GOVERNANCE, AND FUTURE STOCK PRICE RETURNS. THE CASE OF THE NETHERLANDS 369 Elisabetta Basilico, Hugh Grove LEADERSHIP STYLE PERSPECTIVE AND JOB SATISFACTION: A DEVELOPING ECONOMY 380 Jeevarathnam Parthasarathy Govender, Hari Lall Garbharran, Roland Loganathan THE RELATIONSHIP BETWEEN ELECTRICITY CONSUMPTION AND ECONOMIC GROWTH IN BOTSWANA 390 Kafayat Amusa, Temitope L. A. Leshoro COMMUNICATION CHANNELS AND INTERPERSONAL COMMUNICATION BETWEEN SOUTH AFRICAN AND GERMAN BUSINESS PARTNERS 399 Oleg Scheming, Roger B Mason THE OWNERSHIP STRUCTURE, THE BOARD OF DIRECTORS AND THE QUALITY OF ACCOUNTING INFORMATION 410 Nejla Ould Daoud Ellili CORPORATE SOCIAL RESPONSIBILITY INDEX FOR UKRAINIAN BANKS: THE ESSENTIALS FOR IMPLEMENTATION 424 Alexander Kostyuk, Olena Kostyuk, Yaroslav Mozghovyi, Yana Kravchenko 368 Corporate Ownership & Control / Volume 10, Issue 4, 2013, Continued - 4 The Relationship between Earnings Quality, Control Mechanisms of Corporate Governance, and Future Stock Price Returns. The case of the Netherlands Elisabetta Basilico*, Hugh Grove** Abstract This article extends prior research on the relation between earnings quality (assessed by accruals) and future stock price returns and adds new research on the relationships between direct and indirect corporate governance mechanisms of control with accruals and future stock price returns. We study public companies of the Netherlands and find the presence of mispricing associated with very high and very low accruals. We also find evidence that direct corporate governance control mechanisms, such as the existence of separate, independent, and skilled audit committees, are related to higher earnings quality and higher future stock price returns. Keywords: Corporate Governance, Earnings Quality, Earnings Management, Accruals, Stock Returns * USG, University of St. Gallen, St. Gallen, Switzerland E-mail: elisabetta.basilico@yahoo.com ** School of accountancy, Daniels College of Business, University of Denver, Denver, CO, USA E-mail: hgrove@du.edu 1. Introduction In this article, we investigate whether relationships or links exist between a measure of aggregate accruals (Richardson, 2009), a set of corporate governance mechanisms, which capture both direct (Audit Committee level) and indirect (Board of Directors level) control over the financial reporting process, and future stock price returns. We examine public companies of the Netherlands for two reasons. First, we build on prior research showing that differences in accruals indicate mispricing in the Dutch stock market. Second and more importantly, while the Netherlands is ranked as one European country with among the best corporate governance systems1, it also presents an interesting feature in the Dutch corporate governance code for public companies (apply or explain clause). Specifically, we ask the general research question of whether, given differences in terms of direct and indirect corporate governance control mechanisms among extreme deciles of accruals accounting for Dutch companies, it is possible to improve a pure “earnings quality” stock selection tool. Our study contributes to the international finance and corporate governance literature as well as to the investment community. In fact, by investigating a European country it has the potential to provide additional insights into the challenges of accounting and corporate governance based anomalies to capital market efficiency and their pervasiveness outside the U.S. Equally important are 1 insights for investors, portfolio managers, and analysts interested in developing proxies for aggressive accounting or corporate governance practices for European stocks. Financial analysts, portfolio managers and investors are in the business of processing and interpreting companies’ information where the goal is to determine a fair value. An important step in the determination of a firm’s value in the assessment of earnings and the quality of earnings as an indication of current and future performance. The remainder of the article proceeds as follows: Section 2 summarizes the related literature. Section 3 develops the hypothesis and the research questions. Section 4 describes the research methodology. Section 5 provides the empirical results for Dutch public companies and Section 6 concludes. 2 Literature Review 2.1 Accruals Mispricing Basilico and Johnsen (2012) study the presence and magnitude of the accruals anomaly in nine European countries, with particular interest in finding which countries maintain the mispricing after the introduction of International Financial Reporting Standards (IFRS) in 2005. The Netherlands is one of the countries analyzed and the authors find that the country maintains the mispricing for the period from 2006 till 2010. Heydrick and Struggles, 2011 369 Corporate Ownership & Control / Volume 10, Issue 4, 2013, Continued - 4 2.2 Corporate Governance A vast body of literature acknowledges the importance of corporate governance mechanisms to improve financial reporting quality and past literature has demonstrated that good governance helps to reduce the risk of financial reporting problems. According to Hermann (2003, p.44), “Good governance goes in-hand with reduced risk of financial reporting problems and other bad accounting outcomes.” Researchers found evidence on the association between poor governance and poor quality of financial reporting, including earnings manipulation, financial restatements and frauds (Beasley, 1996; Dechow et. al., 1995; Dechow et al., 2002; Peasnell et al., 2000; Klein, 2002; Kao and Chen, 2004). Consequently, monitoring associated with sound governance restricts opportunities for the manipulation of earnings. These early studies focus mainly on the role of the entire Board of Directors as a monitoring tool and the role of non-executive directors in enhancing the quality and integrity of financial reporting information. According to agency theory (Fama and Jensen, 1983; Shleifer and Vishny, 1997), boards with a majority of non-executive directors reduce agency conflicts because non-executives provide an effective monitoring tool for the board. The inclusion of outside directors (typically expert managers from other large organizations who are also independent) increases the boards’ ability to be more efficient in monitoring top management and any related collusion practice. Hence, independent directors become a potentially powerful governance mechanism to mitigate agency costs and protect shareholders wealth (Li, 1994). Other studies, like Davidson et al. (2005), add variables such as the presence of an audit committee and the external audit function and provide evidence of the association of such variables with the reliability of reported earnings. Additionally, the literature investigates observable characteristics of these mechanisms. As studied in the past, key characteristics of the Board of Directors are the inclusion of “independent” directors and the separation of the roles of Chief Executive Officer (CEO) and the Chairman of the Board (Koh et al., 2007; Basilico and Grove, 2008). An interesting characterization of independence comes from the finance literature and relates to school ties (Cohen et al., 2010), which can occur among directors. The idea here is to study whether social networks affect governance matters. On the other hand, key characteristics for the audit committee are size, independence, expertise and diligence (De Zoort and Salterio., 2001; Klein 2002; Krishnan, 2005). Finally, an indication of good governance for the external audit function is the engagement of a top tier audit firm (Cohen et al., 2002). Thus, independence is an important factor at the audit committee level too. Consequently, the expectation is that an independent audit committee should decrease the level of earnings management. A recent article by Kent et al. (2010) studies the association between corporate governance mechanisms and accruals quality. Specifically, the authors derive measures of discretionary and innate (nondiscretionary) components of accruals and regress them against corporate governance characteristics. Their sample is made up of listed Australian companies in 2004. They find a relationship between the use of a Big 4 audit firm and a larger audit committee and discretionary accruals while innate accruals are related to an independent Board of Directors and to a larger and more independent audit committee as well as the use of a Big 4 audit firm. 3 Theory and Research Questions We extend the work by Kent et.al (2010) by not only studying the relationship between corporate governance quality indicators and accruals (a proxy for earnings quality) but also by investigating the relationships between these corporate governance indicators and future stock returns. From a theoretical standpoint, this article contributes to both agency theory and capital markets efficiency theory. From a practical point of view, this article attempts to verify whether it is possible to improve earnings quality ratings with corporate governance ratings to form a better stock selection screening tool. One way for managers to manipulate earnings is to manipulate accruals. Accruals are the difference between firms’ accounting earnings and its underlying cash flow. Under accrual accounting basis (as opposed to cash accounting), revenues are recorded when a good or service has been provided to the customer (not when cash is collected) and expenses are reductions in net assets associated with the creation of those revenues (not when cash is paid). While we cannot completely discard the usefulness of accrual accounting since it provides more timely and relevant information for decision making than cash accounting, this article argues that it is important to discern earnings manipulation in the company performance evaluation process. Building on prior research which investigated the impact of legal, governance and accounting differences among European countries (Basilico and Johnsen, 2012), we use Dutch public companies since the Netherlands represents an interesting corporate governance framework. Concerning corporate governance, board members and board committees should provide controls that ensure compliance with reporting requirements (Dechow et al., 1995; Davidson et al., 2005). Prior research suggests that monitoring associated with sound governance lowers the instances of earnings manipulation (Klein, 2002; 370 Corporate Ownership & Control / Volume 10, Issue 4, 2013, Continued - 4 Davidson et al., 2005; Koh et al., 2007). Following Koh et al. (2007), I distinguish between governance structures that have a direct role in the financial reporting process (audit related governance) and those, which have an indirect role (board related governance). This distinction is also highlighted as an important one in the OECD Principle VI.D.72. The Netherlands constitutes an interesting case from a governance angle because it is a European country with a stellar corporate governance system3, but at the same time, and similarly to other countries, the Dutch corporate governance code (the Tabaksblat Code) contains an “apply-or explain” principle, offering public companies the possibility to deviate from the corporate governance code as long as any such deviations are explained. To the extent that such deviations are approved by a general meeting of board members, the company is deemed to be in compliance. Therefore, it is important to study corporate governance control mechanisms since the correct mechanisms may not be fully in place, due to this exception in the Dutch code. As such, the main research objectives of this article are: 1. To investigate whether there are significant differences in terms of direct and indirect corporate governance control mechanisms within the extreme groups of high and low accruals. 2. To investigate whether there is a relationship between levels of accruals and direct (Audit Committee) and indirect (Board of Directors) corporate governance mechanisms of control. 3. To investigate whether there is a relationship between direct (Audit Committee) and indirect (Board of Directors) corporate governance mechanisms of control and future stock returns. 4 Data and Sample Statistics The sample consists of public companies whose country code is the Netherlands as established by the International Standards Organization and with data available on the Standard and Poor’s Global Vantage database. We consider both active and inactive companies4 as of December 2009 and, similar to prior research studies, we exclude financial firms (those with GICS5 sector 40) from the final sample because of peculiarities in the accruals of such firms. Financial data were collected for the year 2010 using the Standard and Poor’s Global Vantage Database while corporate governance variables were hand collected using the Reuters’ People database as well as individual company’s proxy statements. To measure the accruals mispricing we use a measure introduced by Richardson (2009): the “balance sheet based accruals ratio.” It is calculated by measuring the net change across all noncash accounts. Therefore, aggregate accruals are simply the change in net assets (net of cash and debt related accounts) from the start to the end of the period. Further, this measure needs to be made comparable across companies by adjusting for differences in company size. This is done by deflating the aggregate accrual measure by the average value of Net Operating Assets (NOA). The ratio is calculated as follows: Accruals Ratio BS = (1) Where: NOAt = Net Operating Assets at time t NOAt-1= Net Operating Assets at time t minus 1 NOA = (Total Assets – Cash and Short Term Investments) – (Total Liabilities – Long Term Debt – Debt in Current Liabilities) In addition to these balance sheet items, we calculate 1, 3 and 6 months future holding period returns (1MHPR, 3MHPR, 6MHPR) by compounding monthly returns. According to Hilb (2008), all members of the board (excluding the CEO and possibly one other member of top management) should be independent in order to properly fulfill their fiduciary functions. As Hilb further points out, there is an important distinction between nonexecutive board members and independent board members, e.g., all independent directors are nonexecutive, but not all nonexecutives are independent. Accordingly, we use the following corporate governance variables. In particular, board independence is measured with four variables: CEO Duality: a dummy variable, coded 1 when the CEO is not the Chairman of the Board and coded 0 otherwise, First Level of Board Independence: a dummy coded 1 when there are no more than two executives sitting on the Board and coded 0 otherwise, Second Level of Board Independence: a dummy coded 1 when the majority of the board members are independent according to comprehensive definition of independence (see the British PIRC 6 report, Clarke 1998:122; Hilb 2008:59) including not having directorships in common with other directors, Third Level of Board Independence: a dummy coded 1 when no directors share a school tie (Cohen et al., 2002) and coded 0 otherwise. 2 OECD stands for “Organization for Economic Co-operation and Development” 3 Heydrick and Struggles, 2011 4 I look at both active and inactive companies to control for survivorship bias. 5 The Global Industry Classification Standards (GICS) is collaboration between Standard & Poor’s and Morgan Stanley Capital International. 6 PIRC is the U.K.'s leading independent research and advisory consultancy providing services to institutional investors on corporate governance and corporate social responsibility. 371 Corporate Ownership & Control / Volume 10, Issue 4, 2013, Continued - 4 The Audit Committee independence is instead measured by one variable: Audit Committee Independence: a dummy coded 1 if all members of the audit committee are independent according to the definition previously mentioned. Further, we collect and measure whether both the Board and the Audit Committee are skilled in the field of accounting and finance with two variables: Skilled Board: a dummy coded 1 if at least one of the members of the board has a degree in finance, accounting and (or) a graduate degree in business (i.e. an MBA) and coded 0 otherwise. Skilled Audit Committee: a dummy coded 1 if at least one of the members of the committee has a degree in finance, accounting and (or) a graduate degree in business (i.e. an MBA) and coded 0 otherwise. We also tabulate whether a company in the sample does have a Separate Audit Committee. Different from Kent et al. (2010), we don’t exclude companies, which don’t have an audit committee from the sample. In fact, different from the SarbanesOxley Act of 2002, the Dutch Corporate Governance Code (the Tabaksblat Code) contains an “apply-orexplain” principle, offering the possibility to deviate from the Corporate Governance Code as long as any such deviations are explained. To the extent that such deviations are approved by a general Board meeting, the company is deemed to be in full compliance with the Corporate Governance Code. Accordingly, we think it is important to distinguish between companies that do have an established audit committee and those who don’t, due to the possible significant control mechanisms that an audit committee exerts on financial reporting quality. Finally we tabulate both the size of the Board of Directors (BoD Size) and of the Audit Committee (Audit Size). 5 Research Design In order to test whether there are significant differences in terms of direct and indirect corporate governance control mechanisms within the extreme groups of high and low total accruals, we perform a test of differences for independent variables. Further, to assess the link between accruals, future stocks returns and corporate governance indicators in the Netherlands (research questions 2 and 3), we regress both the accruals ratio and three holding period returns (1, 3, and 6 months) against various combinations of the above mentioned corporate governance variables for the year 2010. Specifically, we test the following equations: AccRatio Rankit = β0 + β1 BoDIndRank + €it AccRatio Rankit = β0 + β1 AudRank + €it (4) AccRatio Rankit = β0 + β1 OverallRank + €it (5) 1moHPR t+1 = β0 + β1 BoDIndRank + €it (6) 1moHPR t+1 = β0 + β1 BoDIndSkilRank + €it (7) 1moHPR t+1 = β0 + β1 AudRank + €it (8) 1moHPR t+1 = β0 + β1 OveralRank + €it (9) Equations 6, 7, 8 and 9 will also be tested with the dependent variables of 3 and 6 month holding periods for future stock price returns. Concerning the relationship between accruals and future stock returns, we also supplement the above technique with a group or decile analysis. 6. Empirical Results Table 1 provides an overview of the sample data set. The total sample size is comprised of 90 active stocks as of the end of 2009. As Table 1 shows the sample size varies from 85 to 89 observations when looking at the different corporate governance variables analyzed in this article7. Looking at the second column in Table 1, it can be noticed that three variables present an equal representation in the sample. In fact, CEO Duality, Second Level of Board Independence and Skill of the Audit Committee are equally represented in the overall sample with roughly 50% of companies with and without the above mentioned corporate governance characteristics. Further, the majority of the companies in the sample do present a ‘First Level of Board Independence’ and at the same time the majority has a ‘Skilled Board of Directors’. On the contrary, the majority of the sample does not have an Audit Committee and of the 28 companies with information on school ties among the directors, the majority does not satisfy this level of independence. Table 2 presents descriptive statistics for the independent variables sorted in ten different deciles where decile 1 contains companies with the highest level of accruals (lowest quality of earnings) and decile 10 contains companies with the lowest level of accruals (highest quality of earnings). The higher quality of earnings companies or deciles have more separate, independent, and skilled audit committees than the lower quality of earnings companies or deciles. (2) AccRatio Rankit = β0 + β1 BoDIndSkilRank + €it (3) 7 In Table 1, the variable BoardIndLev3 presents only 28 observations. Hence, it was dropped from the overall analysis. Future research may look into additional sources to try to increase the coverage of this variable. 372 Corporate Ownership & Control / Volume 10, Issue 4, 2013, Continued - 4 Table 1. Sample Sizes and Corporate Governance Mechanism Characteristics Table 1 provides descriptive statistics for the group as a whole of public companies in the Dutch sample. It presents a series of dummy variables. Dual is a dummy variable, coded 0 if the CEO is also the Chairman of the Board of Directors(BoD) and coded 1 otherwise; Ind Lev 1 is a dummy coded 0 if there are more than two executives sitting on the BoD and coded 1 otherwise; Ind Lev 2 is a dummy coded 1 if the majority of the members of the BoD are independent and coded 0 otherwise; Ind Lev 3 is a dummy coded 1 if there no members sitting on the BoD with school ties and 0 otherwise; Skilled BoD is a dummy coded 1 if there is at least one member of the BoD with an accounting and (or) finance background and coded 0 otherwise; BoD Size is the number of directors comprising the BoD; Sep Audit Com is a dummy coded 1 if there is an audit committee and coded 0 otherwise; Audit Com Ind is a dummy coded 1 if the all of the members of the audit committee are independent and coded 0 otherwise; Skilled Audit Com is a dummy coded 1 if there is at least one member of committee with an accounting and (or) finance background and coded 0 otherwise; Audit Com Size is the number of directors comprising the committee. Table 2. Descriptive Statistics: % Values for Independent Corporate Governance Variables Sorted by Accruals in 10 Deciles Low Accr Decile 10 Decile 9 Decile 8 Decile 7 Decile 6 Decile 5 Decile 4 Decile 3 Decile 2 High Accr Decile 1 Dual 0.66 0.54 0.11 0.44 0.33 0.56 0.24 0.88 0.55 0.66 Ind Lev 1 Ind Lev 2 Ind Lev 3 Skilled BoD BoD Size Sep Aud Com Aud Com Ind Skilled Audit Com Audit Com Size 0.88 0.68 0.39 0.87 6.50 0.75 0.65 0.65 2.59 0.43 0.43 na 1.00 7.21 0.36 0.32 0.35 2.45 0.33 0.3 na 0.95 9.63 0.44 0.42 1.00 2.44 0.67 0.56 0.65 0.98 8.67 0.33 0.31 0.65 2.65 0.67 0.55 na 0.62 8.89 0.67 0.66 0.22 2.65 0.66 0.54 na 0.87 7.25 0.42 0.44 0.38 2.21 1.00 0.26 na 1.00 8.25 0.38 0.38 0.63 2.71 0.87 0.71 na 1.00 6.22 0.33 0.33 0.22 2.25 0.68 0.55 na 0.42 7.36 0.21 0.2 0.21 2.36 0.67 0.23 na 0.54 6.20 0.35 0.31 0.45 2.41 Table 2 provides descriptive statistics for the group of public companies in the Dutch sample sorted by levels of accruals. Table 2 presents a series of dummy variables. Dual is a dummy variable, coded 0 if the CEO is also the Chairman of the Board of Directors (BoD) and coded 1 otherwise; Ind Lev 1 is a dummy coded 0 if there are more than two executives sitting on the BoD and coded 1 otherwise; Ind Lev 2 is a dummy coded 1 if the majority of the members of the BoD are independent and coded 0 otherwise; Ind Lev 3 is a dummy coded 1 if there are no members sitting on the BoD with school ties and 0 otherwise; Skilled BoD is a dummy coded 1 if there is at least one member of the BoD with an accounting and (or) finance background and coded 0 otherwise; BoD Size is the number of directors comprising the BoD; Sep Audit Com is a dummy coded 1 if there is an audit committee and coded 0 otherwise; Audit Com Ind is a dummy coded 1 if the all of the members of the audit committee are independent and coded 0 otherwise; Skilled Audit Com is a dummy coded 1 if there is at least one member of committee with an accounting and (or) finance background and coded 0 otherwise; Audit Com Size is the number of directors comprising the committee. 373 Corporate Ownership & Control / Volume 10, Issue 4, 2013, Continued - 4 Research Question 1 attempts to investigate whether there are significant differences in terms of direct and indirect corporate governance control mechanisms within the extreme groups of high and low accruals (deciles 1 and 10, respectively). As Table 3 shows, we find that significant differences exist for three corporate governance variables: Second Level of Independence, presence of a Separate Audit Committee and presence of an Independent Audit Committee. In fact, except for one variable (CEO Duality which has the same mean score among both the low and high accruals groups), all the corporate governance variables show a higher mean score associated with the ‘low level of accruals’ (the decile 10 group). These results indicate that corporate governance quality is linked to higher earnings quality in financial reporting. Table 3. Test of Differences for Independent Variables in Decile 1 (high accruals) and Decile 10 (low accruals) Decile 10 µ Decile 1 µ p-value Dual 0.66 0.66 1 Ind Lev 1 Ind Lev 2 Ind Lev 3 Skilled BoD BoD Size Sep Aud Com Aud Com Ind Skilled Audit Com Audit Com Size 0.88 0.68 0.39 0.87 6.50 0.75 0.65 0.65 2.59 0.67 0.23 na 0.54 6.20 0.35 0.31 0.45 2.41 0.24 0.05 na 0.22 1.00 0.05 0.05 0.25 1.00 Table 3 is a test of differences for independent variables between the two extreme deciles of the sample under analysis. The variables tested are: Dual is a dummy variable, coded 0 if the CEO is also the Chairman of the Board of Directors (BoD) and coded 1 otherwise; Ind Lev 1 is a dummy coded 0 if there are more than two executives sitting on the BoD and coded 1 otherwise; Ind Lev 2 is a dummy coded 1 if the majority of the members of the BoD are independent and coded 0 otherwise; Ind Lev 3 is a dummy coded 1 if there are no members sitting on the BoD with school ties and 0 otherwise; Skilled BoD is a dummy coded 1 if there is at least one member of the BoD with an accounting and (or) finance background and coded 0 otherwise; BoD Size is the number of directors comprising the BoD; Sep Audit Com is a dummy coded 1 if there is an audit committee and coded 0 otherwise; Audit Com Ind is a dummy coded 1 if the all of the members of the audit committee are independent and coded 0 otherwise; Skilled Audit Com is a dummy coded 1 if there is at least one member of committee with an accounting and (or) finance background and coded 0 otherwise; Audit Com Size is the number of directors comprising the committee. In order to further explore whether there is a relationship between different levels of accruals and direct and indirect corporate governance mechanisms of control (Research Question 2), we regress the dependent variable of aggregate accruals against four different composite rankings formed with different combination of the corporate governance dummies using equations 2, 3, 4 and 5. As Table 4 shows, we find a significant inverse relation with the Audit Ranking (which combines the three direct corporate governance mechanisms: presence of a separate, independent, and skilled audit committee), meaning that companies with low (high) levels of accruals are associated with high (low) direct corporate governance mechanisms of controls. Similarly, the Board of Directors Independence Ranking (which combines CEO duality and two levels of independence) and the Overall Ranking (which averages all seven corporate governance variables in Table 2) show negative coefficients, indicating inverse relations but they are not statistically significant. Table 4. Cross-Sectional Regressions of Corporate Governance Rankings on Accruals Rankings for the Netherlands (for the year 2010) Regression Coefficient T-test Rsquared BoDindRank -2.01 -0.25 0.000 BoDIndSkilRank 0.25 0.025 0.010 AudRank -7.95 1.870 0.037 OverallRank -2.18 -0.265 0.000 Table 4 provides regression results for all companies in the sample. The dependent variable is the Accruals rank while the independent varibles are four different composite rankings formed with different combination of the corporate governance dummies. Specifically, BodIndRank is a composite percentile ranking score calculated by averaging three variables measuring different levels of Independence of the Board of Directors (CEO Duality, Ind Lev 1 Ind Lev 2); BodIndSkillRank is a composite percentile ranking score calculated by averaging four variables measuring different levels of Independence and Skills of the Board of Directors (CEO Duality, Ind Lev 1 Ind Lev 2 and Skilled BoD); AudRank is a composite percentile ranking score calculated by averaging three variables related to the Audit Committee (presence of a Separate, Independent and Skilled Audit Committee; Overall Rank is a composite percentile ranking score calculated by averaging all the seven above mentioned variables. 374 Corporate Ownership & Control / Volume 10, Issue 4, 2013, Continued - 4 Finally, Research Question 3 investigates whether there is a relationship between direct and indirect corporate governance mechanisms of control and future stock returns. We regress three different dependent variables of holding period returns for the year 2010 (1, 3 and 6 months) against four different composite rankings formed with different combinations of the corporate governance variables, using equations 6 through 9. Table 5 summarizes the results in three panels. Panel A presents regression results related to the dependent variable of the 1 month, future holding period returns. We find that the Overall Ranking or composite score has a positive and statistically significant coefficient, indicating that companies with an independent and skilled board of directors as well as a separate, independent and skilled audit committee, exhibit higher 1 month future holding period returns. Panel B presents regression results related to the dependent variable of the 3 month, future holding period returns. Similarly, we find that the Board of Directors Independence Ranking, the Audit Ranking, and the Overall Ranking all have positive and statistically significant coefficients, indicating that companies with an independent and skilled board of directors as well as a separate, independent and skilled audit committee, exhibit higher 3 month future holding period returns. Finally, Panel C presents regression results related to the dependent variable of 6 month, future holding period returns. Similarly, we find that both the Audit Ranking and the Overall Ranking have positive and statistically significant coefficients, indicating that companies with an independent and skilled board of directors as well as a separate, independent and skilled audit committee, exhibit higher 6 month future holding period returns. Thus, more corporate governance rankings are significant for future stock returns in longer holding periods. Table 5. Cross-Sectional Regressions of Corporate Governance Rankings on Holding Period Returns for the Netherlands (for the period 2010) Table 5 provides regression results for all companies in the sample. The dependent variable is respectively the 1 (Panel A), 3 (Panel B) and 6 (Panel C) Holding Period Return while the independent varibles are four different composite rankings formed with different combination of the corporate governance dummies. BodIndRank is a composite percentile ranking score calculated by averaging three variables measuring different levels of Independence of the Board of Directors (CEO Duality, Ind Lev 1 Ind Lev 2); BodIndSkillRank is a composite percentile ranking score calculated by averaging four variables measuring different levels of Independence and Skills of the Board of Directors (CEO Duality, Ind Lev 1 Ind Lev 2 and Skilled BoD); AudRank is a composite percentile ranking score calculated by averaging three variables related to the Audit Committee (presence of a Separate, Independent and Skilled Audit Committee; Overall Rank is a composite percentile ranking score calculated by averaging all the seven above mentioned variables. We supplement the above regression stock returns analysis with an analysis of stock returns across deciles. Table 6 presents the 1, 3 and 6 month holding period, stock returns for portfolios sorted into seven variables which describe different direct and indirect corporate governance mechanisms of control. Specifically, we present evidence of whether by sorting and building portfolios into ‘long’ companies with these seven corporate governance characteristics and ‘short’ companies without these same characteristics, it is possible to have a positive return spread. Table 6 shows that in six of the seven different sorts or groups, there is a positive spread. The only exception is the ‘Second Level of Board of Directors Independence’, which has a negative spread in all three time frames. Thus, these results reinforce the importance of key corporate governance characteristics for positive future stock price returns. 375 Corporate Ownership & Control / Volume 10, Issue 4, 2013, Continued - 4 Table 6. Returns for Portfolios Sorted by Individual Corporate Governance Characteristics Table 6 provides summary return statistics, that is annualized returns and return spreads for all companies in the sample. Stocks are ranked based on the presence or absence of seven variables, which describe different direct and indirect corporate governance mechanisms of control. Dual is a dummy variable, coded 0 if the CEO is also the Chairman of the Board of Directors (BoD) and coded 1 otherwise; Ind Lev 1 is a dummy coded 0 if there are more than two executives sitting on the BoD and coded 1 otherwise; Ind Lev 2 is a dummy coded 1 if the majority of the members of the BoD are independent and coded 0 otherwise; Ind Lev 3 is a dummy coded 1 if there are no members sitting on the BoD with school ties and 0 otherwise; Skilled BoD is a dummy coded 1 if there is at least one member of the BoD with an accounting and (or) finance background and coded 0 otherwise; BoD Size is the number of directors comprising the BoD; Sep Audit Com is a dummy coded 1 if there is an audit committee and coded 0 otherwise; Audit Com Ind is a dummy coded 1 if the all of the members of the audit committee are independent and coded 0 otherwise; Skilled Audit Com is a dummy coded 1 if there is at least one member of committee with an accounting and (or) finance background and coded 0 otherwise; Audit Com Size is the number of directors comprising the committee. Tables 7a through 7d show results of a decile analysis on four different composite rankings: Board Independence Ranking, Board Independence and Skill Ranking, Audit Committee Ranking, and Overall Ranking respectively. At this level of aggregation or rankings, we find positive spreads for the composite score measuring Board of Directors Independence (1 and 6 months HPR), Board of Directors Independence plus Skills (6 months HPR) and the Overall Ranking (1 month HPR). These more granular groups or sorts may be influenced by interactions with different levels of accruals characteristics. Future research may investigate results of a double sorting within the individual accruals group of the above four composite rankings. Again, these results reinforce the importance of key corporate governance characteristics for positive future stock returns. 376 Corporate Ownership & Control / Volume 10, Issue 4, 2013, Continued - 4 Table 7a. Returns for Portfolios Sorted by Accruals and Composite Board of Directors Independence Ranking High Level of Independence Decile 10 Decile 9 Decile 8 Decile 7 Decile 6 Decile 5 Decile 4 Decile 3 Decile 2 Low Level of Independence Decile 1 Decile 10-Decile 1 1MHP Return 3MHP Return 6MHP Return -1.62% 2.25% -7.78% 2.78% -1.78% -25.15% -5.20% -14.32% -21.39% -0.77% -2.98% -11.01% 0.17% -3.77% -20.93% -1.71% 3.30% -3.18% 0.70% 5.25% -4.56% 5.96% 24.56% -9.16% -2.88% -3.54% -16.92% -3.25% 2.70% -12.65% 1.63% -0.45% 4.87% Table 7b. Returns for Portfolios Sorted by Accruals and Composite Board of Directors Independence and Skilled Ranking High Level of Independence/Skill Decile 10 Skill Decile 9 Decile 8 Decile 7 Decile 6 Decile 5 Decile 4 Decile 3 Decile 2 Low Level of Independence/ Decile 1 Skill Decile 10-Decile 1 1MHP Return 3MHP Return 6MHP Return -5.15% -2.69% -15.02% 4.25% -3.45% -28.64% -3.75% -6.81% -12.71% -0.81% 4.30% -7.18% 3.07% -0.35% -9.07% -0.03% -1.19% -11.06% 0.66% 17.17% -11.39% 1.65% 4.21% -9.57% -3.85% -1.50% -16.52% -4.75% -1.98% -18.25% -0.40% -0.71% 3.23% Table 7c. Returns for Portfolios Sorted by Accruals and Composite Audit Committee Independence and Skilled Ranking High Level of Independence/Skill Decile 10 Skill Audit Decile 9 Decile 8 Decile 7 Decile 6 Decile 5 Decile 4 Decile 3 Decile 2 Low Level of Independence/ Decile 1 Skill Audit Decile 10-Decile 1 1MHP Return 3MHP Return 6MHP Return -3.25% 1.26% -16.87% -1.03% -4.98% -14.54% 4.56% 7.44% -13.80% 3.75% 25.76% -5.24% -2.42% -0.24% -12.34% -2.78% -1.54% -12.69% -2.83% -2.75% -10.93% -2.56% -6.50% -22.25% -2.98% -13.25% -25.65% 1.50% 3.54% -6.25% -4.75% -2.28% -10.62% Table 7d. Returns for Portfolios Sorted by Accruals and Composite Overall Ranking High Level of Independence Decile 10 Decile 9 Decile 8 Decile 7 Decile 6 Decile 5 Decile 4 Decile 3 Decile 2 Low Level of Independence Decile 1 Decile 10-Decile 1 1MHP Return 3MHP Return 6MHP Return 5.02% 0.85% -16.25% -1.78% 3.99% -8.24% 2.06% 21.12% -14.54% -5.01% -2.98% -15.99% -4.54% -6.37% -14.69% -3.16% -11.07% -19.80% -0.55% 1.22% -15.64% -0.08% 0.85% -6.35% 1.45% -5.85% -22.24% -1.85% 3.82% -8.63% 6.87% -2.97% -7.62% 377 Corporate Ownership & Control / Volume 10, Issue 4, 2013, Continued - 4 Table 7 provides summary return statistics, that is annualized returns and return spreads for all companies in the sample. Stocks are ranked based on four different composite rankings. 7a: BodIndRank is a composite percentile ranking score calculated by averaging three variables measuring different levels of Independence of the Board of Directors (CEO Duality, Ind Lev 1 Ind Lev 2); 7b: BodIndSkillRank is a composite percentile ranking score calculated by averaging four variables measuring different levels of Independence and Skills of the Board of Directors (CEO Duality, Ind Lev 1 Ind Lev 2 and Skilled BoD); 7c: AudRank is a composite percentile ranking score calculated by averaging three variables related to the Audit Committee (presence of a Separate, Independent and Skilled Audit Committee; 7d: Overall Rank is a composite percentile ranking score calculated by averaging all the seven above mentioned variables. 7. Conclusions This article provides useful insights into important issues related to both capital markets efficiency and agency theory. Specifically, in terms of capital markets efficiency, we add to the literature that direct and indirect corporate governance mechanisms of control are potentially a threat to capital market efficiency. Also, in terms of agency theory, we show that corporate governance control mechanisms contribute to lower asymmetries between the principal (investors) and the agent (management). In fact, we provide some initial evidence that direct corporate governance characteristics are related to the level of accruals and to future stock price returns. First we find that the characteristics of corporate governance variables differ between companies with higher and lower quality of earnings. Specifically, we find that companies with the highest level of earnings quality are characterized by an indenpendent board, as well as the existence of a separate, independent, and skilled audit committee. Second, we find that there exists a significant negative relationship between the level of accruals and an independent, separate audit committee. This is a potentially interesting finding because it shows that an audit committee with good corporate governance characteristics is an effective control mechanism over earnings management. Regarding the relationship between corporate governance indicators and future stock returns, the decile analysis shows positive return spreads for all the individual variables except for the second level of independence. Contrary to Kent et al. (2010), we do find initial evidence that there is a relationship between audit committee characteristics and level of aggregate accruals. This result may relate to the fact that we did not exclude companies without an audit committee, thereby possibly explaining the Kent et al. (2010) limitation of self selection biases. Such results are relevant for portfolio managers and investors, who may want to screen companies based on direct corporate governance control variables in order to earn higher stock price returns. Also, Dutch regulators may want to reconsider the principle of “apply or explain” and make it stricter since we find higher accruals for companies that do not have a separate, independent and skilled audit committee. Hence, it is possible that companies which explain deviation for not applying corporate governance code rules, may be, more prone to earnings management because they don’t have all the control mechanisms in place. Future research may investigate whether there are differences among countries which have an “apply-or-explain” rule and those which do not. This could reinforce the case for regulators to be stricter in the application of corporate governance codes. Additionally, future research could look at a double sorting process, screening by both decile sorting of accruals and by corporate governance rankings, consistently outperforms just accruals decile sorting. Finally, a limitation of this study may be the data availability of corporate governance variables. References 1. 2. 3. 4. 5. 6. 7. 8. 9. 10. 11. 12. 13. 378 Basilico, E. Grove, H. Fraudulent Financial Reporting Detection: Key Ratios Plus Corporate Governance Factors, International Studies of Management Organization, 38 (2008), pp. 10-42 Basilico, E., and Johnsen, T. The Introduction of IFRS: Evidence from the Mispricing of Accruals in Europe, Working paper (2012) Beasly, M.S. An Empirical Analysis of the Relation between the Board of Director Composition and Financial Statement Fraud, The Accounting Review, 71(1996), pp. 443-465 Clarke, T. 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The Effects of Corporate Governance Experience, Financial Reporting and Audit Knowledge on Audit Committee Members’ Judgments, Auditing: A Journal of Practice & Theory, 20 (2001), pp. 31–47 Fama, E. and Jensen, M. Agency Problems and Residual Claims, Journal of Law and Economics, 26 (1983a), pp. 327-349 Heidrick and Struggles. European Corporate Governance Report: Challenging Board Performance, (2011) Hermann, G.P. Sarbanes-Oxley 404: A Compliance Game Plan, Financial Executive, (2003), pp.42-43 Corporate Ownership & Control / Volume 10, Issue 4, 2013, Continued - 4 14. Hilb, M., New Corporate Governance: Successful Board Management Tools, Third Edition, Springer, (2008) 15. Kao, L. and Chen, A. The Effects of Board Characteristics on Earnings Management. Corporate Ownership & Control, 1 (2004), pp. 96-107 16. Kent, P., Routledge, J. and Stewart J. Innate and Discretionary Accruals Quality and Corporate Governance, Accounting and Finance, 50 (2010), pp. 171-195 17. Klein, A. Audit Committee, Board of Director Characteristics and Earnings Management. Journal of Accounting and Economics, 33 (2002), pp. 375-400 18. Koh, P., LaPlante S., and Tong Y. H. Accountability and Value Enhancement Roles of Corporate Governance, Accounting and Finance, 47 (2007), pp. 305–333 19. Krishnan, J. Audit Committee Quality and Internal Control: an Empirical Analysis, The Accounting Review, 80 (2005), pp. 649–675 20. Li J. Ownership Structure and Board Composition: a Multi-Country Test of Agency Theory Predictions, Managerial and Decision Economics, 15 (1994) 359368 21. Peasnell, K.V., Pope, P.F. and Young, S. Accrual Management to Meet Earnings Targets: UK Evidence pre and post Cadbury, British Accounting Review, 32 (2000), pp. 415- 445 22. Richardson S., and Tuna I. Evaluating Financial Reporting Quality. International Financial Statement Analysis, Chapter 17. CFA (2009) 23. Schleifer A., and Vishny R.W. A Survey of Corporate Governance, The Journal of Finance, LII (1997), pp. 737-783 379 Corporate Ownership & Control / Volume 10, Issue 4, 2013, Continued - 4 LEADERSHIP STYLE AND JOB SATISFACTION: A DEVELOPING ECONOMY PERSPECTIVE Jeevarathnam Parthasarathy Govender*, Hari Lall Garbharran**, Roland Loganathan** Abstract Research has suggested a relationship between leadership style and job satisfaction. This paper examines this relationship in the context of a developing country, viz., South Africa. The objective of the paper is to assess the relationship between the two variables as well as the influence of biographical variables on leadership style and job satisfaction. The survey was based on the Minnesota Satisfaction Questionnaire and the Multifactor Leadership Questionnaire. The results suggest a significant correlation between the three leadership styles, viz., transformational leadership, transactional leadership and laissez-faire leadership, and job satisfaction. There were no significant differences between the biographical variables and the three leadership styles. Keywords: Ledership, Job Satisfaction, Leadership Styles * Corresponding author, Department of Marketing, Durban University of Technology, P O Box 1334, Durban, 4000, South Africa Tel.: +2731 3735396 Fax: +2731 3735480 E-mail: govendej@dut.ac.za ** Durban University of Technology, Durban, South Africa 1. Introduction Research has demonstrated a relationship between leadership styles and employee job satisfaction levels. Emery and Barker (2007) found that employees managed under a transformational leadership style displayed higher levels of job satisfaction, against associated factors such as charisma and intellectual stimulation. Conversely, employees managed under a transactional leadership style, displayed higher levels of job dissatisfaction, against associated factors such as management by exception. According to Uhl-Bien, Marion and McKelvey (2007), organizations are being faced with competitive landscapes shaped by globalization, technology, economy and politics. The world of business is constantly faced with challenges by the external environment, demand for increased participation and competition. Employees are seen as intangible assets that contribute to the continued success and development of an organization in this dynamic environment. Job satisfaction can be broadly defined as the extent to which employees are content with their jobs (Mester, Visser & Roodt, 2003). A major breakthrough into understanding job satisfaction was through the Hawthorne studies (Olson, Verley, Santos and Salas 2004). Findings of the study revealed that good working conditions enhanced job satisfaction levels among employees. It also emerged that people work for purposes other than pay. Employees’ moods and emotions are core building blocks that form the affective element of job satisfaction. Job satisfied employees show higher levels of commitment to their jobs and organisations. Leadership theory suggests that transformational leadership, transactional leadership and laissez-faire leadership styles are related to job satisfaction. According to Mester et. al. (2003), several studies have indicated that transformational leadership results in higher levels of job satisfaction than transactional or laissez-faire leadership. However, findings from studies conducted by Naidu and Van Der Walt (2005) reveal that transformational and transactional leadership styles did not correlate significantly to the construct of job satisfaction. The context of the study is a paper mill situated in South Africa. It is envisaged that the study and its findings will bear relevance to organisations, particularly in other developing economies, and also serve as a basis for further discussion and debate. 2. Research Problem and Objectives According to Madlock (2008), job satisfaction is related to job performance. Pattersen, Warr and West (2004) suggest that a job satisfied employee is a productive employee. As a result, this paper 380 Corporate Ownership & Control / Volume 10, Issue 4, 2013, Continued - 4 intends to establish job satisfaction levels associated with varying leadership styles in order to investigate the relationship between these two variables. The objective of this paper is to investigate the relationship between leadership styles and job satisfaction. The sub-objectives are: to identify employee perceptions of their leader’s style; to determine employee job satisfaction levels related to their leader’s style and; to examine the influence of selected biographical variables on job satisfaction and leadership style, respectively. 3. Literature Review Leadership Leadership is a process by which an individual influences colleagues towards accomplishing common goals (Flynn, 2009). It involves influencing the participation of colleagues and providing guidance in a specified course to be navigated. According to Naidu and Van Der Walt (2005), an effective leadership style influences change and creates the impetus for transformation. The role played by a leader could be viewed as an influential change-agent. Banerji and Krishnan (2000) view leadership as a process whereby leaders develop a shared vision, set the tone and influence the behaviours of all in the organisation to work towards common values. The shared vision creates alignment by developing a common mental model for employees to follow. Jones and Rudd (2007) define leadership as a relationship between leaders and followers within a social group. It entails supplying a vision, creating power and using this power for individuals to realize the vision. With the view that leadership is about coping with change, this study identifies leadership as the ability to influence employees to engage in transformation interventions by aligning individual goals with that of the leader, and ultimately, the organisation. Transformation is viewed as the ability to do things differently than in the past. It can also be viewed as the creation of a new entity, not improving on something that already exists. Therefore, transformation interventions will be defined as interventions that bring about change to do things differently, a view supported by Naidu and Van Der Walt (2005). The literature on leadership identifies transformational leadership, transactional leadership and laissez-faire leadership as the three common leadership styles in the current climate, with transformational leadership and transactional leadership being the most dominant (Mester et al., 2003). Transformational leadership Transformational leaders inspire, develop, encourage and coach followers through trust and support. According to Adler and Reid (2008), employees are most satisfied when their leader is supportive and considerate. A successful transformational leader influences followers to perform extraordinary behaviours to go beyond the call of duty. Naidu and Van Der Walt (2005) view transformational leaders as people who inspire their followers to work towards the good of the company, both in the short-term and long-term. Inspiration is created through influence and awareness about outcomes that relate to the realization of the organisation’s vision. Ozaralli (2002) describes transformational leadership as a process whereby a strong personal identification is maintained with the leader. Employees are energized and empowered through participation to embrace an exciting and optimistic vision of the future rather than receiving personal monetary gain. The transformational leader is able to create stamina to effectively implement and sustain transformation initiatives in an organisation. Key elements of transformational leadership are ideolised influence, intellectual stimulation and individualized consideration. Ideolised influence The leader embraces high moral and ethical values and reinforces pride, respect and faith in followers. The leader makes an effort to promote his or her beliefs and values through influence (Flynn, 2009). Ideolised influence comes into play when the leader expresses a sense of conviction and confidence, when making high-impact decisions in the face of threats (Nielsen,Yarker, Brenner, Randall and Borg , 2008). Through role modeling, followers are encouraged to take calculated risks when solving complex problems and observe how they can become more responsible and confident. Intellectual stimulation Intellectual stimulation centres on promoting innovative ideas and creativity among followers. Intellectual stimulation occurs when the leader encourages creativity among followers to look for new and more efficient ways of solving problems compared to methods employed in the past (Mester et al., 2003). Much effort is placed on encouraging followers to proactively search for new ideas and to “think out of the box” when faced with challenges during daily activities Individualised consideration Individualised consideration centres on identifying and addressing individual needs of followers 381 Corporate Ownership & Control / Volume 10, Issue 4, 2013, Continued - 4 through coaching and mentoring initiatives. Mester et al. (2003) explain individualised consideration as a process whereby the leader identifies individual uniqueness, links the individuals’ current needs to the organisation’s needs and provides coaching, mentoring and growth opportunities. Effective leaders must demonstrate concern for individual needs and attend to these needs on an individual basis. A common realization is that the skills and experience levels, needs and expectations vary considerably among individuals. Therefore, an interpersonal connection is paramount to understanding followers personally, with the view of strategically addressing their concerns. A supportive and caring climate is created by the leader, who plays the role of a listener who carefully identifies strengths, weaknesses and development potentials of individuals. The leader’s aim is to assist with individual personal development, while assessing ways to help individuals in meeting their aspirations. Leaders allow followers to grow through personal challenges, through the process of delegated authority. Transactional Leadership Transactional leadership refers to a task-orientated leadership style, relating to reward-based performance initiatives. Transactional leaders motivate employees towards attainment of stated goals by clarifying job roles. Transactional leaders are seen as leaders who reward employees for task completion, thereby attaining power from the transactions. According to Naidu and Van De Walt (2005), a high degree of focus is placed on goal achievement together with a rational exchange reward system for good performance and punishment for sub-standard performance. Cilliers, Van Deventer and Van Eeden (2008) also view transactional leadership as a social exchange process whereby tasks are agreed to and clarified between the leader and follower on the basis that a successfully completed task will result in a reward and avoidance of punishment. The key dimensions of transactional leadership are active management by exception and constructive transaction. Active management by exception The leader actively monitors activities of followers, in search of errors, deviations from standards or failures. Mester et al. (2005) also agree and view this dimension as a proactive management style whereby the leader closely watches performance of followers and takes corrective action to avoid potential problems before they arise. The leader is inclined to reinforce rules in order to minimize mistakes, utilising negative reinforcement patterns. This dimension is known to be more task than relation orientated. In summary, the leader intervenes if actual effort does not match expected effort by the follower, which is viewed as an exception. Constructive transaction The leader-follower interaction is proactive where emphasis is placed on rewards for meeting expected goals. The leader obtains agreement from followers on what must be done and what the rewards would be for the followers involved with the task. Success criteria are agreed upon by both parties with the achievement being either rewarded or punished. Positive reinforcement patterns are used where the leader implicitly clarifies performance standards in order to reinforce follower credibility that valued rewards will be a result of good performance (Xirasagar, 2008). Laissez-Faire leadership According to McColl-Kennedy and Anderson (2005), laissez-faire leadership is a passive style that is reflected by high levels of avoidance, indecisiveness and indifference. It is also commonly viewed as the absence of leadership where the leader takes a “hands-off” approach, abdicating responsibility, delaying decisions and gives no feedback to employees’ (Xirasagar, 2008). The leader makes no attempt to motivate followers or to satisfy their individual needs. It is also viewed as an avoidance of leadership responsibilities which could result in a lack of direction for the organisation. The laissez-faire leader is also viewed as an inactive rather than proactive individual and procrastinates, wherever possible. There are no rewards or feedback to subordinates and developmental needs are left to individuals for self -management. Jones and Rudd (2007) view laissez-faire leadership as a lethargic leadership style where the leader displays no sense of motivation or urgency. The leader assumes that followers are intrinsically motivated and should be left alone to accomplish their tasks. Leadership styles and job satisfaction Mester et al. (2005) believe that the role of a leader has a direct influence on job satisfaction among followers. Madlock (2008) explains that employees are most satisfied when they perceive their leaders to possess a combination of relational (transformational) and task-oriented (transactional) behaviours. The main attributes of transformational leadership, transactional leadership and laissez-faire leadership in relation to job satisfaction are discussed below. Transformational leadership and job satisfaction 382 Corporate Ownership & Control / Volume 10, Issue 4, 2013, Continued - 4 Studies conducted by Berson and Linton (2005) support previous findings that a positive relationship exists between transformational leadership style and job satisfaction. Results of a study conducted by Nielsen et al. (2008) reveal that transformational leadership was positively associated with better employee working conditions. Results of the study are also supported by Herzberg’s Two-Factor Theory, which suggests that good working conditions lead to increased job satisfaction levels. Ideolised influence and job satisfaction Bruch and Walter (2007) argue that the effect of Ideolised influence is more likely to emerge among upper rather than middle managers. This happens in a practical setting where followers are constrained by organisational regulations within its hierarchy. Their ability to engage in innovative decision making is far reaching, which results in a lower appeal to the effects of ideolised influence. Hence, their span of discretion is limited and they are more inclined to adapt to the expectations of their leaders. Cilliers et. al. (2008) also believe that role clarity and goal alignment need to be clear and unambiguous for successfully bringing out ideolised behaviours in followers. Intellectual satisfaction stimulation and job Results of a study conducted by Emery and Barker (2007) support the use of transformational leadership to increase job-satisfaction levels among employees, through mission alignment and intellectual stimulation. Andreassen, Hetland, Hetland, Notelaers and Pallesen (2011) believe that challenging the status quo encourages followers to develop more efficient and new ways of solving problems. Transformational leaders are able to challenge outdated assumptions and traditions, thereby creating an atmosphere of creativity and innovation. Transformational leaders are also mindful of the intellectual ability of followers. They encourage approaching problems from different angles, thus creating readiness for change (Cilliers et al., 2008). This claim is supported by McClelland’s need for achievement whereby satisfaction is gained from the success of doing things differently. The job characteristics model of Oldham and Hackman also supports the claim whereby internal motivation is gained through experienced meaningfulness from task variety and task significance (Oshagbemi, 2003). Individualised consideration and job satisfaction Bruch and Walter (2007) are of the opinion that individualised consideration enhances follower satisfaction through the process of advising, supporting and addressing individual needs. A stable platform is thus created allowing followers space to develop and self-actualise. It becomes increasingly important for the leader to exercise emotional intelligence when aligning personal needs of followers to that of the organisation. Moreover, the ultimate goal of the process is for the organisation to benefit through the transactional leadership process (Mester et. al., 2005). Transactional satisfaction leadership and job Active management by exception and job satisfaction Xirasagar (2008) believes that the leader displays behaviours intended to prevent potential problems before they arise. Applying the job characteristics model of Oldham and Hackman, feedback will provide employees with knowledge of results about a particular task. Although the follower may fear reprimand for non-compliance, satisfaction could be gained from knowing that tasks are over inspected in order to proactively prevent potential failures. Followers will also be motivated to ensure that tasks are performed with diligence in order not to face reprimand. Constructive satisfaction transaction and job According to Emery and Barker (2007), linking individual needs to what the leader expects to accomplish, as well as providing rewards desired by followers, enhances job satisfaction among followers. The exchange agreement between leader and follower is proactive, where followers are confident to receive rewards when tasks are successfully completed. The act of engaging in constructive transaction is adequately supported by the hygiene factors of Herzberg’s Two- Factor Theory, where the exchange of rewards, praise or recognition reduces dissatisfaction among followers. In addition, the exchange of rewards, praise and recognition will motivate followers to perform at higher levels to achieve agreed upon objectives set by the leader. This claim is adequately supported by the job characteristics model of Oldham and Hackman, where feedback from the job and knowledge of actual results of work activities, result in satisfaction among followers. Additionally, the need for achievement will result in motivation to strive for excellent results in pursuit of agreed goals 383 Corporate Ownership & Control / Volume 10, Issue 4, 2013, Continued - 4 set by the leader. This finding is supported by McClelland’s needs theory (Oshagbemi, 2003). Passive management by exception and job satisfaction The passive style of the leader, as indicated by a more reactive rather than proactive approach, may create a perception among followers that some degree of autonomy is afforded in performing tasks to completion. The perception would appear prudent given the common understanding that the leader would only intervene once problems become evident. Hence, followers may experience some fulfillment in their needs for autonomy, which is supported by the job characteristics model of Oldham and Hackman (Madlock, 2008). The fear of failure would be embedded in the minds of followers due to the reactive approach of the leader who intervenes only when performance does not meet expectations, often reacting with negative consequences. Results of studies conducted by Emery and Barker (2007) reveal that a negative correlation exists between job satisfaction and management by exception (passive and active). According to Madlock (2008), common factors that lead to job dissatisfaction are largely driven by interpersonal relationships between the leader and follower. The finding is reinforced when the leader is viewed by followers as less supportive and absent when needed, especially during the initial stages of problem identification. Laissez- Faire satisfaction leadership and job Little or no involvement by the leader could enhance autonomy and empowerment of followers to accomplish goals, thereby leading to their selfdevelopment and progress, which is supported by the job characteristics model of Oldham and Hackman. Followers, in this case, are afforded the opportunity to make decisions in order to shape their work environment to satisfy individual needs. Cilliers et al. (2008) also agree that laissez-faire leadership affords followers the opportunity for selfmanagement. They view the process of avoidance by the leader as an opportunity for followers to work unsupervised and become leaders in their own way, through self-development. Madlock (2008) argues that inadequate supervision, as in the case of the laissez-faire leader, could lead to weak interpersonal relationships, resulting in low employee satisfaction and productivity levels. This finding is supported by Herzberg’s Two-Factor Theory. 4. Methodology This research study was descriptive, quantitative and cross-sectional in nature. The target population for this study consisted of the 240 employees, ranging from grade 7 to grade 12, involved in operations on a daily basis. According to Sekaran and Bougie (2010), 148 is a reliable sample size for a population size of 240. Simple random sampling was used as the preferred type of probability sampling. Bell and Bryman (2007) explain that, with this sampling method, there is almost no opportunity for human bias because the process is not dependent on the employees’ availability. The questionnaire consisted of three sections, namely, biographical information, job satisfaction and leadership styles. Overall job satisfaction was measured using an adapted version of the Minnesota Satisfaction Questionnaire (MSQ), developed by Weiss, Darwiss, England and Lofquist (1967). The questionnaire was designed to measure satisfaction levels for various personal and job related facets. Measurement comprised a five-point Likert measurement scale, with “very dissatisfied” forming the one end of the continuum and “very satisfied”, the other end. Instructions were given regarding the rating of the questions. “Very dissatisfied” indicated low levels of job satisfaction while “very satisfied” indicated high levels of job satisfaction. The instrument was used in studies conducted by Patterson et al. (2004) where a Cronbach Alpha coefficient of 0.92 was reported, suggesting a high degree of reliability. Leadership styles were measured using an adapted version of the Multifactor Leadership Questionnaire (MLQ) developed by Avolio, Bass and Jung (1997). The purpose of the questionnaire was to distinguish the three leadership styles. The questionnaire measured five components of transformational leadership, three components of transactional leadership and one component of laissez faire leadership. The questionnaire consisted of 33 questions. Eighteen questions dealt with the three attributes of transformational leadership. Eleven questions dealt with the three attributes of transactional leadership. Four questions addressed laissez-faire leadership. A pilot test was conducted. Necessary alterations were then done to the questionnaires before conducting the research. The data analysis was performed using the Statistical Package for Social Sciences (SPSS). The level of significance was set at 95% (p= 0.05) 384 Corporate Ownership & Control / Volume 10, Issue 4, 2013, Continued - 4 5. Findings and Discussion followed by the 41-50 group (17%), the 51-60 group (7.2%) and the 17-20 group (2.6%). Regarding job grades, the majority of subjects were operators (32.7%) followed by senior operators (21.6%), shift charge hands (19%), shift supervisors (16.3%) and first-line supervisors (10.5%). Table 2 presents the results with regard to respondent perceptions of leadership style displayed by their supervisors. 5.1 Biographical data and descriptive statistics Table 1 illustrates the distribution of the biographical variables of the sample group. It emerged that the majority of the participants were males (88.2%). In terms of age, the majority of the participants were between 21 and 40 (73.2%) Table 1. Frequency distribution of biographical variables Gender Male Female Age 17-20 21-30 31-40 41-50 51-60 Over 60 Job Grade First Line Supervisor Shift Supervisor Shift Charge hand Senior Operator Operator The mean value for overall transactional leadership (M=3.234) indicates that supervisors displayed a transactional leadership style sometimes. The standard deviation (SD=0.615) reflects the variation in responses. Some respondents perceived their supervisors practising this style occasionally (Min=2), while others view their supervisors using this style always (Max=5). The dimensions of transactional leadership reveal that active management by exception is displayed by supervisors sometimes bordering on fairly often (M=3.692), constructive transaction is displayed sometimes (M=3.415) and passive management by exception being displayed occasionally (M=2.709). The standard deviation was highest for constructive transaction (SD=0.865) followed by active management by exception (SD=0.645). The variation in responses reveal not at all (Min=1) to always (Max=5) in the case of active management by exception and constructive transaction and a maximum score of 4 (fairly often) perceived for passive management by exception. Overall, the results for a transformational leadership style also reveal that supervisors displayed this style sometimes (M=3.029). The standard deviation (SD 0.629) indicates a variation in responses. Some respondents perceived their n 135 18 153 4 52 60 26 11 0 153 16 25 29 33 50 153 % 88.2 11.8 100.0 2.6 34.0 39.2 17.0 7.2 0 100.0 10.5 16.3 19.0 21.6 32.7 100.0 supervisors practising this style (Min=2) while others view their supervisors using this style always (Max=5). The dimensions of transformational leadership reveal that ideolised influence (M=2.913), individualised consideration (M=0.296) and intellectual stimulation (M=3.165) are displayed by supervisors sometimes, bordering on fairly often. The standard deviation was highest for individualised consideration (0.879), followed by intellectual stimulation (0.700), and ideolised influence (0.681). In terms of job satisfaction, respondents were satisfied sometimes (M=3.470). The standard deviation (SD = 0.601) shows a variation in responses. Some subjects were dissatisfied (Min=2) while others were very satisfied (Max=5). As far as laissez-faire leadership was concerned, respondents perceived their supervisor as displaying this style occasionally to sometimes (M=2.792). The standard deviation (SD=0.665) shows the variation in their responses. The minimum score of 1 indicates that some participants felt that their supervisors did not display a laissezfaire leadership style while others (maximum=5) perceived their supervisors as always using this style. 385 Corporate Ownership & Control / Volume 10, Issue 4, 2013, Continued - 4 Table 2. The study variables Transactional leadership: overall Transactional leadership: Active management by exception Transactional leadership: Constructive transaction Transactional leadership: Passive management by exception Transformational leadership: overall Transformational leadership: Ideolised influence Transformational leadership: Individualised consideration Transformational leadership: Intellectual stimulation Laissez-Faire leadership Job satisfaction 5.2 The variables relationship 5.2.1 Transformational satisfaction among leadership and the job The results show that there was a significant correlation between overall transformational leadership and its dimensions, viz., ideolised influence, individualised consideration and intellectual stimulation, and job satisfaction. The following values were observed:  Overall transformational leadership and job satisfaction (r=0.501;p<0.05);  Ideolised influence and job satisfaction (r=0.343;p<0.05);  Individualised consideration and job satisfaction (r=0.445;p<0.05); and  Intellectual stimulation and job satisfaction (r=0.501; p<0.05). The correlations ranged from weak to moderate, and statistical significance was found (p<0.05 in all instances), leading to the conclusion that there was a significant correlation between transformational leadership, (and its dimensions) and job satisfaction. This correlation concurs with the findings of Adler and Reid (2008) where a significant correlation between overall transformational leadership and job satisfaction was found. A correlation of r=0.646 was observed. A study conducted by Berson and Linton, (2005) also showed that transformational leadership was a strong predictor of job satisfaction. A correlation of r=0.64 for p<0.01 was observed in this case. Studies conducted by Emery and Barker (2007) reveal that intellectual stimulation was positively correlated with job satisfaction (r=0.130, p<0.5). Therefore, results from other studies corroborate with the findings of this study. N 153 Min. 2 Max. 5 Mean 3.234 Std. Dev. 0.615 153 1 5 3.692 0.848 153 1 5 3.415 0.866 153 1 4 2.709 0.645 153 2 5 3.029 0.629 153 1 5 2.913 0.682 153 1 5 2.996 0.879 153 2 5 3.165 0.700 153 153 1 2 5 5 2.792 3.470 0.666 0.601 5.2.2 Transactional leadership and job satisfaction It emerged that there was a statistically significant correlation between overall transactional leadership and its attributes (active management by exception and constructive transaction and passive management by exception) and job satisfaction. The following correlations were observed:  Overall transactional leadership and job satisfaction (r=0.403, p<0.05);  Active management by exception and job satisfaction (r=0.360, p<0.05);  Constructive transaction and job satisfaction (r=0.442, p<0.05); and  Passive management by exception (r=0.109, p<0.05). Studies by Adler and Reid (2008) show a statistically significant correlation between overall transactional leadership and job satisfaction. A correlation of r=0.582 was observed. Findings by Berson and Linton (2005) reveal that a negative, weak correlation existed between transactional leadership and job satisfaction. A correlation of r= 0.08 for p<0.05 was observed. Also, findings from the study conducted by Emery and Barker support the argument that a negative relationship exists between active management by exception and job satisfaction. A correlation of r= -0.244 for p<0.1 was observed. The findings of this study are in agreement with those of others, that there was a statistically significant correlation between overall transactional leadership and its attributes Finally, the results of the study also indicate a statistically significant correlation between laissezfaire leadership and job satisfaction (r=0.230; p<0.05). 386 Corporate Ownership & Control / Volume 10, Issue 4, 2013, Continued - 4 5.2.3 Transformational biographical variables leadership and the The results regarding transformational leadership, its dimensions and the biographical variables, gender, grade and age are presented in Table 3. The results show no statistically significant difference in the perceptions of overall transformational leadership and its dimensions, and the biographical variables of gender, grade and age. The results of the t-test reflect no significant difference between males and females with regard to transformational leadership as well as its dimensions (p>0.05) in all instances. Table 3. Biographical variables and transformational leadership T-test Variable: Gender Transformational leadership Ideolised influence Individualised consideration Intellectual stimulation ANOVA Variable: Grade Transformational leadership Ideolised influence Individualised consideration Intellectual stimulation Variable: Age Transformational leadership Ideolised influence Individualised consideration Intellectual stimulation The ANOVA also reflected no significant difference between the different grades and age groups and their perceptions of transformational leadership and its dimensions (p>0.05) in all instances. t 1.080 1.055 1.125 0.655 p 0.282 0.293 0.262 0.513 F 0.081 0.022 0.163 0.564 p 0.988 0.999 0.957 0.689 0.605 0.802 0.506 0.772 0.660 0.526 0.732 0.545 5.2.4 Transactional Leadership and the biographic variables The results of transactional leadership and its dimensions and the biographical variables are shown in Table 4. Table 4. Biographical variables and transactional leadership T-test Variable: Gender Transactional leadership Active management by exception Constructive transaction Passive management by exception ANOVA Variable: Grade Transactional leadership Active management by exception Constructive transaction Passive management by exception Variable: Age Transactional leadership Active management by exception Constructive transaction Passive management by exception The results show no statistically significant differences in the perceptions of the gender groups, the job grade categories and the age groups with regard to overall transactional leadership and its dimensions (p>0.05 in all instances). 387 t -0.024 -0.156 -0.732 1.077 p 0.981 0.876 0.465 0.283 F 0.395 0.910 0.562 0.642 p 0.812 0.460 0.691 0.633 0.769 0.784 1.100 1.763 0.547 0.537 0.359 0.139 Corporate Ownership & Control / Volume 10, Issue 4, 2013, Continued - 4 5.2.5 Laissez-Faire biographical variables leadership and the Table 5. Biographical variables and laissez-faire leadership T-test t p 1.223 F 0.220 p 1.586 0.181 1.351 0.254 Variable: Gender Laissez-faire leadership ANOVA Variable: Grade Laissez-faire leadership Variable: Age Laissez-faire leadership The results, as reflected in Table 5, show no statistically significant differences in the perceptions of laissez-faire leadership between males and females. Furthermore, it emerged that there was no significant difference in the perceptions of laissezfaire leadership and its dimensions between the variables of job grade and age. 5.2.6 Biographical variables and job satisfaction The results, as indicated in Table 6, reflect no statistically significant differences in job satisfaction between males and females. Table 6. Biographical Variables and Job Satisfaction T-test Variable: Gender Job satisfaction ANOVA Variable: Grade Job satisfaction Variable: Age Job satisfaction Furthermore, it emerged that there was no significant difference between the age groups as well as the different grades, in so far as job satisfaction is concerned (p>0.05) in all instances. 6. Managerial Implications This paper has various managerial implications. Emery and Barker (2007:87) believe that followers strive to emulate their leaders. They trust their leader’s judgment and support their leader’s values, often forming strong emotional ties with their leader. The leader is thus seen as a role model. To this end, the manager needs to lead by example, and employee engagement should reach down to the lowest level of the organization. Intellectual stimulation centres on promoting innovative ideas and creativity among followers. Intellectual stimulation also occurs when the leader encourages creativity among followers to look for new and more efficient ways of solving problems compared to methods employed in the past (Mester et al., 2005:73). Managers, therefore, need to utilise innovative and creative thinking models to stimulate thinking among employees. The application of trouble shooting techniques and problem solving t 0.170 p 0.865 F 0.362 p 0.835 0.772 0.545 guides should involve all employees affected by problems. Mester et al. (2005:73) regard individualised consideration as a process whereby the leader identifies individual uniqueness, links the individuals’ current needs to the organisation’s needs and provides coaching, mentoring and growth opportunities. Leaders, therefore, need to demonstrate a concern for employees’ individual needs and adopt a personalized approach. It must also be borne in mind that skills and experience levels, needs and expectations vary considerably among individuals. A strong interpersonal connection between the leader and employee is required in order to sustain a supporting and caring climate. The laissez-faire leadership style should not be dominant in the leadership mix as this style is viewed as the absence of leadership (Xirasagar, 2008:603). The proposed leadership style for the organisation should contain a mix of transactional attributes (active management by exception and constructive transaction) with the transformational attributes (inspirational motivation, individualised consideration and ideolised influence) being more dominant. Transformational leadership attributes 388 Corporate Ownership & Control / Volume 10, Issue 4, 2013, Continued - 4 (intellectual stimulation, individualised consideration and ideolised influence) are key variables to create a culture that supports continuous learning, innovation and knowledge sharing. 7. Conclusion This paper sought to establish the relationship between leadership style and job satisfaction. Employee perceptions of leadership style, job satisfaction and the influence of biographical variables on these two variables were examined. The results suggest a significant correlation between transformational leadership, transactional leadership, laissez-faire leadership and job satisfaction. It emerged that there were no significant differences in job satisfaction, based on the biographical characteristics of gender, job grade and age category. Some managerial implications are presented. References Adler, R.W. and Reid, J. (2008). “The effects of leadership styles and budget participation on job satisfaction and job performance”, Asia-Pacific Management Accounting Journal, Vol. 3 No.1, pp. 21-46. 2. Andreassen, C.S., Hetland, J., Hetland, H., Notelaers, G. and Pallesen, S. (2011). “Leadership and fulfillment of the three basic psychological needs at work”, Career Development International, Vol.16 No.5, pp.507-523. 3. Avolio, B., Bass, B. and Jung, D.I. (1997). A replicated confirmatory factor analysis of the Multifactor Leadership Questionnaire (Form 5x). Redwood City. 4. Banerji, P. and Krishnan, V.R. (2000). “Ethical preferences of transformational leaders: an empirical investigation”, Leadership and Organisation Development Journal, Vol. 28 No.1, pp.405-403. 5. Bell, E. and Bryman, A. (2007). Business Research Methods. Oxford University Press, New York. 6. Berson, Y. and Linton, D. (2005). “An examination of the relationships between leadership style, quality and employee satisfaction in R&D versus administrative environments”. R&D Management, Vol.35 No.1, pp. 51-60. 7. Bruch, H. and Walter, F. (2007). “Leadership in context: investigating hierarchical impacts on transformational leadership”. Leadership and Organisational Development Journal, Vol.28 No.8. pp.710-726. 8. Cilliers, F., Van Deventer, V. and Van Eeden, R. (2008). “Leadership styles and associated personality traits: Support for conceptualization of transactional and transformational leadership”. South African Journal of Psychology, Vol.38 No.2, pp.253-267. 9. Emery, C.R. and Barker, K.J. (2007). “The effect of transactional and transformational leadership styles on the organizational commitment and job satisfaction of customer contact personnel”. Journal of Organizational Culture, Communications and Conflict, Vol.11 No.1, pp.77-90. 10. Flynn, S.I. (2009). “Transformational and Transactional Leadership”. Research Starters Sociology: Vol.1 No.1, pp.1-6. 1. 11. Jones, D.W. and Rudd, R.D. (2007). “Transactional, Transformational or Laissez-Faire Leadership: An assessment of College of Agriculture Academic Program Leaders (Deans) Leadership Styles”. Proceedings of the AAAE Research Conference, Vol. 3. 12. Madlock, P.E. (2008). “The link between leadership style, communicator competence and employee satisfaction”. Journal of Business Communication, Vol.45 No.1, pp.61-78. 13. McColl-Kennedy, J.R. and Anderson, R.D. (2005). “Subordinate – manager gender combination and perceived leadership style influence on emotions, self-esteem and organizational commitment”. Journal of Business Research, Vol.58 No.2, pp.115125. 14. Mester, C., Visser, D. and Roodt, G. (2003). “Leadership style and its relation to employee attitudes and behavior”. SA Journal of Industrial Psychology, Vol.29 No.2, pp. 72-82. 15. Naidu, J. and Van Der Walt, M.S. (2005). “An exploration of the relationship between leadership styles and the implementation of transformation interventions”. SA Journal of Human Resource Management, Vol.3 No 2, pp.1-10. 16. Nielsen, K., Yarker, J., Brenner, S.O., Randall, R. and Borg, V. (2008). “The importance of transformational leadership style for the well-being of employees working with older people”. Journal of Advanced Nursing, Vol.63 No.5, pp. 465-475. 17. Olson, R., Verley, J., Santos, L. and Salas, C. (2004). “What we teach students about the Hawthorne Studies: A Review of Content within a sample of Introductory IO and OB Textbooks”, The Industrial Organisation Psychologist, Vol.41 No.3, Available online: https:www.siop.org/tip/backissues/Jan 2004/TOC.aspx [Accessed 1 March 2013]. 18. Oshagbemi, T. 2003. “Personal correlates of job satisfaction: empirical evidence from UK universities”, International Journal of Social Economics, Vol.30 No.12, pp. 1210-1232. 19. Ozaralli, N. (2002). “Effects of transformational leadership on empowerment and team effectiveness”. Leadership and Organisation Development Journal, Vol.24 No. 6, pp.335-344. 20. Pattersen, M., Warr, P. and West, M. (2004). “Organizational Climate and Company Productivity: The role of Employee Affect and Employee Level”. London Economic and Social Research Council, Vol.1 No.1, pp.1-31. 21. Sekaran, U. and Bougie, R. (2010). Research Methods for Business: A Skill-Building Building Approach, John Willey & Sons Ltd, West Sussex. 22. Uhl-Bein, M., Marion, R., and McKelvey, B. (2007). “Complexity Leadership Theory: Shifting Leadership from the Leadership Age to the Knowledge Era”, The Leadership Quarterly, Vol.18 No. 1, pp.298-318. 23. Weiss, D.J., Dawis, R.V., England, G.W. and Lofquist, L.H. (1967). Manual for the Minnesota Satisfaction Questionnaire, University of Minnesota: St Paul, MN, USA. 24. Xirasagar, S. (2008). “Transformational, transactional and laissez-faire leadership among physician executives”. Journal of Health Organisation and Management, Vol.22 No.6, pp.599-613. 389 Corporate Ownership & Control / Volume 10, Issue 4, 2013, Continued - 4 THE RELATIONSHIP BETWEEN ELECTRICITY CONSUMPTION AND ECONOMIC GROWTH IN BOTSWANA Kafayat Amusa*, Temitope L.A. Leshoro** Abstract Concerted effort to diversify Botswana economy, in recent years, has seen increased activity of major sectors, which includes higher reliance on electricity. The demand and consumption of electricity within the Botswana economy increased substantially from the 1980’s. However there have been shortfalls in the country’s electricity generation capacity causing increased reliance on imports from neighbouring countries especially South Africa. Given the importance of electricity in Botswana, this study examined the relationship between electricity and economic growth, employing bounds testing approach to co-integration. Results obtained confirmed the importance of electricity for Botswana’s economic growth. The result also passed a battery of diagnostic tests. This study recommends the need for energy policy reforms that will enable increased electricity production capacity.*** JEL Classification: C32, Q43 Keywords: Electricity Consumption, Economic Growth, Cointegration, Botswana * Department of Economics, University of South Africa (UNISA), P.O. Box 392, Unisa, Pretoria, 0003, South Africa E-mail: Amusako@unisa.ac.za ** Department of Economics, University of South Africa (UNISA), P.O. Box 392, Unisa, Pretoria, 0003, South Africa E-mail: lesholat@unisa.ac.za *** Paper presented at the 2011 Global Development Finance Conference: 8-10 November 2011, Dubai. 1. Introduction Electricity consumption is increasingly becoming important in increasing economic growth for many African economies. More and more, the development of economic activities such as industrial production and the service industry is driving growth and increasing output in many developing countries. This has necessitated higher demand for and consumption of electricity. The onset of economic development in Botswana brought with it increased demand for electricity by both household and business sectors. Botswana’s relatively high economic growth has over the years been sustained by the mining sector, especially diamond mining. In recent years, there has been a concerted effort in the diversification of the economy with increased activity in other sectors. Diversification has brought with it higher reliance on electricity. Compared to other Southern African countries, the growth in the country’s demand for electricity is the highest, standing at 6 percent, Southern Africa Power Pool (SAPP). The demand and consumption of electricity within the Botswana economy increased substantially from the 1980’s. However there remains a shortfall in the country’s electricity generation capacity resulting in increased reliance on imports from neighbouring countries especially South Africa. Presently, electricity import, generation and transmission are overseen by the Botswana Power Corporation (BPC). Morupule, the sole electricity generating power station in the country provides approximately 33 percent of the nation’s electricity demand and the shortfall is met by imports from South Africa, Mozambique and the SAPP. Between 2009 and 2010, the shortfall in electricity generation in South Africa forced the authorities to restrict their supply of electricity to Botswana. Botswana experienced severe load shedding which affected households and businesses. It is estimated that the period of load shedding cost the economy millions of dollars. The rural electrification plan implemented in Botswana to connect more households to the national electricity will increase demand for electricity and put even more pressure on its sources of electricity. The potential shortage in the region’s electricity pool and from other countries will without a doubt affect the economy negatively. The realization of the importance of electricity in increasing growth has generated renewed interest in this area for both developed and developing countries (Ebohon, 1996; Yang, 2000; Soytas and Sari, 2003; Jumbe, 2004; Oh and Lee, 2004; Shiu and Lam, 2004; Wolde-Rufael, 2006; Squalli, 2007; Akinlo, 2008; Odhiambo, 2009; Gupta, and Chandra, 2009; Quedraogo, 2010). Studies examining the relationship 390 Corporate Ownership & Control / Volume 10, Issue 4, 2013, Continued - 4 between electricity consumption and economic growth can be generalized into two main categories, those that determine the nature of the relationship between electricity consumption and economic growth and others that examine the direction of causality between the electricity consumption and economic growth. This study contributes to the literature in two major ways. Firstly, it is crucial to understand the exact nature of the relationship between growth and electricity consumption. This is due to the fact that the realization of the importance of electricity for the economy has prompted the government to increase electricity production capacity by building new plants in order to reduce both the shortfall between electricity demand and generation and the country’s reliance on external electricity sources. This study therefore intends to fill that gap. Secondly, this study utilizes econometric developments in its methodology, employing an ARDL bounds testing approach to cointegration to determine both the long run and short run impacts of electricity consumption on economic growth. The rest of the paper is organized as follows; section 2 provides a description of Botswana’s energy sector and Section 3 provides a review of selected literature. Section 4 explains the data and methodology employed; section 5 provides the report and discussion of empirical results and section 6 draws conclusions and offers policy recommendations. 2. Botswana’s Energy sector Botswana is well endowed with coal, fuel wood and solar energy and its energy sector is comprised of coal, electricity and petroleum products, a significant amount of which is imported from foreign sources. Botswana Power Corporation (BPC) oversees the internal generation, transmission and distribution of electricity in the country. Morupule power station produces thermal energy from coal and is the main source of electricity supply domestically. ESKOM in South Africa, Mozambique and SAPP make up the external sources of electricity supply in Botswana. The power generating capacity has failed to keep up with this increase in consumption. Presently the Morupule power station, the single power generating station in the country, is only able to meet about 33 percent of the country’s electricity needs (SAPP, 2005). Figure 1 below indicates the divergence between electricity production and consumption in the country. Figure 1. Electricity Production and Consumption in Botswana (kWh). 1980-2008 The short fall between electricity production and consumption is met by imports from neighboring countries (South Africa, Mozambique) and the SAPP. The short fall between the demand and the supply of electricity has resulted in increased load shedding episodes in the country due to supply pressures from South Africa. As Botswana’s economy has grown, so has the demand for electricity8 within all types of economic activity. In 2009 for example, mining, domestic, commercial and government sectors accounted for 39, 26, 25 and 10 percent of the demand of electricty, underscoring the importance of electricty for the country’s growth. The economy relies predominantly on the mining sector therefore it is not suprising to find the demand for electricity highest in mining Observation of the electricity consumption and economic growth indicates a comovement between the two variables. Figure 2 displays trends in real gdp per capita and per capita electricity consumption (1981-2010). Both variables are observed to move in the same direction, indicating a positive correlation. 8 Electricty consumtion has increased significantly since the 1980’s. Electricity consumption per capita increased from 5741kWh in the 1980’s to 9055 kWh in the 1990’s and 11670kWh in 00’s. 391 Corporate Ownership & Control / Volume 10, Issue 4, 2013, Continued - 4 Figure 2. Trend in electricity consumption and GDP per capita, 1981 – 2008 Source: World Bank, World Development indicators 3. Review of selected literature There exists a rich literature that examined the electricity consumption and growth nexus in both single and multi country contexts for developed and developing countries and employing a variety of estimation techniques. Studies that consider the nexus for African countries are numerous. Wolde-Rufael (2006) employed time series analysis in examining the relationship between electricity consumption and growth in nineteen African economies. The study addresses the limitations of methods in previous studies that require time series aggregates to be integrated of order zero, I(0), suggesting that this limits the ability to make inference from variables that are otherwise integrated of a higher order, I(1). In addition, in the examination of causality, prior studies use the F-statistic. However this suffers from a lack of standard distribution when the variables are cointegrated. To this end, the study used bounds testing approach to cointegration to investigate the long run and causal relationship between electricity consumption and growth. The results obtained are mixed. For six of the countries causality runs from growth to electricity consumption, indicating the importance growth for electricity. In four countries, causality was observed to run from electricity consumption to economic growth. For the remaining countries no long run relationship was observed between electricity consumption and growth. For Burkina Faso, Quedraogo (2010) utilized time series data from 1968-2003 in a bounds testing approach to cointegration framework to examine the relationship between electricity consumption and economic growth. The findings indicate the importance of electricity consumption for the Burkina- Faso economy, reflected by the bidirectional relationship between electricity consumption and economic growth. Jumbe (2004) applied granger causality together with an error correction modelling approach to examine the cointegration of and causality between electricity consumption and economic growth in Malawi between 1970 and 1999. The study considered GDP, non agriculture GDP and agriculture GDP to account for the importance of the agriculture sector in Malawi’s GDP. The study found cointegration between electricity consumption, non agriculture GDP and GDP. The results from the error correction model indicated that electricity consumption is not an important factor in Malawi’s economic growth, a plausible result given that Malawi’s economic growth is highly dependent on the agricultural sector. Unlike many studies that investigate the relationship between electricity consumption and economic growth, Odhiambo (2009) uses trivariate causality test to examine the impact of electricity consumption on electricity growth in South Africa. The study used electricity consumption, economic growth and manufacturing sector employment level (as proxy for employment level) in the estimations. Bi-directional causality was found between electricity consumption and economic growth, while unidirectional causality was observed from employment to economic growth. The results imply that electricity consumption drives economic growth and economic growth is also important for electricity consumption in South Africa. Studies on the relationship between electricity consumption and economic growth in Asian, Middle Eastern and developed countries also yielded mixed results. Gupta and Chandra (2010) examined the relationship for India between 1960 and 2006. Unidirectional causality from electricity consumption to economic growth is observed for India. The authors concluded that reforms in the country’s power sector are essential if India hopes to meet its growth potential. For Taiwan, Cheng and Lai (1997) observed similar unidirectional causality from electricity consumption to economic growth. In a multivariate framework, Narayan and Singh (2007) found the causality to be unidirectional from electricity 392 Corporate Ownership & Control / Volume 10, Issue 4, 2013, Continued - 4 consumption and economic growth in Fiji. Squalli (2007) employed the Toda-Yamamoto and bounds testing estimation technique in investigating the relationship between electricity consumption and economic growth for Indonesia and six Middle Eastern countries respectively. For Indonesia, causality ran from electricity consumption to economic growth, while in the Middle Eastern countries, causality was observed to run from economic growth to electricity consumption. A few studies found evidence of bi directional causality between electricity consumption and economic growth. For example, Masih and Masih (1997) investigated the causality between electricity consumption and economic growth in India, Indonesia, Pakistan, Malaysia, Singapore and the Philippines using an error correction modelling approach. Causality is found to run from electricity consumption to economic growth in India, from economic growth to electricity consumption in both Indonesia and Pakistan. For the other countries, the relationship was determined to be neutral. Narayan and Smyth (2005) using multivariate granger causality test in the case of Australia, Hondroyiannis and Papapetrou (2002) using error correction modelling approach in the case of Greece found that causality ran from economic growth to electricity consumption. Soyta and Sari (2003) using error correction modelling approach, Lee (2006) employing Toda –Yamamoto causality tests for 10 western countries found evidence of unidirectional causality from economic growth to electricity consumption for some countries and for other countries causality ran from electricity consumption to economic growth. Description The specification of the model which explains the relationship between electricity consumption and economic growth for Botswana, using the recently developed autoregressive distributed lag (ARDL) approach to co-integration, is discussed in this section. The ARDL modelling was initially introduced by Pesaran and Shin (1999) and later further developed by Pesaran, Shin and Smith (2001). Some of the many advantages of using the ARDL model include first, its attractiveness in conducting co-integration analysis in small samples as it avoids the finite sample bias, second its efficiency over the vector autoregressive (VAR) methods (Banerjee et.al, 1993; Inder, 1993), third, It allows the undertaking of cointegration analysis irrespective of the order of integration of the underlying regressors. I.e. whether the regressors are integrated of zero order [I(0)], order [I(1)]. Lastly, ARDL uses a single reduced form equation instead of the system of equations as used in the conventional Johansen co-integration with consistent estimates and valid t-ratios (Inder, 1993; 68). The model is thus: ln GDPt   0  1 ln ECt   t and Data A bivariate approach to investigate the relationship between electricity consumption and economic growth is taken in this study, using annual time series data from 1981 to 2010. The variables considered are real gross domestic product (GDP) as a proxy for economic growth measured in millions of U.S. dollars, 2000 constant prices, and electricity consumption measured in kilowatt hours. The data on these variables is sourced from World Bank, World Development Indicators database. m n i 1 j 0 Autoregressive This approach is based on estimating the long-run relationship between the variables, as well as estimating the short-run and long-run coefficients of each variable in equation 1 using a conditional unrestricted error correction model (UECM) to cointegration. Although, many time series data are not stationary and overlooking such could result in spurious regression, the method of ARDL does not require pre-testing for the presence of unit root and the order of integration does not have to be the same. It is only important that the maximum order of integration be of order one, I(1). Equation (1) is modeled as a conditional autoregressive distributed lag (ARDL) with each variable regressed on each other:  ln GDPt   0   1i  ln GDPt i   2 j  ln EC t  j  1 ln GDPt 1  2 ln EC t 1   1t m n i 1 j 0 (1) where lnGDPt is the log of real GDP in time t; lnECt is log of electricity consumption in kilowatt hours at time t. Our objective is to find the marginal effect of electricity consumption on economic growth, that is, whether β1 is positive or negative and if statistically significant. 4.3 Co-integation – Distributed Lag (ARDL) 4. Data and model specification 4.1 Variable Sources 4.2 Model Specification  ln ECt  0   1i  ln ECt i  2 j  ln GDPt  j  1 ln ECt 1  2 ln GDPt 1   2t 393 (2) (3) Corporate Ownership & Control / Volume 10, Issue 4, 2013, Continued - 4 where Δ denotes first difference, the parameters ф’s and β’s capture the coefficients of the short run dynamic, ψ’s and ρ’s give the long run coefficients. The other variables are as earlier defined. The long-run equations are as follows: ˆ 1 ln GDPt 1  ˆ 2 ln ECt 1  0 ˆ1 ln GDPt 1  ˆ 2 ln ECt 1  0 (4) The ARDL approach to co-integration uses the F-statistic (or Wald statistic) to test the joint significance of the lagged levels of the variables lnGDPt-1, lnECt-1. The null hypotheses of ‘no cointegration’ against the alternative are: In equation 1: H 0 : 1   2  0; GDP coefficient will be H1 : 1   2  0 In equation 2: H 0 : 1  2  0; I(0). If the computed test statistic at a chosen level of significance lies below the lower bounds value, the null hypothesis of ‘no co-integration’ cannot be rejected. If the test statistic obtained from the Wald test lies between the upper bound and the lower bound, there is no conclusive inference on the cointegration test. If the computed F-statistic exceeds the upper bound, we reject the null hypothesis of no co-integration. The coefficients of the variables in their first differences gives the short-run effects and the long-run coefficients are obtained by multiplying the coefficients of the one lag of the explanatory variable by a negative sign, then divide by the coefficient of the one-period lag of the dependent variable. Thus, the long-run coefficients of the electricity consumption will be  2  1 and real H1 : 1  2  0 Pesaran et al. (2001) developed two sets of critical values for a given level of significance namely, the upper bound I(1) and the lower bound   2 1 . 5. Empirical results The unit root tests performed indicate that both variables are not stationary at levels. They became stationary after the first difference; that is, they are integrated of order one, I(1). Table 1 shows the results of the unit root test using both DF-GLS and PhillipsPerron (PP) tests for unit root. Table 1. Summary of Unit root tests: Variables lnGDPt lnECt Variables lnGDPt lnECt DF-GLS Levels First difference Intercept Trend & Intercept Intercept Trend & Intercept -4.024*** -1.626 -3.013 -3.650** -1.048 -3.592** -5.511*** -5.471*** Phillips-Perron Levels First difference Intercept Trend & Intercept Intercept Trend & Intercept -3.645*** -1.285 -2.944** -3.27** -2.055 -2.704 -8.128*** -10.192*** Conclusions I(1) I(1) I(1) I(1) *10%; **5%; ***1%. A general-to-specific ARDL model was first performed where a lag length of one was chosen (based on all the lag length criteria, except the LogL criterion (See Appendix A). Then the insignificant variables were dropped one after the other while observing the Akaike determine the importance The result of the bounds where each variable is dependent variable. 394 information criterion to of the dropped variables. test is shown in Table 2, in turn regressed as a Corporate Ownership & Control / Volume 10, Issue 4, 2013, Continued - 4 Table 2. Cointegration test results Critical value bounds of the F statistics: restricted intercept and no trend Critical Values F-statistics 1% level 5% level (k = 1, T = 30) I(0) I(1) I(0) I(1) 6.84 7.84 4.94 5.73 lnGDP = (lnGDP\lnEC) = 4.86* lnEC = (lnEC\lnGDP) = 4.79* 10% level I(0) 4.04 I(1) 4.78 Critical values obtained from Pesaran, Shin and Smith (2001), Case III, p.300. I(0) – lower bound; I(1) – upper bound. *10%; **5%; ***1%. The result shows that the null of ‘no cointegration’ among the variables is rejected. The coefficients ψ and ρ are significantly different from zero in both instances; that is, where real GDP and electricity consumption are in turn used as the dependent variable. The result shows that the calculated F-statistics, 4.86 and 4.79, exceed the upper critical limit obtained from Pesaran et. al (2001) at 10% level in both cases, that is, when GDP is taken as the dependent variable and when electricity consumption is taken to be the dependent variable. This therefore implies that there is a long-run relationship between the two variables, GDP and electricity consumption. Table 3 below shows the short-run and long-run effects in both equations. Electricity consumption does not have a short-run effect on GDP, in the model where GDP is the dependent variable. However, in the long-run, electricity consumption has a positive and significant effect on GDP, where a percentage increase in electricity consumption will lead to an increase in GDP by over 80%. Table 3. Short-run and long-run relationships Dependent variables lnGDP lnEC Short-run ∆lnGDP ___ -0.545 (-1.895) Long-run lnGDP(-1) ___ 0.836 (0.015)** ∆lnEC ___ ___ lnEC(-1) 0.882 (0.072)* ___ *10%; **5%; ***1%. Figures in parentheses indicate P-value On the other hand, GDP shows a negative effect on electricity consumption in the short-run, but this is insignificant. Nevertheless, there is a significantly positive relationship in the long-run of GDP on electricity consumption. A percentage increase in GDP will cause an equally over 80% increase in electricity consumption in the long-run. This further affirms the result of the bounds test, where an evidence of a long-run relationship between the variables, co-integration, was found. A battery of diagnostic tests of normality, autocorrelation, heteroskedasticity and model mis-specification, was carried out and the result fails to reject any of the null hypotheses. The result of the diagnostic tests is shown in Table 4. CUSUM and CUSUM of squares (see Appendix B) were also adopted to test the stability of the model and the result shows that the parameters of the model are stable as the cumulative sum of squares lie inside the 5% significance lines. Table 4. Set of diagnostic tests Tests Jarque-Bera Serial Correlation LM Test+ Heteroskedasticity Test++ Ramsey RESET Test Dependent variable: lnGDP JB: 1.417 (0.492) F-statistic: 0.174 (0.841) F-statistic: 1.124 (0.359) F-statistic: 1.297 (0.208) Dependent variable: lnEC 0.928 (0.231) 0.708 (0.504) 0.143 (0.933) 0.006 (0.995) *10%; **5%; ***1%. +Breusch-Godfrey. ++Breusch-Pagan-Godfrey. Figures in parentheses indicate P-value 6. Conclusion and Recommendations The study utilizes bounds testing approach to cointegration in examining the relationship between electricity consumption and economic growth Botswana from 1981-2010. The study aimed investigating whether electricity consumption important for the growth. Despite the myriad 395 in at is of Corporate Ownership & Control / Volume 10, Issue 4, 2013, Continued - 4 literature on the relationship between electricity consumption and growth, very little has been done to understand the role of electricity in Botswana’s economy which is driven predominantly by the mining sector. In this study, DF-GLS and PP were used to test for stationarity and the variables were found to be integrated of order one, although a pre-test of the presence of unit root is not required. We therefore continued to apply the ARDL technique of bounds test approach to co-integration and we found evidence of a long-run relationship between GDP and electricity consumption in Botswana. Furthermore, the result showed that electricity consumption does not have a short-run effect on GDP, but it has a significantly positive effect on GDP in the long-run. Conversely, GDP has both short-run and long-run effects on electricity consumption, although not significant in the short-run, it has a positive and significant effect on electricity consumption in the long-run. This study is important for a number of reasons; first, the efforts to diversify the economy away from its reliance on the mining sector have meant the development of other economic sectors. This has brought with it increased demand for electricity in these sectors, putting further pressures on the already limited energy capacity and supply. Second, the country’s electricity production capacity is inadequate and unable to match the demand. This means the economy will be vulnerable to any shocks in electricity supply from neighboring countries. This has been evidenced in the last few years, where frequent load shedding or electricity rationing as a result of declining supply from foreign suppliers especially South Africa has negatively impacted on the economy, with losses reported in the millions of US dollars. Third, the study and its findings have a bearing on the country’s energy policy. It points to the need for increased electricity production ability in the country. This requires the government to consider opening up the energy sector to private suppliers, thus ensuring increased competition and efficiency which would otherwise not be achievable with BPC monopolizing the generation, transmission and distribution of electricity. Given that electricity consumption is positively related to growth especially in the long run, the country’s energy policy must be structured so as to be able to sustain growth. With projected increase in overall energy demand within all forms of economic activity, and considering that the country is well endowed with coal, fuel wood and solar energy, there is a need to venture into developing alternative energy sources, increase the research into sustainable clean energy such as solar energy to reduce the bottlenecks in electricity supply. This will ensure that the country’s reliance on external energy supply is reduced and that growth plans are not jeopardized by electricity shortages similar to those that are presently on going in the country. References 1. 2. 3. 4. 5. 6. 7. 8. 9. 10. 11. 12. 13. 14. 15. 16. 396 Akinlo, A.E. (2008), “Energy consumption and economic growth: evidence from 11 Sub Saharan African countries”, Energy Economics, 30, pp. 23912400. Banerjee, A. Dolado, J. Galbraith, J. and Hendry, D. (1993), “Co-integration, Error-Correction, and the Econometric Analysis on Non-Stationary Data”, Oxford University Press, Advanced Texts in Econometrics. Oxford. Botswana Power Cooperation (BPC) Annual Report (various years). Ebohon, O. J. (1996), “Energy, economic growth and causality in developing countries: a case study of Tanzania and Nigeria”, Energy Policy, 24, pp. 447453. Cheng, B.S. and Lai, T.W. (1997), “An investigation of cointegration and causality between energy consumption and economic activity in Taiwan”, Energy Economics, 19, pp. 435-444. CIA World Factbook Online. Gupta, G. and Chandra, S. (2009), “Causality between electricity consumption and economic growth: empirical evidence from India”, Munich Personal RePEc Archive (MPRA), Paper No, 22942. Hondroyiannis, G. and Papapetrou, G. (2002), “Energy consumption and economic growth: assessing the evidence from Greece”, Energy Economics, 24, pp. 319-336. Inder, B. (1993), “Estimating Long-Run Relationships in Economics: A Comparison of Different Approaches”, Journal of Econometrics, 57, pp. 53-68. Jumbe, C.B.l. (2004), Cointegration and causality between electricity consumption and GDP: empirical evidence from Malawi. Energy Economics. 24, pp. 6168. Lee, C. (2006), “The causal relationship between energy consumption and GDP in G-11 countries revisited”, Energy Policy, 34, pp. 1086-1093. Masih, A.M.M. and Masih, R. (1997), “On the causal relationship between energy consumption, real income prices: some new evidence from Asian NICs based on multivariate cointegration/vector error correction approach”, Journal of Policy Modelling, 19, pp. 417440. Narayan, P.K. and Smyth, R. (2005), “Electricity consumption, employment and real income in Australia: evidence from multivariate Granger causality tests”. Energy Policy, 33, pp. 1109-1116. Narayan, P.K. and Singh, B. (2007), “The electricity consumption and GDP nexus for Fiji Islands”, Energy Economics, 29, pp. 1141-1150. Odhiambo, N. (2009), “Electricity consumption and economic growth in South-Africa: A trivariate causality test”, Energy Economics, 32, pp. 635-640. Oh, W. and Lee, K. (2004), “Causal relationship between energy consumption and GDP revisited: the case of Korea 1970-1999” Energy Economics, 26, pp. 51-59. Pesaran, M. H. Shin, Y. and Smith, R. J. (2001), “Bound testing approaches to the analysis of level relationships”, Journal of Applied Econometrics, 16, pp. 289–326. Corporate Ownership & Control / Volume 10, Issue 4, 2013, Continued - 4 17. Quedraogo, I.M. (2010), “Electricity consumption and economic growth in Burkina-Faso: A cointegration analysis”, Energy Economics, 32, pp. 524-531. 18. Shiu, A. and Lam, L.P. (2004), “Electricity consumption and economic growth in China”, Energy Policy, 32, pp. 47-54. 19. Southern Africa Power Pool (SAPP) Annual Report, 2005. 20. Soytas, U. and Sari, R. (2003). “Energy consumption and GDP: causal relationship in G-7 countries and emerging markets” Energy Economics, 25, pp.33-37. 21. Squalli, J. (2007), “Electricity consumption and economic growth: Bounds and causality analyses of OPEC members” Energy Economics, 29, pp. 11921205. 22. Wolde-Rufael, Y. (2006), “Electricity consumption and economic growth: a time series experience of 17 African countries”, Energy Policy, 34, pp. 1106-1114. 23. World Development Indicator (WDI) online database. 24. Yang, H.Y. (2000), “A note on the causal relationship between energy and GDP in Taiwan”, Energy Economics, 22, pp. 309-317. 397 Corporate Ownership & Control / Volume 10, Issue 4, 2013, Continued - 4 Appendix A Table A.1. Shortfall in Botswana Electricity demand and supply (Billion kWh). 2000-2010 years 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 Electricity production 1 0.61 0.51 0.41 0.41 0.93 0.89 0.82 0.98 0.98 1.05 Electricity consumption 1.62 1.52 1.45 1.56 1.56 1.89 2.64 2.46 2.57 2.57 2.65 Short fall 0.62 0.91 0.94 1.15 1.15 0.96 1.75 1.64 1.59 1.59 1.6 Source: CIA World Factbook, Online Table A.2. VAR Lag Order Selection Criteria lag 0 1 2 3 LogL 8.61354 90.01658 93.48778 96.18075 LR NA 144.7165* 5.656773 3.989583 FPE 0.002101 6.81e-06* 7.13e006 7.98e-06 AIC -0.489892 -6.223450* -6.184280 -6.087463 SC -0.393904 -5.935487* -5.704340 -5.415547 HQ -0.461350 -6.137824* -6.041569 -5.887667 * indicates lag order selected by the criterion. LR: sequential modified LR test statistic (each test at 5% level). FPE: Final prediction error. AIC: Akaike information criterion. SC: Schwarz information criterion. HQ: Hannan-Quinn information criterion Figure A.3. CUSUM for equation 2 15 10 5 0 -5 -10 -15 88 90 92 94 96 98 CUSUM 00 02 04 06 08 10 08 10 5% Significance Figure A.4. CUSUM for equation 3 15 10 5 0 -5 -10 -15 88 90 92 94 96 CUSUM 98 00 02 04 5% Significance 398 06 Corporate Ownership & Control / Volume 10, Issue 4, 2013, Continued - 4 COMMUNICATION CHANNELS AND INTERPERSONAL COMMUNICATION BETWEEN SOUTH AFRICAN AND GERMAN BUSINESS PARTNERS Oleg Scheming*, Roger B Mason** Abstract Good communication skills are vital, especially in business. This study investigated the role of interpersonal communications in managing South African – German business relationships. The objective of the study was to identify which communication channels South African businesses use to communicate with their German business partners, and which are perceived to be the most effective. In order to accomplish the objective, a survey was conducted by means of self-administered e-mail based questionnaires. In addition, a few depth interviews were conducted to help interpret the quantitative results of the study. In both cases, the respondents were purposively selected. Based on the findings, recommendations were provided on how communication can be made more effective to improve South African and German business relationships. Keywords: Interpersonal Communication Channels Communication, Business Relationships, Global Partnerships,  Department of Marketing & Retail Management, Durban University of Technology, South Africa ** Corresponding author, Department of Marketing & Retail Management, Durban University of Technology, South Africa; Institute of Systems Science Fax: +27(0)86 674 1196 Tel.: +27(0)31 373 5385 E-mail: rogerm@dut.ac.za 1 Introduction Germany has been one of South Africa’s main business trading partners over the past ten years, being consistently the largest supplier of imports into South Africa and being either the third or fourth largest export customer for South African goods. For example, in 2008, Germany accounted for 11.3% of all imports into South Africa and for 7.2% of all South Africa’s exports (South African Revenue Services, 2012). Clearly, maintaining sound relationships between South African and German firms is essential to continue such successful and important trade activities. Managing business relationships is a key ingredient of business success – across all industries (Limehouse, 1999: 100). According to Wang and Ji (2010: 173), business expectations have become a primary concern for organisations, especially those who trade in the global market. Hemamalini (2002: 3) states that besides changing market conditions and new global competitors, the businesses themselves are changing. The challenges of rapid innovation, shrinking product life cycles, falling prices and global competition make it difficult for companies to focus on managing business relationships. According to Jordan and Eldredge (2003: 44), it takes more than just technology to maintain business relationships. It takes improved business processes and a method for providing the information needed in business in an efficient and effective manner, and that means that proper interpersonal business communication between organizations is needed (Kaufman, 2001: 36). The way business partners communicate with each other can either build or destroy relationships and, therefore, has a direct influence on the effectiveness of business (Bambacas & Patrickson, 2008: 53). Ridilla (2008: 70) explains that there are three separate forms of business communications that are critical to maintain a positive working relationship between businesses. These are body language, verbal aspects and documentation. The Manufacturers' Agents National Association (MANA) agency found that 95 percent of all business problems in 2006 evolved from a lack of communication which shows how important communication is to be successful in business (A perfect principal doubleheader, 2006: 47). Before the problems in communication can be addressed, it is important to first identify how business people communicate with each other and which communication channels they use. Therefore this study set out to identify and examine the interpersonal channels used by business organisations in South Africa to communicate with their German 399 Corporate Ownership & Control / Volume 10, Issue 4, 2013, Continued - 4 business partners. First the literature on previous research is presented, then the method used to conduct the study is explained and the statistical findings from the empirical study are presented. Finally, the implications of these findings for the businesses are interpreted and recommendations are made. 2 Literature review 2.1 Building a positive between partners relationship The most effective means of creating a positive relationship in business is using straight talk; open communication between the business partners is a necessity to keep a positive relationship (Banker to banker, 2007: 27). Romaniello (2004: 43) declares that closer and more frequent communication between business partners fosters tighter and more successful relationships. However, both partners’ support must encourage the creation of a positive relationship. Evenson (2010: 69) indicates that building a positive relationship begins when your business partner gets a first impression of you and your company. Bilanich (2009: n/a) nominates three things that should be done for building strong and positive relationships. First, get to know yourself, second, give with no expectation of return and, third, resolve conflict positively with minimal disruption to your relationships. 2.2 Challenges in building business relationships global Magrath (1997: 46) indicates that to understand global business partners, their priorities and the knowledge of how to solve global business relationship problems create challenges. Korzeniowski (2001: 40) declares that “International connections are a challenge for every company”, and many large international companies are hesitant because they have concerns about the long-term viability. Brown (cited in Handley, 2010) states that global businesses and their relationships can struggle if there is no central person or team deciding what skills are needed. Developing the right international objectives is a critical component to international operations, and to build efficient relationships significant time and effort have to be invested into research and planning (Glover, 2001: 66). 2.3 Differences in culture, technology and communication Culture impacts on behaviour, morale, and productivity at work, and includes values that influence company attitudes and actions (Harris, Moran & Moran, 2004: 4). The primary reason for global business failures is a lack of understanding of foreign cultures and the right communication is the cornerstone to improve such understanding (Kanungo, 2006: 26). Apart from that, different technology standards in different countries can have an influence on building business relationships. Rishel and Burns (1997: 3) explain that strong relationships also depend on the technology standard used by organizations. A study was done at the Computerworld’s premier 100 IT leaders conference in 2005 regarding the main obstacles to global strategies for IT companies. These were cultural issues (32%), lack of globalisation plans (30%), political issues (29%) and technological issues (9%). Clearly, therefore, organizations should pay more attention to cultural issues. 2.4 Communication in business In the words of Ludlow (cited in Kushal, 2009: 2), “Business communication is a process of transfer of information and understanding between different parts and people of a business organization. It consists of various modes and media involved in communication interchanges”. Communication is necessary in business and, if it is done effectively, it supports organizational growth, survival and future success (Barnes, 2002: 30). According to Namita (2009: 3) communication is the main ingredient of business because no business can grow and expand without proper communication channels. Ramsey (1994: 45) states that multinational organizations need effective communication if they want to be successful abroad. 2.5 Verbal and nonverbal communication Kirst-Ashman and Hull (2008: 48) claim that human communication involves both verbal and nonverbal behaviour. Erasmus, Bowler and Goliath (1998: 8) state that success in business often depends on a person’s ability to communicate effectively, and effective communication combines verbal and nonverbal communication. Verbal communication contains oral and written communication between people and involves the use of words in speaking, writing, reading and listening (Erasmus, Albin & Donavon, 1998: 8). According to Hughes (2003: 21), the right word choice and clarity in verbal communication is important and requires attention to personal dynamics. According to Yuan (2007: 77), compared with verbal communication, nonverbal communication is often indirect and ambiguous and people may use different nonverbal signals to show different attitudes when speaking. Preston (2005: 83) states that nonverbal messages can support or interfere with the verbal messages which are delivered by people. 2.6 Communication channels in business The communication process is successful only if the receiver understands the message as intended by the 400 Corporate Ownership & Control / Volume 10, Issue 4, 2013, Continued - 4 sender. This process sounds simple but it is not always achieved in business (Guffey, Rogin & Rhodes, 2009: 12) because of various reasons, including incorrect encoding and decoding of the message, interfering messages and incorrect choice of communication channel. Harris (2007: 18) states that there are many communication channels which can be used to transfer information. Guffey and Almonte (2009: 34) maintain that choosing the right communication channel depends on the importance of the message, the amount and speed of feedback required, the necessity of permanent record, the cost of the channel, and best practice in the company. Cabot and Steiner (2006: 64) suggest that different positions and jobs in the company require different communication channels to be used. According to Abell and Codd (2003: 21), choosing the right communication channel is a way to influence the right people in business and helps to establish a credible platform from which to negotiate. 2.7 Types of organizations communication in Communication is not simply a matter of the face-toface exchange of information. In organizations, people participate in a number of different levels of communication (Fielding, 2005: 25). According to Lehman and Dufrene (2007: 9), communication in organizations can refer to different audiences and generally can take place on five levels:  Intrapersonal communication;  Interpersonal communication;  Group communication;  Public communication; and  Mass communication. 2.8 Interpersonal communication “Interpersonal communication is the process of message transaction between two or more people to create and sustain shared meaning” (West & Turner, 2008: 10). Weiten, Lloyd, Dunn and Hammer (2008: 205) state that interpersonal communication is an interaction process in which one person sends a message to another while using a certain communication channel. Interpersonal communication is extremely important in business and bad interpersonal skills contribute considerable inefficiencies in companies and other organizations (Ellet, 2006: 101). Interpersonal communication is the most common context of business and professional relationship building, and interpersonal communication skills are obviously the foundation of success in business (Troester & Mester, 2007: 156). Consequently, aspects of interpersonal communication are important in attempting to understand issues such as long-term bonding and the development of trust (Olkkonen, Tikkanen & Alajoutsijarvi, 2000: 404). According to Coyle (1993: 4), employees need relationships to realize their potential – in today’s workplace relationships require interdependence that can most effectively be achieved through better quality in interpersonal communications. Just (1999: 84) suggests that organizations are no longer relying on power and control, but rather on empowerment and commitment. Moreover, building strong interpersonal working relationships help to create synergy and teamwork within a work group or an organization. 2.9 Communication barriers problems and Communication is the most important skill for success in business and studies show that people in organizations generally spend over 75 percent of their time in interpersonal communications (Carroll, 2009: ix). According to Sedam (2002: 44), if people talk about communication problems in business, they should look deeper for the cause, such as different behavioural styles, personalities, company policies, structure and culture. According to Harris and Hartmann (2001: 315), objectivity in receiving and interpreting messages is often difficult to achieve because of communication problems caused by perceptual and psychological reasons or as a result of specific situations. Obstacles and factors which disturb the communication process and, therefore, make the communication incomplete and ineffective are known as communication barriers (Debasish & Das, 2009: 61). Communication barriers are any factors that interfere with the success of the communication process (Krizan, Merrier, Logan & Williams, 2007: 16). According to Qazi and McKenzie (1983: 70), communication slowdowns or breakdowns can result from ambiguous or misinterpreted verbal or nonverbal communications. Pancrazio and Pancrazio (1981: 31) go further and declare that communication barriers lead to miscommunication and cause problems in communications such as causing defensive reactions, cutting off further communication, diminishing chances to identify options and resulting in confusion or misunderstanding. Sri Jin and Sunitti (2009: 45) define miscommunication as “… a ruined form of communication. What is to be communicated does not get communicated and an obstructed form of message is transmitted”. Considering the importance of inter-cultural communications, this study aimed to identify the interpersonal communications channels used by organisations in South Africa to communicate with their business partners in Germany, as well as to investigate interpersonal communication problems experienced by such businesses in managing their business relationships. To meet this objective, the following issues, identified from the literature, were determined to be key to successful interpersonal 401 Corporate Ownership & Control / Volume 10, Issue 4, 2013, Continued - 4 business communications and were used to develop the questionnaire:  Use of communication channels especially Web 2.0 communication channels  Familiarity with these communication channels  Perceived suitability of communication channels  Interpersonal skills and their role as barriers to communication  Cultural aspects and their role as barriers to communication  Language and use of terminology and its role as a barrier to communication These issues therefore formed the basis of the empirical study and will be discussed in detail in the Results section of this paper. 3 Method An exploratory research design with both quantitative and qualitative instruments was used to collect the necessary data. The survey method, using a questionnaire, was chosen in order to collect the quantitative data. To develop more understanding of the quantitative findings, in-depth interviews were also conducted. The target population was South African companies that communicate with Germany on business matters. Within these firms, the research elements were Managing Directors, Heads of Departments, and employees who work in sales, marketing and purchasing, and who communicate with German suppliers or customers. The data was collected during September and October 2011 from firms based in South Africa. The sample frame was the South African – German Chamber of Commerce and Industry membership list of 500 organizations. A nonprobability sampling design was used for the survey. Specifically, the sampling design was a mixture of purposive sampling, census and self-selected sampling. The first step was to select the companies suitable for the study from the South African – German Chamber of Commerce and Industry list. Non-trading organisations and service firms such as restaurants were excluded from the frame. The remaining companies were phoned to make sure that they are qualified and then asked to participate in the survey. From these selected companies, an e-mail based census was done. Finally, the achieved sample was based on a self-selected sampling. A self-selected sample is a form of convenience sample where the respondents determine whether or not to be a part of the sample (Kim, 2011: 41). The final achieved sample consisted of 200 companies. The questionnaire was developed from the literature on business communications, with questions stated simply to ensure that they were understood by all respondents. To ensure validity, each question was pre-tested. Closed-ended Likert scaled questions were mainly used. In addition to pre-testing, the developed questionnaire was also checked via a pilot-study to test validity. Most of the questions can be seen in Table 5. The data was then collected via an e-mail online survey. The respondents received an Internet link via e-mail, which they had to click on to access the questionnaire. The Statistical Package for the Social Sciences (SPSS), version 18, was used to analyse the data. Descriptive statistics were used, summarising the results mainly in terms of mean values. To test for statistical significance chi-square tests were used. Regarding the qualitative interviews, a nonprobability sample was used. Purposive sampling was chosen because information regarding the research topic and research problem was believed to be held by certain respondents. Six interviews were conducted in this study to gain more in-depth information. The requirement for qualifying for the interview was that the respondent communicated regularly with German business partners and worked for a company based in South Africa. A qualitative interviewer framework, based on the study aim, was developed to explore some of the quantitative results. Information provided by the interviewees was audio recorded, transcribed, and then the transcription was deconstructed and reconstructed according to the research themes. 4 Results 4.1 Sample demographics The gender of the participants in the quantitative study shows a reasonable spread. The results can be seen in Table 1, which also shows respondents’ ages. Over 70 per cent of the respondents were over 40 years old. This finding was expected because the study was designed to collect information mainly from managing directors or senior managers, who would be expected to be older. 402 Corporate Ownership & Control / Volume 10, Issue 4, 2013, Continued - 4 Table 1. Age and gender Gender Age 18 - 30 41 - 50 > 50 Total f % f % f % f % Like age and gender, work experience was felt to be an important criterion for ensuring representativeness of the sample. The length of employment in years of the respondents showed an even spread, with experience from 1 year up to over 20 years. In summary, 80% of the respondents had worked for more than 4 years and over 40% had worked over 10 years for the company. This relatively high level of experience means that the sample respondents could be expected to be sufficiently knowledgeable about their organizations’ activities and communications. A comparison of the opinion questions in terms of the demographics questions was done using analysis of variance. None of the comparisons were found to be significant. Thus it was concluded that the respondents’ opinions about interpersonal communications did not differ between genders, age Female Male Total 9 14.1% 15 23.4% 10 15.6% 34 53.1% 10 15.6% 8 12.5% 12 18.8% 30 46.9% 19 29.7% 23 35.9% 22 34.4% 64 100.0% categories or length of time worked at the company. Therefore, subsequent analyses were only conducted and discussed according to the total results. 4.2 Familiarity and use of communication channels Table 2 shows the communication channels that South African business people are most familiar with, and the frequency with which each channel is used per day. There were obviously high levels of familiarity with the telephone, face-to-face and e-mail. However, only about a third (34.4 percent) were familiar with Web 2.0 services, and approximately 47 percent with videoconferencing. In other words, the more modern or sophisticated communications channels are not well known. Table 2. Communication channel familiarity and use (%) Channel Telephone Face to Face Videoconferencing Electronic mail Web 2.0 % familiar with channel 96.9 84.4 46.9 100.0 34.4 Times channel used per day Domestic (South African) International (German) 0 1-5 6-15 >15 0 1-5 6-15 >15 32.3 43.5 24.2 9.7 72.6 11.3 6.5 10.5 70.2 8.8 10.5 85.7 11.1 1.6 1.6 85.0 15.0 84.9 15.1 1.6 6.3 31.7 60.3 1.6 52.4 23.8 22.2 79.0 9.7 8.1 3.2 81.7 10.0 3.3 5.0 Table 2 also shows a comparison of how often South African business people use each communication channel to communicate with their domestic business partners on the one hand, and with their German business partners on the other hand. On average, approximately 80% of respondents did not use videoconferencing or Web 2.0 to communicate with neither their domestic partners nor with their German business partners. This is consistent with the low level of familiarity with these channels. The two most used channels for domestic communication were e-mail, which was used more than 15 times a day by 60.3% of respondents, and face-to-face which was used less often (1 – 5 times a day by 70.2% of respondents). Obviously a high percentage of the respondents did not use face-to-face to communicate with German firms. Most communication is via telephone (72.6%) and electronic mail (52.4%). In each instance, these channels were used between 1 and 5 times per day. The findings from the qualitative study suggest that South African organizations use the telephone more often to communicate with their domestic business partners than with their German business partners because the staff in South Africa can usually solve problems. Calls to Germany are made only in urgent cases. Another reason is that people are much better prepared when they make calls overseas (Germany) and therefore less time is spent on the 403 Corporate Ownership & Control / Volume 10, Issue 4, 2013, Continued - 4 phone and less communication in general is necessary to solve problems. As Table 2 shows, South African business people have very little face-to-face contact with their German business partners. Based on the qualitative interviews, the two main factors seem to be money and time. Flights are so expensive and timeconsuming that people try to solve problems via email and telephone. Another salient point highlighted by Table 2 is that videoconferencing and Web 2.0 technology are rarely used by South African organizations. This finding is surprising since videoconferencing is a cheap, immediate, comfortable and direct communication channel. The qualitative interviews suggest that South African business people stick to old habits (telephone and e-mail) with which they feel comfortable. Furthermore, South African organizations seem to not really know how to use this new communication technology, and in addition, connections for overseas calls sometimes break down or have a time delay, which makes speech awkward. Service providers often have problems in guaranteeing a stable connection, which is necessary to use videoconferencing properly. With Web 2.0 being an important future channel for business communication, a more in-depth investigation was warranted. Table 3 illustrates that few respondents had an opinion about Web 2.0 services. Over one third do not even know if their company uses or offers Web 2.0 services for communication. Furthermore, nearly half the respondents do not have an opinion on whether Web 2.0 technology is going to play a bigger role for business communication in the future. Table 3. Opinions about Web 2.0 communication channels % responses Questions Our company uses Web 2.0 to communicate with German business partners. Web 2.0 Technology will be more important for efficient communication with global business partners in the next 5 years. Web 2.0 Technology will not be allowed for communication by the companies because it is developed more for private use and not for business. Some interviewees indicated that Web 2.0 services certainly have potential for business communication, but companies are uncertain and hesitant about their use. Some felt that employees might use it more for private than for business issues. Moreover, data security was also an issue; companies do not like to publish important or confidential information on the web. The fact that 70% of the sample was over 40 years old could be a reason for the lack of knowledge about, or interest in, Web 2.0 services. A survey of younger employees may produce a different result. In general, South African organizations use their communication channels less often to communicate Agree Neutral Disagree 12.9 33.9 53.2 35.5 41.9 22.6 27.0 46.0 27.0 with German business partners than to communicate with their domestic partners. According to the interviews, this is natural because South Africa is where the selling and buying takes place (rather than in Germany). Therefore, more communication with the domestic partners is necessary on a daily basis. 4.3 Suitability channels of communication Table 4 represent the opinions on how suitable or applicable the various communication channels are for South African organizations to communicate with German businesses. Table 4. Suitability of communication channels Inappropriate Less suitable Suitable Most suitable - 1.7% 55.0% 43.3% Face to Face 14.3% 22.4% 24.5% 38.8% Videoconferencing 2.9% 42.9% 51.4% 2.9% - 4.9% 19.7% 75.4% 25.0% 28.6% 46.4% - Telephone Electronic mail Web 2.0 Overall, respondents felt that the different channels are generally appropriate. However, some channels were more favoured than others. These include telephone, face-to-face and e-mail. Moreover, despite the uncertainty previously mentioned, about half the respondents think that Web 2.0 and videoconferencing are suitable for communication. As discussed previously, these communication channels are hardly used for communication, which is 404 Corporate Ownership & Control / Volume 10, Issue 4, 2013, Continued - 4 consistent with the fact that about half perceive them as unsuitable. 4.4 Opinions regarding communications Table 5 provides a summary of the opinions of the respondents regarding interpersonal communications and barriers to such communications. These means were all found to be significant with p values of 0.000. Most questions had a spread of positive and negative answers, with the means hovering around the mid, neutral point of 3 (between 2.5 and 3.5). In most cases, the respondents disagreed with the statements about communication barrier causes (e.g. making promises that cannot be kept, remembering the conversation context, problems in summarising the conversation, interruptions due to technological problems or time zone difficulties). The only factor that emerged as a fairly strong communication barrier was the different cultural backgrounds and traditions (mean of 3.5469). Although most means hover around the mid-point of 3, the relatively high standard deviations indicate that there were a fairly high number of respondents who did believe significant communications barriers exist. For example: ‘German business partners not understanding what is said’ (x=2.8281, SD=1.12058). Table 5. Summary of opinion questions Opinion questions GENERAL German business partners often send unimportant and unnecessary e-mails. n Mean Std. Dev. 64 2.1406 .79417 Face-to-face communication is the most efficient way to get results when dealing with 64 German business relationships. 3.2500 1.02353 While talking on the phone, one should also be interested in the person and not only in 63 the business issues. 3.6984 .81587 German companies use Videoconferencing too often and neglect therefore the personal 64 2.5937 .92099 face-to-face contact with the South African business partners. INTERPERSONAL SKILLS – BARRIERS – ABILITY TO UNDERSTAND WHAT OTHER PEOPLE SAY Good interpersonal skills of business partners positively affect the communication 64 efficiency. 4.4531 .58905 German business partners often don’t understand what is said. 64 German business partners often make promises they cannot keep. 64 German business partners often have difficulties in remembering the conversation 64 context (includes face-to-face and telephone). INTERPERSONAL SKILLS – BARRIERS – SIGNIFICANCE OF ORAL SKILLS German business partners always have a positive attitude and are kind. 64 German business partners often have problems in summarizing the conversation. 63 German business partners often have trouble in structuring the conversation flow on 64 the phone. INTERPERSONAL SKILLS – BARRIERS – SIGNIFICANCE OF WRITTEN SKILLS 2.8281 2.2187 1.12058 .91667 2.2656 .92996 3.2813 2.3333 .89918 .78288 2.5000 1.05409 Written responses from German business partners are always on time. The written context from German business partners is often not structured. The grammar of written messages from German business partners is often wrong. 64 64 64 3.3750 2.5000 2.8906 .91721 .94281 1.02535 I often don’t understand the foreign language terminology that German business 64 partners use. 2.6250 .96773 Different cultural backgrounds and traditions affect business communication. 64 (Differences such as: just now and Afrikaans: now now). 3.5469 .94162 The communication flow with German business partners will often be interrupted 64 because of technology problems. 2.4375 .83333 Different time zones make it difficult to define the right business hours for 64 communication. 2.2344 .97170 A noisy and disruptive environment often disturbs the communication flow. 3.0313 1.16794 CULTURAL ASPECTS – BARRIERS 405 64 Corporate Ownership & Control / Volume 10, Issue 4, 2013, Continued - 4 4.5 Bivariate analysis statistical significant relationship between the two considered variables. As already indicated in the univariate analysis of this chapter, Web 2.0 is little used by South African organizations for business communication. However, it is interesting to know what South African organizations think of the future development of Web 2.0 in business communication. The majority of the respondents disagreed with the statement that their company is using Web 2.0 for business communication but they think that Web 2.0 will be more important for business communication in the next five years, as Table 6 shows. South African business people are quite confident that Web 2.0 will be more useful for business communication in the next five years. This section covers the bivariate analysis that involved the comparison of two variables of relevance related to Web 2.0. Cross tabulations and chi square tests were used for this analysis. 4.5.1 Cross tab of Web 2.0 today and tomorrow in business The respondents were asked if their company was using Web 2.0 for business communication and how they think Web 2.0 will change in business communication over the next five years. A Pearson chi-square test (p – 0.000) showed that there is a Table 6. Use of Web 2.0 in business in the future Web 2.0 Technology will be more important for efficient communication with global business partners in the next 5 years. Strongly Strongly Disagree Neutral Agree disagree agree Our company uses Web 2.0 to communicate with German business partners. Strongly disagree Disagree Neutral Agree Strongly agree Total Total 5 1 6 4 0 16 0 0 0 5 2 1 6 13 0 4 6 1 1 0 4 16 21 6 0 0 1 0 1 2 5 9 26 15 6 61 the two considered variables. This is consistent with the univariate analysis, which showed that many respondents disagreed with the statement that face-toface is the most efficient way to communicate with German business people, and that the majority also disagreed with the statement that they do not understand the language or terminology that German business partners use. 4.5.2 Cross tab of face-to-face communication and language/terminology A cross tabulation (shown in Table 7), between whether ‘face-to-face is the most efficient way to communicate with German business partners’ and ‘if the language/terminology is often misunderstood’, showed a significant relationship (p = 0.02) between Table 7. Face-to-face as most efficient and language/terminology Language/Terminology: I often don’t understand foreign language terminology that German business partners use. Strongly Strongly Disagree Neutral Agree disagree agree Face-to-face communication is most efficient way to get results when dealing with German business relationships. Total Strongly disagree Disagree Neutral Agree Strongly agree Total 0 0 0 0 1 1 1 2 1 8 10 7 5 7 4 2 2 5 0 0 1 16 21 18 1 4 1 2 0 8 5 29 17 11 2 64 Obviously, South African business people understand the German language/terminology quite well and, therefore, probably do not need to meet German business people in person to clarify misconceptions. In this case, the difference between being effective and efficient must be explained. It 406 Corporate Ownership & Control / Volume 10, Issue 4, 2013, Continued - 4 might be that face-to-face is the most effective way to communicate but with the background of time and cost, it might not be the most efficient way from an economic point of view. 5. Conclusion The objective concerned the communication channels used by South African organizations to communicate with German businesses. The result of the research shows that the main communication channels used by South African organizations are e-mails, telephone and face-to-face communication. According to Sussman, Adams, Kuzmits and Raho (2002: 315), these are the main communication channels in business. According to the literature, e-mail is used mainly because messages can be sent quickly and inexpensively across the time zones or borders; telephones are also used for gathering or delivering quick information and face-to-face conversation takes place when business people need to be persuasive (Guffey and Almonte, 2009: 35). These insights from the literature review are confirmed by this study, which found that South African business people mainly communicate via e-mail and telephone. Videoconferencing is hardly used by South African organizations to communicate with German business people. Bigger companies use videoconferencing occasionally. According to the literature, this channel would be used when group consensus and interaction are important but the members are not available personally (Guffey and Almonte 2009: 35). Although videoconferencing provides a comfortable and cheap communication channel over distance, this study has found that this communication channel is not used by South African organizations to communicate with their German business partners. Lack of knowledge and different technology standards play a role in why videoconferencing is not in standard use for communication in South African companies. In relation to Web 2.0 and business communication, there is little literature available because this area is still relatively new. The study confirmed that many people do not know what Web 2.0 is, or whether their company is using this channel for business communication. Even after being given a definition of Web 2.0: “Web 2.0 is the term given to describe a second generation of the World-Wide-Web that is focused on the ability for people to collaborate and share information online”, many respondents answered the questions concerning Web 2.0 with neutral answers. This shows that people are relatively ignorant about this particular area and that Web 2.0 is not adequately considered for business communication. 6. Implications of the study This research has clearly shown the importance of interpersonal communication in business. Due to the complexity of all the factors that influence communication, research in this particular area is justified. In addition to making a contribution to knowledge about interpersonal communication between South African and German businesses, it has also contributed to knowledge about the use of Web 2.0 in South Africa, an unanticipated benefit. Web 2.0 is generally in demand for business communication, and this study has highlighted that the benefits of its use are probably being missed by South African businesses. In addition to increasing awareness of the advantages and disadvantages of this new communication channel, companies should also ensure that their employees know more about their business partners and their communication habits to make business communication as efficient and effective as possible. Companies should carry out workshops and training in the company on interpersonal and inter-cultural communication in business, and on effective and efficient ways of conducting business communication. Such training in communication could be offered on a generic basis, or could be specifically related to certain countries – in this case, communication between South Africa and Germany. 7. Limitations and further research Three limitations of this research were that many respondents did not know much about Web 2.0 (as indicated by the large number of neutral responses), and the small sample size of only 64 respondents. For an exploratory study, this was sufficient, but for reliable answers for a conclusive study, this was insufficient. A third limitation was that the problem was only viewed from a South African perspective. Further research is needed in the area of Web 2.0 technology for business communication. The question of whether Web 2.0 can be used for efficient and effective business communication needs to be explored further. Furthermore, the same study could be conducted in Germany to explore the problem from a German perspective. 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(2002), "A lesson in communication", Professional Builder, Vol. 67 No. 5, pp. 43-44. 47. South African Revenue Services, (2012), "South Africa Main Trading Partners by Value - 1998–2008“, Available http://www.sars.gov.za/home.asp?pid=211 (Accessed 23 August 2012). 48. Sri Jin, K. & Sunitti, A. (2009), Business Communication, FK Publications, Darya Ganj. 49. Sussman, L, Adams, A.J., Kuzmits, F.E. & Raho, L.E. (2002), "Organizational politics: Tactics, channels, and hierarchical roles", Journal of Business Ethics, Vol. 40 No. 4, pp. 313-329. 50. Troester, R. & Mester, C.S. (2007), Civility in business and professional communication, Peter Lang, New York. 51. Wang, T. & Ji, P. (2010), "Understanding customer needs through quantitative analysis of Kanos´s model", International Journal of Quality & Reliability Management, Vol. 27 No. 2, pp. 173-184. 52. Weiten, W, Lloyd, M.A., Dunn, D.S. & Hammer, E.Y. (2008), Psychology Applied to Modern Life: Adjustment in the 21st Century, 9th ed., Cengage Learning, Belmont. 53. West, R. & Turner, L.H. (2008), Understanding Interpersonal Communication: Making Choices in Changing Times, 2nd ed., Cengage Learning, Boston. 54. Yuan, H. (2007), "Nonverbal Communication and Its Translation", Canadian Social Science, Vol. 3 No. 4, pp. 77-80. 409 Corporate Ownership & Control / Volume 10, Issue 4, 2013, Continued - 4 THE OWNERSHIP STRUCTURE, THE BOARD OF DIRECTORS AND THE QUALITY OF ACCOUNTING INFORMATION Nejla Ould Daoud Ellili* Abstract High quality accounting information is vital for the accuracy of the financial statements, whereas poor quality information may lead to serious economic problems. The recent financial crisis has attracted the interest of many researchers in determining the factors that may affect the quality of accounting information. In this field, our research investigates the possible impact of the ownership structure and of the make-up of the board of directors on the quality of accounting information, using annual data from 29 companies listed on the Abu Dhabi Securities Exchange in 2008 and 2009. The actual research starts by presenting an appropriate measure of the quality of the accounting information, then developing a model explaining the relationship between the ownership structure, the board of directors and the quality of the accounting information. In the light of our results, we will be able to provide recommendations for helping the companies improve the quality of their financial reporting. JEL Classification Codes: C21, G32, G34 Keywords: Earnings Management, Discretionary Accruals, Ownership Structure, Board of Directors * College of Business Administration, Abu Dhabi University Tel.: +971 50 7766392 E-mail: nejla.ellili@adu.ac.ae 1. Introduction Separation between ownership and control of a company creates conflicts of interests between managers and shareholders (Berle and Means, 1932). Shareholders are interested in maximizing the value of their company while managers seek to increase the consumption of both pecuniary and non-pecuniary advantages. The financial literature specifies a certain number of governance mechanisms which could help companies to reduce their agency problems and to align the interests of their managers more closely with those of their shareholders. These mechanisms include managerial ownership (Jensen and Meckling, 1976), blockholders ownership (Agrawal and Mandelker, 1990), institutional ownership (Brickley, Lease and Smith, 1988), the board of directors (Fama and Jensen, 1983), managerial compensation (Mehran, 1995), control market (Jensen and Ruback, 1983), the labor market (Fama, 1980) and the product market (Hart, 1983). Several studies have been carried out into the relationship between managerial ownership and the performance of companies. Jensen and Meckling (1976) affirm that this relationship is linear and that high levels of managerial ownership can reduce agency problems within a company. Other authors affirm that the relationship between managerial ownership and the performance of the company is nonlinear (Morck, Shleifer and Vishny, 1988; Shorts and Keasy, 1999). This takes the form of alignment of interests in regard to managerial entrenchment. However, according to Himmelberg, Hubbard and Palia (1999), Cho (1998), and Demsetz and Villalonga (2001), managerial ownership is an endogenous variable which depends on the performance of the company. The impact of the characteristics of the board of directors was also the subject of several studies. Fama and Jensen (1983) affirm that the separation between positions of the Chief Executive Officer and the Chairman of the Board of Directors improves the performance of the companies. Jensen (1993) and Yermack (1996) suggest that the small boards of directors are more effective, and that they control managerial discretion more effectively. Fama (1980) argues that a large presence of the external members in the board of directors ensures a better performance of the companies. The actual study continues in the same spirit of the previous research by examining the interrelationships between managerial ownership, the characteristics of the board of directors and the practice of earnings management. Accounting earnings are considered to be one of the main indicators of the financial performance of a company and the practice of earnings management has attracted the interest of many researchers. In this study, panel data from 29 companies trading on the Abu Dhabi Securities Exchange between 2007 and 2009 has been 410 Corporate Ownership & Control / Volume 10, Issue 4, 2013, Continued - 4 used. As can be seen so far, there are only three empirical analyses conducted on the corporate governance of UAE companies. The first analysis was conducted by Moustafa (2005) on the impact of separation between the ownership and control of the UAE firm performance, the second by Aljifri and Moustafa (2007) on the impact of corporate governance mechanisms on the UAE firm performance and the third by Ellili (2012) on the interrelationships between the different mechanisms of control. In the three aforementioned analyses, the researchers have studied the impact of the ownership structure of the performance of the company, but in this study we will incorporate the discretionary accruals as a measure of the earnings management practice. To study the interrelationships between the managerial ownership, the characteristics of the board of directors, and the quality of the accounting information, many models have been used. The panel data regressions are used to analyze the simultaneous impacts of both the managerial ownership and characteristics of the board of directors on the discretionary accruals. The empirical results showed the presence of important impacts of the managerial ownership, the blockholders’ ownership and the board’s duality on the earnings management practice. More particularly, we found that both managerial and blockholders ownership have negative impacts on the discretionary accruals which confirms that the high presence of the managers and the blockholders in the ownership structure of the company is associated with a weak practice of the earnings management and leads to good quality accounting information. In addition, the results showed that board duality has a positive effect on discretionary accruals, which confirms that the duality of a CEO can be related to a high earning management practice. These empirical results help companies to optimally manage the various mechanisms of governance in order to improve the quality of the accounting information. The remainder of this paper is organized as follows: firstly, a literature review of the ownership structure is presented. Then there is a presentation of the corporate governance system in UAE, followed by an explanation of data and methodology, empirical results analysis, and finally a conclusion. 2. Literature Review 2.1. The ownership structure In the financial literature, while there has been extensive research that has examined the relationship between ownership structure and corporate performance (Jensen and Meckling, 1976; Morck, Shleifer and Vishny, 1988; Short and Keasy, 1999), only a few studies have examined the relationship between ownership structure and the quality of accounting information (Warfield et al., 1995; Rajgopal et al., 1999; Fang and Wong, 2002). The quality of the financial reports can be adversely affected by the widespread practice that earning management have of increasing their earnings as a consequence of the information asymmetries between owners and managers (Hadani, Goranova and Khan, 2011). This process is defined by the manipulation of the firm’s earnings as reported in the financial statements (Pfarrer, Smith, Bartol, Khanin and Zhang, 2008). Healy and Wahlen (1999) underline that “Earning management occurs when managers use judgment in financial reporting and in structuring transactions to alter financial reports to either mislead some stakeholders about the underlying economic performance of the company or to influence contractual outcomes that depend on reported accounting numbers”. Any analysis of the relationship between the ownership structure and earning management needs to distinguish between the managerial ownership (2.1.1.), blockholders’ ownership (2.1.2.) and the institutional ownership (2.1.3.). 2.1.1. The managerial ownership From a theoretical point of view, managerial ownership seems have two conflicting effects on the quality of the accounting information: the convergence of interest effect and entrenchment. Based on the Convergence of Interest Hypothesis (Jensen and Meckling, 1976), the agency theory would suggest that managerial ownership leads to a better quality of accounting information (Gegenfurtner, Ampenberger and Kaserer, 2009). Hence firms with high managerial ownership seem to reflect the true financial situation. Therefore, the convergence effect predicts that managers with higher ownership have stronger incentives to act in line with shareholders’ interests. In contrast, agency costs are high when the managerial ownership is at a low level. This convergence effect suggests that as the managerial ownership increases, the opportunistic managerial behavior decreases monotonically. The Managerial Entrenchment Effect Hypothesis (Morck, Shleifer and Vishny, 1988) argues that managers with larger ownership have greater control over firms, and therefore possess more freedom to act in their own private interests, often to the detriment of those shareholders who engage in opportunistic behavior to serve their own interests, since they are less likely to be controlled and dismissed. According to Morck and al. (1988) and Sort and Keasy (1999), the entrenchment effect is dominant only within the intermediate levels of ownership. In the empirical financial literature, the researchers focus on the relationship between the managerial ownership and corporate performance. In fact, Morck et al. (1988) find a positive relationship between the managerial ownership and firm performance (measured by Tobin’s q) for the low and 411 Corporate Ownership & Control / Volume 10, Issue 4, 2013, Continued - 4 high levels of ownership, and thereby the dominance of the convergence effect. Moreover, they indicate that there is a negative relationship between the managerial ownership and firm performance at the intermediate levels of managerial ownership, consistent with the entrenchment effect. Short and Keasy (1999) argue that the relationship between managerial ownership and firm performance is nonmonotonic. McConnell and Servaes (1990) also provide evidence that is consistent with the managerial entrenchment effect. In the context of UAE, the empirical results of Ellili (2012) show that the managerial ownership does not have any impact on the performance of the firm. Indeed, managerial ownership is endogenous and the performance of the firm is one, among others, of its determinants. Warfield et al. (1995) and Salsiah, Norman and Hassan (2008) indicate that the quality of accounting information (measured by the earnings response coefficient) is positively related to managerial ownership, whereas the magnitude of the discretionary accruals is negatively related to it. Their results confirm that the quality of the accounting information increases as managerial ownership increases, supporting by consequence the convergence of the interest effect hypothesis. Gul and Wah (2002) examined the effect of the convergence of the interests and of the managerial entrenchment on the accounting informativeness by comparing the intervals of managerial ownership already specified by Morck et al. (1988).The accounting informativeness represents the response of the market to the disclosure of the accounting income and is measured by the regression coefficient of the market value on the accounting income. These authors find that the informativeness is higher in the intervals of convergence of interests than in those of the managerial entrenchment. Consequently, if the interests of the managers are aligned with those of the shareholders, the accounting income will be of a higher quality since the managers will be less likely to manipulate their financial statements. From the same perspective, Lennox (2005) shows that the relationship between managerial ownership and audit quality is significantly negative for the low and high levels of ownership (the convergence of interest effect). He also indicates that the relationship is slightly positive for the intermediate levels of managerial ownership (the entrenchment effect). This result is supported by Teshima and Shuto (2008) who find that the relationship between the managerial ownership and the discretionary accruals of the Japanese firms (proxy of the quality of the accounting information) is non monotonic (both convergence of interest and entrenchment effects). In related research, LaFond and Roychowdhury (2008) examined the effect of managerial ownership on the conservatism of accounting as measured by the asymmetric timeliness of earnings. They underline that, as the managerial ownership decreases, there is greater asymmetric timeliness of earnings (a higher demand for accounting conservatism). This result is consistent with the implication of the convergence of interest effect on managerial ownership. In an extension of this, Shuto and Takada (2010) examined the effect of managerial ownership on the accounting conservatism defined as the imposition of stricter verification standards for recording good news as gains than for recording bad news as losses. Their empirical results reveal that there is a nonmonotonic relationship between managerial ownership and accounting conservatism. In fact, within the low and high levels of managerial ownership, managerial ownership is significantly negatively related to the asymmetric timeliness of earnings, which is consistent with the convergence of interest effect. They also find a significant positive relationship between managerial ownership and the asymmetric timeliness of earnings with regard to the intermediate levels of managerial ownership, as suggested by the management entrenchment effect. These results are very helpful for our research in that they show that accounting conservatism is able to reduce the agency costs of the firms through a corporate governance system. Therefore, the following hypothesis can be tested H1: There is a negative relationship between the managerial ownership and the quality of the accounting information. 2.1.2. The Blockholders ownership Block holders are defined as the large stockholders who hold at least 5 % of the shares of a company. In the financial literature, there is no consensus on the relationship between the blockholders and the performance of the company on terms of positive or negative signs, nor on the direction of causality between the two variables. In financial theory, and more particularly in agency theory literature, the relationship between ownership concentration and the performance of a company is generally seen as positive. Blockholders have more power and stronger incentives in controlling efficiently the managers and the more concentrated structures are associated to less governance problems arising from the separation between ownership and control (Shleifer and Vishny, 1986; Denis, Denis and Sarin, 1995; Agrawal and Mandelker, 1992). In contrast to all the previous research, Demsetz (1983) and Demsetz and Lehn (1985) affirm that the ownership structure of the company is endogenous and is the result of an optimal shareholder value maximizing process. Despite the number of studies that have been carried out, the theoretical relationship between ownership structure and the performance of the company is still ambiguous. Blockholders may get private benefits in terms of control which are detrimental to the interests of the other shareholders and which may lead to the entrenchment of the managers and expropriation of the wealth of the 412 Corporate Ownership & Control / Volume 10, Issue 4, 2013, Continued - 4 minority shareholders because of their privileged access to inside information and their high level of risk aversion compared to that of the diversified shareholders (Morck et al., 1988). In the context of UAE, the empirical results of Ellili (2012) show that the impact of blockholders’ ownership on the performance of a firm can be negative. Therefore, the presence of blockholders in the ownership structure of the company does not always ensure good performance. On the contrary, it often leads to a poor performance. This could be explained by the managerial entrenchment theory which argues that the blockholders are not always considered to be an efficient internal monitoring mechanism. In fact, the blockholders may enjoy private benefits from their control, to the detriment of the other shareholders, and can expropriate the wealth of minority shareholders because of their privileged access to inside information and their high risk aversion compared to the diversified shareholders (Morck et al., 1988). In the accounting literature, Firth, Fung and Rui (2007) examined, across listed companies in China, the quality of the financial statements manifested in their earnings informativeness. In their paper, informativeness is primarily measured by the association between stock returns and earnings. Their empirical results, based on data from 1998 to 2003, show that firms with highly concentrated share ownership have lower earnings informativeness. This has been attributed to an entrenchment effect, whereby blockholders may influence the adoption of accounting policies to reflect their wishes, rather than the economic substance of a business transaction. Therefore, the following hypothesis can be tested: H2: There is a positive relationship between the blockholders ownership and the quality of the accounting information. 2.1.3. Institutional Ownership: In financial literature and especially in the analysis of the relationship between the institutional ownership and corporate performance, Pound (1988) proposes three hypotheses: the efficient monitoring hypothesis, the conflict of interest hypothesis and the strategic alignment hypothesis. According to the efficient monitoring hypothesis, institutional ownership has a positive impact on performance because of the greater expertise of institutional investors and their ability to monitor managers at a lower cost. According to the conflict of interest hypothesis, institutional investors have business relationships with the firm in which they are shareholders. Therefore, the institutional owners are less likely to monitor the manager more efficiently. According to the strategic alignment hypothesis, the institutional owners and managers have a mutually advantageous system of cooperation which may reduce the beneficial effect on the value of the firm. In consequence, both conflict of interest and strategic alignment hypotheses predict a negative relationship between the institutional ownership and the performance of the firm. In the same research framework, Brickley, Lease and Smith (1988) classify the institutional investors into two groups: pressureresistant and pressure-sensitive institutional investors. Pressure- resistant institutional investors only have investment relationship with the firm in which they are owners like the brokerage house, the investment companies and the mutual funds. In contrast, the pressure sensitive institutional investors have both an investment and business relationship with firms in which they are owners like the banks and the insurance companies. Despite the number of the researchers, the impact of the institutional investors on the performance of the firm is still ambiguous. Cornett, Marcus, Saunders and Tehranian (2007) found a positive relationship between institutional ownership and the performance of the firm. However, Limpahayom and Polwitoon (2004) found a non monotonic relationship between bank ownership and the performance of a firm in Thailand. Their empirical results show that low bank ownership increases the value of a firm while a high level of bank ownership reduces the value of a firm. In the context of UAE, Ajifri and Moustafa (2007) and Ellili (2012) find a negative relationship between the institutional investor and the performance of the firm. This result does not support an “efficient monitoring hypothesis" and by consequence, the institutional investors are not able to efficiently control opportunistic managerial behavior. In the spirit of the earning management research, Hadani et al. (2011) found that institutional ownership is negatively related to earnings management, which indicates that institutional owners are better positioned to constrain the practice of earnings management by their ability to gauge firm performance against the long-term fundamentals of a firm. Therefore, the following hypothesis can be tested: H3: There is a negative relationship between institutional ownership and the quality of accounting information. From an annual report voluntary disclosure perspective, Jiang and Habib (2009) found that the firms with the financial-controlled ownership structures disclose significantly less (more) at high (low) ownership concentration levels, suggesting that the expropriation phenomenon is likely to dominate efficient monitoring by increasing institutional ownership. 2.2. The board of directors Various studies have focused on the relationship between the quality of the accounting information and the characteristics of the board of directors such as the board’s duality (2.2.1.) and its size (2.2.2.) 413 Corporate Ownership & Control / Volume 10, Issue 4, 2013, Continued - 4 2.2.1. The board’s duality: Duality is usually deemed to be present when the Chief Executive Officer (CEO) of a company is also its chairman. In the corporate governance literature, two theories (the agency theory and the theory of the normal succession) attempt to explain the separation between the chairman of the board of directors and the CEO. The agency theory argues that firms distinguish between the chairman and the CEO in order to control agency costs. In fact, Fama and Jensen (1983) suggest that the separation between the positions on decisions (initiation and implementation of investment projects) and the control positions (ratification and monitoring of investments) reduces agency costs and improves corporate performance. In consequence, the highest position in the control structure (the chairman) should not be held simultaneously by the person at the highest level of the decision structure (the CEO). If the CEO is also the chairman of the board, he or she would have a great influence on the board and on arranging his or her own compensation. Fama and Jensen (1983) argue that effective separation between management and control requires that two different people holding these positions. If the CEO is also chairman, this may be a dangerous situation for the shareholders. CEOs are more likely to act against the shareholders' wealth. Jensen (1993) believes that the CEOs should not also be chairman of the board as this would give them enormous power within the company and would be likely reduce their control effectiveness. The normal succession theory suggests that the separation between the CEO and the chairman of the board of directors emerges as a part of the normal succession process. The new CEO must therefore pass through a probation period during which the directors assess his/her performance and determine whether he/she is ready or not to hold the position of the chairman. Davidson, Worrell and Cheng (1990) add that in this case, the separation between the CEO and the chairman does not lead to a better performance. Another group of researchers found that board duality can actually lead to better performance (Rechner and Dalton, 1991; Pi and Timme, 1993; Fosberg and Nelson, 1999). Brickley, Coles and Jarrell (1997) confirm that separation between the CEO and the chairman does not necessarily lead to better performance. According to them, board duality can improve and facilitate the decision-making process. Similarly, in the context of UAE, Ellili (2012) shows that with board duality there is a positive impact on the performance of a company. This indicates that the separation between the positions of the CEO and the chairman of the board of directors does not lead to an improvement in corporate performance. In an accounting context, Bowen, Rajgopal and Venkatachalam (2002) indicate that the separation between the CEO and the chairman is important to avoid earnings management malpractice. In fact, they find that the earning management malpractice is higher in firms with CEO duality. This result is supported by Mohd Saleh, Mohd Iskander and Rahmat (2005), who provide evidence that CEO duality is positively related to earning management and that companies with CEO duality did not perform well compared with their counterparts. We can therefore test the following hypothesis: H4: There is a positive relationship between the separation and the quality of the accounting information. 2.2.2. The board’s size The effect of board size on the corporate performance is still controversial, even though in corporate governance literature most studies show that a small board of directors can enhances the performance of a firm (Jensen, 1993; Yermack, 1996; Hermalin and Weisbach, 2003). It is obviously true that having additional directors can improve a control system but, conversely, they can slow the process of the decision making. Jensen (1993) argues that the board is at the top of the internal control system and the ultimate consequence of its dysfunction is the failure of the firm. According to Jensen (1993), the smaller board improves the corporate performance and to control easier the managers, the number of directors should not exceed seven or eight. Yermack (1996) and Hermalin and Weisbach (2003) find a negative relationship between the size of the board of directors and corporate performance, confirming that the small boards operate more effectively. Pearce and Zahra (1992) and Dwivedi and Jain (2005), however, conclude that the board size has a positive impact on performance. In fact, large boards could provide the diversity that can help firms to secure critical resources and reduce environmental uncertainties. In the context of UAE, the empirical results of Aljifri and Moustafa (2007) and Ellili (2012) reveal that board size often has a negative impact on the performance of a firm. This suggests that UAE firms, on average, do not select their board members optimally, which may lead to a lack of coordination and communication and cause decision making problems. Therefore, boards with a small size are more effective in the control of the managerial discretion. In the earning management context, there is a kind of consensus on the impact of the board size on discretionary accruals. Xie, Davidson and DaDalt (2003) and Rashidah and Fairuzana (2006) find that a larger board is associated with lower levels of discretionary current accruals, confirming that a larger board can often be more effective in monitoring such accruals than a smaller board. This result indicates that the outside directors may lack the financial expertise and skills to detect the earning management. Therefore, we can test the following hypothesis: 414 Corporate Ownership & Control / Volume 10, Issue 4, 2013, Continued - 4 H5: There is a positive relationship between board size and the quality of accounting information. 2.3. The quality information: of accounting High quality accounting information is vital to ensure the accuracy of financial statements and poor quality of information may lead to serious economic problems. In the accounting literature, the quality of information is a complex concept and has many definitions. In general, the quality of the accounting information is related to different areas such as value relevance, earning management and accounting conservatism. In the empirical literature, the quality of the accounting information is measured by several approaches. In fact, the quality of the accounting information disclosed by firms has been measured by estimating the value relevance of the accounting numbers for the stock market (Alford, Jones, Leftwich, and Zmijewski, 1993). Accounting information is included in investors’ valuation models and helps in decision making. Another approach involved in measuring the quality of disclosed financial reports is to study conservatism in accounting (Garcia Lara and Mora, 2004). The International Financial Reporting Standards (IFRS) state that accountants should prepare reliable and relevant financial reports in order to provide high quality information. The quality of the accounting information can be also measured by the degree of the earnings management. The most common definition of earnings management is the direct or indirect manipulation of financial reports through accounting methods. This manipulation happens to meet the investors’ expectations or to overcome the period of volatile earnings. The managers engage in earnings management activities with the objective of obtaining many incentives such us debt covenants, management compensation and job security (Alzoubi, 2012). Also, since the shareholders exercise earnings for bonus and stock options, the managers manipulate the earnings to get more profits. Therefore, the managed earnings are considered to be misleading signals for investors (Dechow, 1994). In our study, we follow many researchers (Liu and Lu, 2007; Jaggi and Leung, 2007) and we measure the quality of the accounting information by the discretionary accruals as a proxy of the earning management because in the recent accounting literature, there is a consensus that the current discretionary accruals are the most powerful models for estimating discretionary accruals. corporate direction and performance. The board of directors is typically central to corporate governance. Its relationship to the other primary participants, typically shareholders and management, is critical. Additional participants include employees, customers, suppliers, and creditors. The corporate governance framework also depends on the legal, regulatory, institutional and ethical environment of the community”9. In UAE, a code of corporate governance was issued by the “Security and Commodities Authority” (SCA) in 2007 and it has been superseded and amended by the “Ministry of Economy’s Decision No. 518 of 2009”. The code requires companies and institutions that have securities listed in any securities market in UAE (either in Dubai or in Abu Dhabi) and members of their boards of directors to adopt corporate governance rules that aim to: 1- Specify clearly the duties of the board of directors; 2- Describe the responsibilities of the chairman of the board of directors; 3- Explain the roles of members of the board of directors; 4- Determine the audit charges, the nomination and the remuneration committees; 5- Decide on the remuneration of the board members 6- Create an internal control system within their company; 7- Encourage the companies to adopt the principles of good corporate governance, to publish their corporate governance report and make them available to all the shareholders; 8- Establish an effective framework for the protection of shareholder rights; and 9- Strengthen transparency within the company. To advance corporate governance reform in UAE and to promote the economic development, two organizations were created: the Hawkamah (the Institute for Corporate Governance) in Dubai and the Center for Corporate Governance in Abu Dhabi. Both organizations encourage and assist the private and the public sectors to adopt the highest standards and practices of corporate governance. Also, the UAE requires its banks as well as the companies listed on the UAE’s new stock exchange and the Dubai International Foreign Exchange to abide by IFRS in order to project an image of integrity, efficiency and transparency and to comply with international standards. 4. Data and methodology 4.1.Data 3. Corporate governance in UAE Corporate governance does not have a single formal definition but it “is most often viewed as both the structure and the relationships which determine The objective of this paper is to determine the relationship between ownership structure and the quality of the accounting information of the 9 http://www.corpgov.net/library/definitions.html 415 Corporate Ownership & Control / Volume 10, Issue 4, 2013, Continued - 4 companies listed on the Abu Dhabi Stock Exchange (ADX), using data from 2008 and 2009. The data has been hand collected and the choice of the companies was based on the availability of data. The number of companies included in our analysis is 29. The banks and the financial institutions have been excluded from our sample because of their specific financial activities in terms of their supervision by the central bank. 4.2. The choice of variables: In our model, managerial ownership is measured by the proportion of the capital held the Chief Executive Officer (CEO). Blockholders’ ownership is the proportion of the capital held by the external shareholders when they hold more than 5% of the capital of the firm and if they are different from the managers and the institutional shareholders. Institutional ownership is measured by the proportion of capital held by the institutions. To measure a firm’s ownership concentration, we use the Herfindahl index of the firm's ownership structure, which it is calculated as the sum of squared percentage of shares held by the largest three shareholders. Table 1. The ownership variables Variables Notation Managerial ownership MO Blockholders ownership BO Institutional ownership IO Herfindahl index HI Measure Potential impact on quality of the accounting information The part of the capital held by the Negative manager The part of the capital held by Positive external shareholders having more than 5% The part of the capital held by the Negative institutional shareholders The sum of squared percentage of Negative shares held by the largest three shareholders. The board duality is a dummy variable that takes the value of 1 if the CEO is at the same time the chairman of the board of directors and 0 otherwise. The board size is the number of the members of the board. According to the above ministerial resolution, one-third of the board members must be independent. Table 2. The board variables Variables Notation Board duality BD Board size BS Measure Potential impact on quality of the accounting information 1 if the CEO is the chairman of the Positive board, 0 otherwise The number of the directors in the Positive board Other factors other than ownership structure may also affect the quality of the accounting information. To take them into account, we introduce a set of control variables. Dummy variables for industries are used to control the difference between the sectors. Also, the capital structure variable is defined as total debt to total assets and firm size is defined as the logarithm of total assets. Table 3. The Firm’s variables Variables Notation Measure Sector Debt Size Performance DUM DEBT SIZE ROE Dummy variable: i=1,2,…7 total debts/total assets Log (total assets) Net income/ shareholder’s equity 416 Potential impact on quality of the accounting information Positive Positive - Corporate Ownership & Control / Volume 10, Issue 4, 2013, Continued - 4 In our study, the quality of the accounting information is measured by the discretionary accruals according to the two Jones models (1991). In the first model, the total accruals (TACC) are regressed on both the change in the revenues (Δ Rev) which is a normal component of the working capital accruals and the level of gross property, plant and equipment (PPE), which is a component of long-terms accruals. ( ) ( TACC: Total accruals in year t, calculated as the difference between the net income and operating cas flows. TA: Total assets at the beginning of the year. Δ Rev: Change in the revenues. PPE: Gross property, plant and equipment. i,t : Firm and year index. ( ) All the variables in the regression are divided by the lagged total asset to avoid the heteroskedasticity problem. The non-discretionary accruals (NDCC) are the predictions from the Ordinary Least Squares (OLS) of the model below, while the discretionary accruals (DACC) are the residuals. The specific model is: ) ( ) In the second mode, the only differences from the first model are the changes in the revenues, which are adjusted by the changes in receivables (Δ Rec). The non-discretionary accruals (Mod_NDCC) are the predictions about the OLS estimation of the model, while the discretionary accruals (Mod_DACC) are the residuals. The specific modified model is: ( ) TACC; TA; Δ Rev: Change in the revenues; PPE: Gross property, plant and equipment; i,t : Firm and year index: as defined previously. ( ) Δ Rec: Change in the accounts receivable. Table 4. The variables of the accounting information quality Variables Total accruals Notation TACC Change in the revenues The difference between the changes in revenues and the changes in the accounts receivables Gross property, plant and equipment (PPE) Non-discretionary accruals Modified non-discretionary accruals Δ Rev Δ Rev- Δ Rec Discretionary accruals DACC Modified discretionary accruals Mod_DACC PPE NDACC Mod_NDACC 4.3. Methodology: This study employs cross-sectional and multivariate regression analysis in an attempt to understand the relationship between the ownership structure, the Measure The difference between net income and operating cash flows. Ending revenues-Beginning revenues (Ending revenues-Beginning revenues)- (Ending accounts receivables-Beginning accounts receivables) Gross fixed assets Predictions from the OLS of the first above model Predictions from the OLS of the second above model The difference between the total accruals and the non-discretionary accruals The difference between the total accruals and the modified non-discretionary accruals board of directors and the quality of the accounting information. In our empirical analysis, we test the following models: DACCit =β0 + β1 MOit + β2 BOit + β3 IOit + β4 HIit +β5 BDit + β6 BSit + εit (1) Mod_DACCit =β0 + β1 MOit + β2 BOit + β3 IOit + β4 HIit +β5 BDit + β6 BSit + εit (2) 417 Corporate Ownership & Control / Volume 10, Issue 4, 2013, Continued - 4 Given that the four ownership variables (managerial, blockholders, Institutional and concentration) and the two board variables (duality and size) are not the only factors affecting the earnings management, we also include in our analysis several control variables (the debt, the size, the performance and the industry sector). DACCit =β0 + β1 MOit + β2 BOit + β3 IOit + β4 HIit +β5 BDit + β6 BSit + β7 DEBTit + β8 SIZEit + β9 ROEit + β10 DUMit + εit (3) Mod_DACCit =β0 + β1 MOit + β2 BOit + β3 IOit + β4 HIit +β5 BDit + β6 BSit + β7 DEBTit + β8 SIZEit + β9 ROEit + β10 DUMit + εit (4) 5. The empirical results typical company in the sample has 8 directors and only 7% of the companies have a CEO who is also chairman of the board of directors. The average debt ratio is 35.96%. The average company in the sample has total assets of AED 645,349,427. The average ROE of the companies included in our analysis is 4.40. The discretionary accruals and modified discretionary accruals have respective averages of 0.0605 and -0.0511. 5.1. Descriptive statistics Table 5 below shows descriptive statistics for the variables used in the study of the relationship between ownership structure, the board of directors and the quality of the accounting information. The average of managerial ownership is 4.82%. Blockholders’ ownership has an average of 7.19% while institutional ownership has the highest average at 47.97%. The Table 5. Descriptive statistics Variables Mean Min Max Std. Dev MO BO IO HI 0.0482 0.0719 0.4797 0.8650 0.00 0.00 0.05 0.03 0.7521 0.4270 0.9992 2.83 0.1517 0.1124 0.2655 0.7185 BD 0.07 - - - 8.2 3 17 2.7 0.9100 SIZE 0.3596 17.6665 0.01 9.00 22.0000 0.2459 3.4430 ROE 4.40 -0.11 115.69 18.74 DACC -0.0000 -0.3949 0.2338 0.0831 Mod_DACC -0.0607 0.0765 0.0134 0.0105 BS DEBT Table 6 below shows the correlation matrix of the independent variables. As shown in the table, the highest correlation coefficients are (0.8566) between the Herfindahl Index and the Institutional Ownership and (-0.5048) between the blockholders Ownership and the Board’s Size. All the other correlation coefficients are less than 0.5 which means that there is no multicollinearity problem. Table 6. Correlation matrix for the variables MO BO IO HI BD BS DEBT SIZE ROE MO 1.0000 - 0.0528 -0.4068 -0.1749 -0.0369 -0.0661 0.1753 0.2898 -0.0732 BO IO HI BD BS DEBT SIZE ROE 1.0000 -0.4858 -0.2850 0.2525 -0.5048 -0.0586 0.3346 -0.1379 1.0000 0.8566 -0.0203 0.1823 -0.0602 -0.0852 0.0986 1.0000 0.0374 0.1779 0.0731 0.2182 0.0521 1.0000 -0.0717 -0.0855 0.2002 -0.0621 1.0000 0.0447 -0.3606 0.1842 1.0000 0.0497 0.0688 1.0000 -0.0185 1.0000 418 Corporate Ownership & Control / Volume 10, Issue 4, 2013, Continued - 4 Table 7 below reports the average by sector of the different ownership variables. The highest average of the managerial ownership is in the industrial sector, with a value of 11.05%, while the managers hold 0% of ownership in the energy, the telecommunications, and the real estate. The highest average of the blockholders’ ownership is in the health care industry sector with a value of 28.50% while the blockholders have 0% of ownership in energy, industrial, telecommunications and real estate. The highest average of institutional ownership is in the telecommunications sector with a value of 76.73 %. The institutional investors hold ownership in all the sectors. Table 7. Ownership Structure by Sector Sector Energy Industrial Consumer Health care Telecommunication Construction Real estate Number of the firms 2 4 7 3 3 9 1 Managerial 0.0000 0.1105 0.1068 0.0639 0.0000 0.0599 0.0000 The table 8 below shows the degree of the ownership concentration by sector. The highest ownership concentration is in the telecommunications Blockholder 0.0000 0.0000 0.0490 0.2850 0.0000 0.0249 0.0000 Institutional 0.4626 0.3182 0.3620 0.3448 0.7673 0.6155 0.3098 sector while the lowest is in the real estate sector. As shown above by the table 5, ownership in both sectors is held only by institutional investors. Table 8. Ownership Concentration by Sector: Cumulative percentage of shares controlled by different types of shareholders Sector Sector 1 Definition Energy C1 0.3574 C2 0.4626 C3 0.4994 HI 0.7126 Sector 2 Industrial 0.3208 0.3111 0.4144 0.3757 Sector 3 Sector 4 Sector 5 Sector 6 Sector 7 Consumer Health care Telecommunication Construction Real estate 0.3630 0.3081 0.7673 0.5454 0.1886 0.4291 0.4386 0.7673 0.6320 0.2560 0.4857 0.5512 0.7673 0.6335 0.3083 0.5887 0.5684 1.8365 1.2431 0.1666 C1- percentage holding of largest shareholders, C2- combined percentage holdings of 2 largest shareholders, C3- combined percentage holdings of 3 largest shareholders. Table 9 below shows the discretionary accruals by sector. The highest discretionary accruals are in the real estate industry (DACC= 0.0586 and the ModDACC= 0.0648). This ranking is a comparative measure of the size of discretionary accruals across the sectors, and is a proxy for the quality of a firm’s earnings. A high amount of discretionary accruals indicates lower-quality earnings and is a sign that the management in the real estate may be using the aggressive accounting to overstate earnings. According to the tables 7 and 8, the real estate sector is characterized by the lowest institutional ownership (30.98%) and the lowest Herfindahl index (16.66%). Table 9. Discretionary Accruals (DACC) and Modified Discretionary Accruals by sector Sector Energy Industrial Consumer Health care Telecommunication Construction Real estate Number of the firms 2 4 7 3 3 9 1 DACC 0.0379 -0.0518 -0.0073 0.0036 0.0019 0.0110 0.0586 419 Mod_DACC 0.0404 -0.0438 0.0011 -0.0016 0.0091 0.0138 0.0648 Corporate Ownership & Control / Volume 10, Issue 4, 2013, Continued - 4 6. Empirical results Here we present the results of the regression of the four models above. An important part of the analysis below consists of separating the discretionary accruals and the modified discretionary accruals. The estimation of the panel data with fixed effects of the four above models invalidates the presence of the individual effects. Thus, we can consider the coefficients of the pooled estimation, since the data comprise N*T rather than panelized observations. The two first models are examined to test the relation between the ownership structure (managerial, blockholder and institutional) and the board of directors’ characteristics (duality and size) and earning management measured by the DACC and Mod_DACC. The two last models look at the effect of the ownership structure, the board of director’s characteristics as well as others factors that may affect the earning management like DEBT, SIZE, ROE and the industry sector on the DACC and Mod_DACC. In the two first models and the fourth model, the board’s duality has a positive and significant impact (at 10%) for both discretionary accruals and modified discretionary accruals. Our empirical results confirm that the duality of the CEO is related to a high earning management. Our findings corroborate those of Bowen, Rajgopal and Venkatachalam (2002) who indicate that the separation between the CEO and the chairman is important to avoid earnings management malpractices and confirm that the earning management practices are higher for firms with CEO duality. This result is supported by Mohd Saleh, Mohd Iskander and Rahmat (2005) who provide evidence that CEO duality is positively related to the earning management and that companies with CEO duality do not perform well compared with their counterparts. In the two last models, other control variables have been included, along with ownership structure and the board of directors’ characteristics and all the signs remain the same (except the board size). The empirical result of the third model shows that managerial ownership has a negative and significant impact (at 10%) on discretionary accruals. This result confirms that a high presence of mangers in the ownership structure is associated with a weak practice of the earning management. Our result confirm the findings of Warfield et al. (1995) and Salsiah et al. (2008) who indicate that the quality of the accounting information is positively related to managerial ownership, whereas the magnitude of the discretionary accruals is negatively related. Indeed, their results confirm that the quality of the accounting information increases as managerial ownership increases, thus supporting the convergence of interest effect hypothesis (Morck et al., 1988). Blockholders’ ownership has a negative and significant impact (at 5% in the second model and 10% in the third and fourth models) on both discretionary accrual and modified discretionary accruals. According to this result, the high presence of the blockholders in the ownership structure of the company ensures a good quality of accounting information. Our result contradicts those of Fung and Rui (2007) who confirm that firms with highly concentrated share ownership have lower earnings informativeness. Their result has been attributed to an entrenchment effect, where blockholders may influence the adoption of accounting policies to reflect their wishes rather than the economic substance of a business transaction. In all the above models, institutional ownership has a negative but non-significant impact on earning management. Therefore, the institutional ownership is not necessarily associated with the practice of earning management. Our findings contradict those of Hadani et al. (2011), who find that institutional ownership is negatively related to earnings management and indicate that institutional owners are better positioned to constrain the practice of earnings management by their ability to gauge firm performance against the long-term fundamentals of a firm. With regard to the Herfindahl Index, our study fails to find any significant association between the ownership concentration and earning management. Similarly, in the four models, the impact of the board’s size is nonsignificant. The empirical result of the third model shows that the debt level of a company has a positive and significant (at 5%) relationship with discretionary accruals. This result illustrates that high leverage is associated with a high level of earning management. Our result validates the findings of Jiang, Lee and Anandarajan (2008) who confirm that the highly leveraged companies have strong incentives to use income increasing accruals to relax the contractual debt-constraints. With regard to size, it appears that it negatively and significantly (at 5%) affects earnings management. This finding shows that the larger companies have better earnings quality since they engage less in earnings management and suggests that these companies are more closely scrutinized than smaller companies. Indeed, the larger companies are more encouraged to produce a higher quality of reported earnings compared to the smaller companies (Park and Shin, 2004). Regarding the industry sector, two other models show that in the industrial sector, there is a weak practice of earnings management (the coefficient is significant at 5%), while this practice is high in the construction and real estate sectors, (the coefficients of both sectors are positive and significant at 5 % and 10%, respectively). This result could be explained by the higher prevalence of managerial ownership in the industrial sector than in the construction and real estate sector. As shown above, high managerial ownership is associated with good accounting information. 420 Corporate Ownership & Control / Volume 10, Issue 4, 2013, Continued - 4 7. Conclusion The aim of this research was to analyze the relationships between the ownership structure, the board of directors’ characteristics and the quality of the accounting information. The empirical results show that managerial and blockholders ownerships have negative impacts on the discretionary accruals. This result confirms that the high presence of the managers and blockholders in the ownership structure of a company are associated with a weak practice of the earning management and will lead to good quality of the accounting information. Indeed, our empirical results confirm that the quality of the accounting information increases as managerial ownership increases, thus supporting the convergence of interest effect hypothesis (Morck et al., 1988). Regarding the blockholders’ ownership, our results show that firms with highly concentrated share ownership have higher earnings informativeness which confirms that blockholders influence the adoption of accounting policies to reflect the economic substance of the business transaction and not their wishes. In addition, our study shows that the board’s duality is positively associated with the discretionary accruals. Indeed, our empirical result confirms that the duality of the CEO is related to a high earnings management practice. Our findings indicate that the separation between the CEO and the chairman is important to avoid the earnings management practices. With regard to institutional ownership, our study failed to find any significant association with the practice of the earnings management. Our findings validate the theory that institutional owners are not always better positioned to constrain the practice of earnings management by their ability to gauge firm performance against the long-term fundamentals of the firm. Our empirical results show that the debt level of a company positively affects the discretionary accruals and confirms that highly leveraged companies have strong incentives to use income increasing accruals to relax contractual debtconstraints. With regard to size, it appears that this negatively affects earnings management, which shows that the larger companies have better earnings quality since they are more closely scrutinized than smaller companies. Finally, with regard to the industry sector, our study shows that there is often a weak practice of earnings management when this practice is common in the construction and real estate sectors. This could be explained by there being more managerial ownership in the industrial sector than in the constructions and real estate sectors. As shown above, high managerial ownership is associated with good quality accounting information. This study contributes to the existing literature on the relationship between managerial ownership, the board of directors and the earnings management practice within the company. In fact, the high presence of the managers and the blockholders in the ownership structure of the company ensures high quality of the accounting information while the nonseparation between the CEO and the chairman of the board leads to a high practice of the earnings management. In addition, the contribution of the institutional owners is not always a gauge of the quality of accounting information. References 1. 2. 3. 4. 5. 6. 7. 8. 9. 10. 11. 12. 13. 14. 421 Agrawal, A. & Mandelker, G. (1992). Shark repellent and the role of institutional investors in corporate governance. 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The interaction of CEO and the ownership control in publicly traded firms: performance implications ", Working paper, School of Business, University of Kansas. 30. McConnell, J., Servaes, H., & Lins, .K. (2004). Changes in insider ownership and changes in the market value of the firm. CEPR Discussion paper n°4411, http://papers.ssrn.com/abstract=560084 31. Mohd Saleh, N., Mohd Iskandar, T., & Rahmat, M. M. (2005). Earnings management and board characteristics: Evidence from Malaysia. Journal Pengurusan, 24, 77-103. 32. Morck, R. Shleifer, A., & Vishny, R.W. (1988). Management ownership and market valuation. Journal of Financial Economics, 20, 293-315. 33. Park, Y. M & Shin, H.H. (2004). Board composition and earnings management in Canada. Journal of Corporate Finance, 10, 431-457. 34. Pfarrer, M. D., Smith, K. G., Bartol, K. M., Khanin, D. M. & Zhang, X. (2008). Coming forward: The effects of social and regulatory forces on the voluntary restatement of earnings subsequent to wrongdoing. Organization Science, 19(3), 386-403. 35. Rajgopal, S., Venkatachalam, M., & Jiambalvo, J. (1999). Is institutional ownership associated with earnings management and the extent to which stock prices reflect future earnings? Working Paper, University of Washingto. 36. Rashidah, A.R. & Fairuzana Haneem, M.A. (2006). Board, audit committee, culture and earnings management: Malaysian evidence. Managerial Auditing Journal, 21, 783 – 804. 37. Salsiah, M. A., Norman, M. S & Hassan, M. S. (2008). Ownership structure and earnings management in Malaysian listed companies: the size effect. Asian Journal of Business and Accounting, 1, 89-116. 38. Shleifer, A. & Vishny, R.W. (1986). Large shareholders and corporate control. Journal of Political Economy 94, 461-479. 39. Short, S H., & Keasy, K. (1999). Managerial ownership and the performance of firms: Obviousness from the U.K. Journal of Corporate Finance, 5, 79101. 40. Shuto, A. & Takada, T. (2010). Managerial ownership and accounting conservatism in Japan: a test of management entrenchment effect. Journal of Business Finance and Accounting, 37, 815-840 41. Teshima, N. & Shuto, A. (2008). Managerial ownership and earnings management: Theory and empirical evidence from japan. Journal of International Financial Management and Accounting, 19, 107–32. 42. Warfield, T.D., Wild, J.J. & Wild, K.L. (1995). Managerial ownership, accounting choices, and informativeness of earnings. Journal of Accounting and Economics, 20, 61-91. 43. Xie, B., Davidson W. N.& DaDalt. P.(2003). Earnings management and corporate governance: The role of the board and the audit committee. Journal of Corporate Finance, 9, 295-316 422 Corporate Ownership & Control / Volume 10, Issue 4, 2013, Continued - 4 Appendix 1. Total Accruals Constant Δ Rev Δ Rev- Δ Rec PPE Original Measure Coefficient t-Student -0.0605 -4.63 0.0745 1.12 -0.0010 -1.11 Modified Measure Coefficient t-Student -0.0555 -4.43 -0.0003 -0.0009 -1.11 -1.09 Appendix 2. The Quality of the Accounting Information, the Ownership Structure and the Board of directors Constant MO BO IO HI BD BS R2 R2 adjusted Discretionary Accruals Coefficient t-Student 0.0231 1.29 -0.0427 -1.40 -0.1811 -1.04 - 0.0188 - 1.14 -0.0131 -1.33 0 .0338 1.73* -0.0009 -1.19 Modified Discretionary Accruals Coefficient t-Student 0.0416 1.51 -0.0422 -1.39 -0.2277 -2.29** -0.0022 -1.02 -0.0078 -1.20 0.0318 1.68* -0.0015 -1.30 *, ** Significant at a confidence degree of 10 % and 5 %, respectively. Appendix 3. The Quality of the Accounting Information, the Ownership Structure, the Board of directors and the Control Variables Constant MO BO IO HI BD BS DEBT SIZE ROE Energy Industrial Consumer Health care Telecommunication Construction Real estate R2 R2 adjusted Discretionary Accruals Coefficient t-Student 0.0877 1.43 -0.1485 -1.93* -0.1618 -1.80* -0.0858 -1.46 -0.0040 -1.07 0.0368 1.61 0.0029 1.36 0.1147 2.43** -0.0061 -2.05** 0.0001 1.24 -0.0151 -1.17 -0.0831 -2.12** 0.0228 1.26 0.0432 1.41 0.0117 1.12 0.0596 1.67* 0.0607 2.02** *, ** Significant at a confidence degree of 10 % and 5 %, respectively. 423 Modified Discretionary Accruals Coefficient t-Student 0.0875 1.42 -0.0955 -1.59 -0.1773 -1.86* -0.0650 -1.34 -0.0086 -1.15 0.0442 1.72* 0.0033 1.41 0.1136 2.39** -0.0062 -2.05** 0.0002 1.25 -0.0213 -1.24 -0.0790 -2.04** 0.0259 1.29 0.0160 1.15 0.0094 1.10 0.0549 1.61 0.0624 2.03** Corporate Ownership & Control / Volume 10, Issue 4, 2013, Continued - 4 CORPORATE SOCIAL RESPONSIBILITY INDEX FOR UKRAINIAN BANKS: THE ESSENTIALS FOR IMPLEMENTATION Alexander Kostyuk*, Olena Kostyuk**, Yaroslav Mozghovyi***, Yana Kravchenko**** Abstract The aim of this paper is to solve the problem of CSR performance measurement for Ukrainian banking institutions by developing a CSR index. It is done by measuring a corporate social responsibility (CSR) through 25 different indicators for 40 Ukrainian banks, which represent 80% of total banking system assets. This paper is a first attempt in Ukrainian practice to put CSR indicators into a standard metrics and develop specific methodology that would allow comparing CSR for different banks. To check the adequacy of our preliminary findings we compare CSR results for Ukrainian banks with CSR results for Swedish banks, where the level of CSR is definitely higher, since it is a socially directed developed economy. After that the weights of CSR index for Swedish banks counted by our methodology was compared to different professionally made indexes. Keywords: Corporate Social Responsibility, CSR performance measurement, Index, Banks, Ukraine, Sweden * Department of International Economics, Ukrainian Academy of Banking of the National Bank of Ukraine E-mail: alex_kostyuk@virtusinterpress.org ** Department of International Economics, Ukrainian Academy of Banking of the National Bank of Ukraine *** Department of International Economics, Ukrainian Academy of Banking of the National Bank of Ukraine E-mail: mozghovyi@gmail.com **** Hanken School of Economics, Finland, E-mail: yana.kravchenko.ua@mail.ru 1. Introduction The concept of the corporate social responsibility (CSR) has been developed since the first part of the XX century by many world known economists. Importance and significance of the CSR for all kinds of firms and corporations became obvious many years ago. Organizations are being called upon to take responsibility for the ways their operations influence societies and the environment. The type of relationships that a company has with its employees, customers, investors and government determines success of its operations in general. Thus, companies are also being asked to apply sustainability principles to the ways in which they conduct their businesses. Many scientific papers mentioned the view that CSR can contribute to the corporate financial performance (CFP) of a company. However, there is currently a debate on the extent to which CSR influences a CFP of a company. This topic became even more prominent during the last economic and financial crisis, especially for banking institutions, since they are the key sector of market economy. It should be mentioned that it is difficult to describe the correlation between CSR and CFP for Ukrainian banking sector, since there were no practice calculating any CSR index or measuring CSR in any mathematical way. But still, drawing on the experiences of those companies that have adopted CSR, it is undoubtedly, that good CSR activities are crucial for the company if its strategic goal is to maximize long-term financial returns. Since Ukraine did not launch yet a CSR concept fully, it would be useful to draw managers’ attention to this fact. So our paper is an attempt to provoke new scientific researches and attract more attention to such important field of research. 2. Previous studies Hurst N. (2004) in his study compared governance and CSR practices of corporations based in the United States and Europe. To measure similarities and differences the author took such indicators as the existence of Code of Conduct, CSR or sustainability report, the disclosure of company’s conflict of interest guidelines and some others. Hurst admits that Dow Jones Sustainability Index (DJSI) is one of the most competitive indexes due to its high social, ethical, and environmental standards. Though DJSI provides objective benchmarks to manage sustainability-driven portfolios, the index is only calculated for the leading sustainability companies, leaving behind the majority 424 Corporate Ownership & Control / Volume 10, Issue 4, 2013, Continued - 4 of other companies. For instance, the DJSI World covers only the largest 2500 companies by market capitalization in the Dow Jones Global Index. Boston College Center for Corporate Citizenship and Reputation Institute developed CSR Index for American companies. It is counted on an annual basis and is performed as ranking of top 50 companies with the best CSR. However, the problem lies in the absence of methodology of how the index is calculated. Also, it is calculated only for American companies. All above-mentioned makes it impossible to compare this index with other ones and calculate it for non-American companies. According to Lockett et al. (2006), there are some peculiarities for CSR measurement in developed and in developing countries. He states that in developed countries the CSR literature is dominated by quantitative methods (80%), whereas CSR papers on developing countries are more likely to be qualitative. Dimtcheva, Marsland and Morrison (2002) published report, where analyzed socially responsible investing in the context of the choice of benchmark and briefly compared the Dow Jones Sustainability Index and FTSE4Good Index. FTSE4Good, a UKbased index, developed with Ethical Investment Research Service (EIRIS), evaluates a company’s commitment to SR by examining the environment, human rights and stakeholder relationships. Unfortunately, index includes companies with progressing practices of SR, excluding companies with controversial activities. Another criterion due to which companies fail to be included in FTSE4Good is lack of data. So FTSE still have to work together with EIRIS to overcome such problem and make its index more competitive. It was concluded that the main difference between the two SRI benchmarks is that FTSE4Good Indices are based on the exclusion methodology (negative screening) and DJSI are based on the "bestin-class" approach (positive screening). Mitchell, Holt, Swartz, Kido, Song and Kolind (2004) reviewed existing sustainable metrics. Researched showed that many existing indices are not independent and do not provide an objective measure of sustainability. The authors chose five indices: Dow Jones Sustainability Index (DJSI), Ethibel, FTSE4Good, Domini 400 Social Index and Vanguard Calvert Social Index Fund, that according to them provided the most comprehensive evaluation of sustainable practices and then analyzed the indicators used by each index in their evaluation and compared the companies d that tin each index. As a result, some similarities and differences were identified across indices but according to the authors the indices and metrics we reviewed were vague and provided little tangible metrics to evaluate. Overall, we came up with clear vision that already existing indices do not provide enough information about their methodologies, thus we can conclude that they don’t have much meaning without full transparency. Even CSR rankings groups that publish their methodologies rarely offer enough sufficient information to determine what differentiates their indices from others. So taking all these facts into account we decided that it would be useful to develop our own CSR Index that would on the one hand have a clear and open methodology, on the other – would rely on such information that could be easily accessed for the majority of companies all over the world, including Ukrainian ones. 3. Methodology 3. 1 Index components As a basis for our CSR index was chosen one of the most fundamental and most cited works in this sphere – “The Pyramid of Corporate Social Responsibility: Toward the Moral Management of Organizational Stakeholders” by A. Carroll [5]. In this work A. Carroll presented his pyramid of the CSR that is some kind of analogue of Maslow’s hierarchy of needs. The pyramid consists of 4 levels. Their priority is reducing from the bottom to the top. It is suggested that four kinds of social responsibilities constitute total CSR: economic, legal, ethical and philanthropic. Among these levels of CSR we have picked up those parameters that could be easily indicated through the websites of the analyzed institutions and annual reports etc. On the next stage of the research we’ve tried to simplify the methodology even more. To exclude the subjectivity and possible unprofessionalism from the research we decided that we will assess only the presence or absence of different parameters in the banking activity with the help of the dummy variables like “0” or “1”. At the end index of CSR will appear in the form of the total number of the variables. So the first level of the pyramid is presented by economic responsibilities. Carroll writes that historically business organizations were created as economic entities designed to provide goods and services to societal members. The profit motive was established as the primary incentive for entrepreneurship. Before it was anything else, business organization was the basic economic unit in our society. At some point the idea of the profit motive got transformed into a notion of maximum profits, and this has been an enduring value ever since. All other business responsibilities are predicated upon the economic responsibility of the firm, because without it the others become moot considerations. Table 1 summarizes some important statements characterizing economic responsibilities. 425 Corporate Ownership & Control / Volume 10, Issue 4, 2013, Continued - 4 Table 1. Economic and Legal Components of Corporate Social Responsibility Economic Components (Responsibilities) 1. It is important to perform in a manner consistent with maximizing earnings per share 2. It is important to be committed to being as profitable as possible. 3. It is important to maintain a strong competitive position. 4. It is important to maintain a high level of operating efficiency. 5. It is important that a successful firm be defined as one that is consistently profitable. From the first level of the pyramid we’ve included into the index parameter of profit and paid dividends. They should represent responsibility to shareholders. Taxes paid by bank are also included into the economic level and represent responsibility to the country. This level of responsibility is generally accepted and should be fulfilled by the majority of the banks. Next level refers to the legal responsibilities that are also depicted in the Table 2. According to Carroll society has not only sanctioned business to operate according to the profit motive; at the same time business is expected to comply with the laws and regulations promulgated by federal, state, and local governments as the ground rules under which business must operate. As a partial fulfillment of the "social contract" between business and society firms are expected to pursue their economic missions within the framework of the law. Legal responsibilities reflect a view of "codified ethics" in the sense that they embody basic notions of fair operations as established by our lawmakers. They are depicted as the next layer on the pyramid to portray their historical development, but they are appropriately seen as coexisting with economic responsibilities as fundamental precepts of the free enterprise system [5]. On this level we have picked up only two parameters: regulative compliance (fulfillment capital requirements, risk requirements, different resolutions and decree and absence of the not obidance record in the examined period); law obedience (fulfillment of the general law requirements, absence of public scandals etc.). The third level of CSR according to Carroll is represented by ethical responsibilities. Although economic and legal responsibilities embody ethical norms about fairness and justice, ethical responsibilities embrace those activities and practices that are expected or prohibited by societal members even though they are not codified into law. Ethical responsibilities embody those standards, norms, or expectations that reflect a concern for what consumers, employees, shareholders, and the community regard as fair, just, or in keeping with the respect or protection of stakeholders' moral rights. Legal Components (Responsibilities) 1. It is important to perform in a manner consistent with expectations of government and law. 2. It is important to comply with various federal, state, and local regulations. 3. It is important to be a law-abiding corporate citizen. 4. It is important that a successful firm be defined as one that fulfills its legal obligations. 5. It is important to provide goods and services that at least meet minimal legal requirements. The business ethics movement of the past decade has firmly established an ethical responsibility as a legitimate CSR component. Though it is depicted as the next layer of the CSR pyramid, it must be constantly recognized that it is in dynamic interplay with the legal responsibility category. That is, it is constantly pushing the legal responsibility category to broaden or expand while at the same time placing ever higher expectations on businesspersons to operate at levels above that required by law [5]. It is like that in developed countries. But in developing countries laws a mainly directed on satisfying needs in legal economic activity and do not refer to the ethical issues. That’s why some parameters included by us in this segment belong to the sphere of legal responsibilities in developed countries, but in Ukraine they are purely ethical. Ethical level of responsibilities obtains by proposed in this paper methodology the biggest quantity of parameters because by our point of view it shows social intentions of the company most eloquently. It is not obligatory, like previous two and not so populist like the last level – philanthropic. Ethical level consists of responsibilities directed to different stakeholders of the company: employees – existence of the compensation that exceeds the average in the sector, and programs that support professional and individual development, provide competitive and comfortable working environment; shareholders, customers, partners and general public that could be provided by the information disclosure and quality of the information on the company’s activity (remuneration disclosure, information on the board of directors and top management, availability of the information to all groups of stakeholders, existence of the separate report on CSR, reporting according Global Reporting Initiative or other socially directed standards), by the environmental responsibility of the company (although this issue for financial institutions is not so critical and important as for the industrial companies, banks could show good example and provide public initiatives on environmental responsibility to its customers, partners, competitors), by making of the socially responsible investments (this segment of the investments is a fast growing sector that controls at 426 Corporate Ownership & Control / Volume 10, Issue 4, 2013, Continued - 4 the moment several trillions USD in funds, banks as active financial players could sufficiently support it by own activity directed like on the profit seeking purposes and at the same time on the social projects. We have also regarded in this category providing of the socially responsible loans, with environmental and social conditions). Table 2 depicts statements that help characterize ethical responsibilities. The figure also summarizes philanthropic responsibilities, discussed next. Table 2. Ethical and Philanthropic Components of Corporate Social Responsibility Ethical Components (Responsibilities) 1. It is important to perform in a manner consistent with expectations of societal mores and ethical norms. 2. It is important to recognize and respect new or evolving ethical moral norms adopted by society. 3. It is important to prevent ethical norms from being compromised in order to achieve corporate goals. 4. It is important that good corporate citizenship be defined as doing what is expected morally or ethically. 5. It is important to recognize that corporate integrity and ethical behavior go beyond mere compliance with laws and regulations. The last fourth level of CSR is represented according to Carroll by philanthropic responsibilities. He wrote that philanthropy encompasses those corporate actions that are in response to society’s expectation that businesses be good corporate citizens. This includes actively engaging in acts or programs to promote human welfare or goodwill. Examples of philanthropy include business contributions to financial resources or executive time, such as contributions to the arts, education, or the community. The distinguishing feature between philanthropy and ethical responsibilities is that the former are not expected in an ethical or moral sense. Communities desire firms to contribute their money, facilities, and employee time to humanitarian programs or purposes, but they do not regard the firms as unethical if they do not provide the desired level. Therefore, philanthropy is more discretionary or voluntary on the part of businesses even though there is always the societal expectation that businesses provide it. One notable reason for making the distinction between philanthropic and ethical responsibilities is that some firms feel they are being socially responsible if they are just good citizens in the community. This distinction brings home the vital point that CSR includes philanthropic contributions but is not limited to them. In fact, it would be argued here that philanthropy is highly desired and prized but actually less important than the other three categories of social responsibility [5]. On this level of CSR we’ve picked up such parameters as philanthropic activity of the company in general, arts support, education and research support, and volunteering activity of the staff. Except of the CSR four levels Carroll also describes the way of management that reflects CSR in Philanthropic Components (Responsibilities) 1. It is important to perform in a manner consistent with the philanthropic and charitable expectations of society. 2. It is important to assist the fine and performing arts. 3. It is important that managers and employees participate in voluntary and charitable activities within their local communities. 4. It is important to provide assistance to private and public educational institutions. 5. It is important to assist voluntarily those projects that enhance a community’s "quality of life." best way. It is called “moral management”. Its main features applied to different groups of stakeholders are represented in Table 3. Taking into account Carroll’s moral management concept we have decided to include into index some more components (that were not included in previous four levels). Several of them are connected with the risk management and orientation towards the stakeholders. Managing risk is a central part of many corporate strategies. Reputations that take decades to build up can be ruined in hours through incidents such as corruption scandals or insolvency crisis in bank. These can also draw unwanted attention from regulators, courts, governments and media. Building a genuine culture of 'doing the right thing' within a corporation can offset these risks.10 Levine (2008) highlights managing risks as a main benefit of CSR in the short-term: “Why implement a CSR program? In short, to manage risks and to ensure legal compliance companies may be exposed to a variety of legal and reputation risks if they do not have adequate social compliance or CSR/sustainability programs in place” (2008: 2). But financial risks on the contrary of the non financial risks, form the core of the bank’s management. Moreover, we should consider that CSR and CFP in bank are closely tight not only to the reputational risks but also to the effectiveness of the financial risk management and control process. This is why we put the risk issue under consideration in terms of its management and control. 10 Kytle, Beth; (2005). "Corporate Social Responsibility as Risk Management: A Model for Multinationals" 427 Corporate Ownership & Control / Volume 10, Issue 4, 2013, Continued - 4 Table 3. Main features of the Carroll’s moral management oriented toward different stakeholders Group of stakeholders Orientation Toward Owner/Shareholder Stakeholders Orientation Toward Stakeholders Employee Orientation Toward Stakeholders Customer Orientation Toward Community Stakeholders Local Features Shareholders' interest (short- and long-term) is a central factor. The best way to be ethical to shareholders is to treat all stakeholder claimants in a fair and ethical manner. To protect shareholders, an ethics (or CSR) committee of the board is created. Code of ethics is established, promulgated, and made a living document to protect shareholders' and others' interests. Employees are a human resource that must be treated with dignity and respect. Goal is to use a leadership style such as consultative/participative that will result in mutual confidence and trust. Commitment is a recurring theme. Employees' rights to due process, privacy, freedom of speech, and safety are maximally considered in all decisions. Management seeks out fair dealings with employees. Customer is viewed as equal partner in transaction. Customer brings needs/expectations to the exchange transaction and is treated fairly. Managerial focus is on giving customer fair value, full information, fair guarantee, and satisfaction. Customer rights are liberally interpreted and honored. Sees vital community as a goal to be actively pursued. Seeks to be a leading citizen and to motivate others to do likewise. Gets actively involved and helps institutions that need help—schools, recreational groups, and philanthropic groups. Leadership position in environment, education, culture/arts, volunteerism, and general community affairs. Firm engages in strategic philanthropy. Management sees community goals and company goals as mutually interdependent. Risk issue is one of the questions Basel Committee works on. In March 2010 The Basel Committee published a consultative document “Principles for enhancing corporate governance”, where the main recommendations about risk management in banks were stated. According to The Basel “Large banks and internationally active banks, and others depending on their risk profile and local governance requirements, should have an independent senior executive with distinct responsibility for the risk management function and the institution’s comprehensive risk management framework across the entire organization. This executive is commonly referred to as the chief risk officer (CRO).” Mentioned document highlights the necessity of the external risk control infrastructure in the bank. We suppose that risk controlling process could be executed more effectively on the level of Board of Directors, who plays the crucial role in risk management as the main body of decision making process of the bank. Pursuant to the Third King Report on Governance 2009, the formed Board of Directors must:  take into account not only financial indicators, but also the impact of the company’s activities on society and environment;  protect and invest in welfare of the economy, society, and environment;  ensure the company’s actions and cooperation with stakeholders based on the law;  take into account the need for joint efforts with stakeholders in order to promote ethical conduct and good corporate governance;  provide measurability of implemented CSR programs;  be aware that the strategy, risk, indicators, and sustainability are inseparable and consider sustainability as business opportunity;  ensure efficient governance based on ethical principles;  contribute to the company remaining and being considered a responsible corporate citizen;  the company has an efficient and independent audit committee whose duties include audit of both financial and non-financial statements. It should be mentioned, that control functions can’t be objectively executed by the internal employee. The position of the controlling director must be taken by the independent person. Moreover, the tendency to hire independent directors is on the rise with the purpose of improving quality of decisions made at the level of the Board who have different experience, skills, knowledge, and expertise which means “diversity” in the CSR language. This aspect ensures more reasonable decisions concerning financial and non-financial issues and brings about positive results. We also consider that independent directors could better execute their functions in risk management process and CSR activity of the bank, if they are grouped in profile collegiate bodies, such as committees of the Board. Among the committees 428 Corporate Ownership & Control / Volume 10, Issue 4, 2013, Continued - 4 which effect bank’s CSR policy we could name following: CSR committee, audit committee, corporate governance committee, risk management and control committee. Also writing about orientation to the shareholders Carroll talks about the code of conduct [5]. Codes of conduct are mainly used as tools of corporate governance, but their usage grows for purposes of CSR with the following priority issues:  the company’s impact on the economic, environmental, and social areas, sustainability;  working atmosphere;  labour relationships;  relationships with suppliers;  ethical conduct. An ethics code and practices that foster transparency are the basis for a company to comply with its operational and strategic objectives. These guide companies on how to behave when managing relationships with suppliers, investors and employees. Communications and control mechanisms on compliance form part of this category. In the CSR literature, codes of conduct are variably described and defined and have common elements, such as being self-regulatory or voluntary in nature, used to influence behavior of a specified group or groups, and/ or to define intentions/ actions on a certain group of issues or to a certain group of individuals, sometimes from a market-based perspective (Kolk, van Tulder and Welters, 1999; Kaptein and Wempe, 2002; United States Council for International Business, 2000; ILO, n.d.a; ILO, n.d.b; Forcese, 1997; Alexander, 1997; Dickerson and Hagan, 1998; OECD, 2001; Diller, 1999). In this literature, an implicit relationship exists between codes and CSR that is well illustrated by the United States Council for International Business (USCIB) where the corporate responsibility section on their website has a recent ‘position/ statement document’ on codes of conduct, where codes are defined as ‘…commitments voluntarily made by companies, associations, or other organizations that put forth standards and principles of business conduct in the marketplace, and are thus primarily marketdriven’ (2000, p.2). In some cases, this primarily implicit relationship between codes and CSR is made explicit such as with Kolk, van Tulder and Welters (1999) who define codes of conduct as ‘...encompass[ing] guidelines, recommendations or rules issued by entities within society (adopting body or actor) with the intent to affect the behavior of (international) business entities (target) within society in order to enhance corporate responsibility’ (p.151). Other authors indicating a more explicit relationship between codes and CSR include Dickerson and Hagen (1998) and OECD (2001). As we will see later, Kolk, van Tulder and Welters (1999) make an important distinction between these ‘international’ codes and internal codes of conduct ‘…which consist of guidelines for staff on how to behave when confronted with dilemmas such as conflict of interest, gifts, theft, insider trading, pay-offs and bribery’, arguing that the internal codes do not address the business-society relationship. Efficient code of conduct should declare information for bank personnel about right treatment of the clients. We suppose, that compliance of the rules, stated in the code provides for the bank better dialog with the clients, and thus could assist in increasing of the deposit volume that could be treated as competitive advantage of the bank and positively influence it’s CFP. That’s why the result of the presence of the code of conduct could be analyzed by the comparative indicator of the bank’s deposits share in the total banking system deposits volume. So abovementioned pushed us to including into the index such parameters: independent directors in the board; committees of the board, and separately corporate governance committee, CSR committee and audit committee; code of conduct. And final parameter that was included in to the index is CSR development by the company, which means engagement of the company into public affairs concerning CSR like conferences, workshops, informative and consultative activity etc. For each of the proposed parameters was chosen its marking (Appendix 1). Formula 1 describes the final form of the index: Icsr=Σ Ec (p, dp, tp), Lc (rc, lo), Eth (Ir, Ex>av, esp, Enr, Dr, Dbd, Dst, Rcsr, CGRI), Phr (ph, arts, eds, vaemp), MMc (Di, Cb, Ca, Ccsr, Ccg, Cc), SRd 3. 1 Research sample For our research and statistical analysis we’ve picked top 40 banks which operate on Ukrainian market whose share in assets of the whole banking system exceeds 80% so representation degree is high enough. Among them 17 are banks owned by national shareholders, we call them “resident banks” and 23 owned by foreign shareholders, we call them nonresident banks. (1) To identify parameters of the CSR index we’ve analyzed financial reports of the banks for the 2010, their websites and publicly available information. Final data on parameters was summarized according to formula 1 into one index for each institution. To verify the adequacy of the index it was decided to check its’ operation on the Swedish banks, players of the country, that has one of the most highly developed welfare states in the world. The country has a higher level of social spending to GDP than any other nation. In 2010, it was ranked fourth in the 429 Corporate Ownership & Control / Volume 10, Issue 4, 2013, Continued - 4 world in The Economist's Democracy Index and ninth in the United Nations' Human Development Index. In 2010, the World Economic Forum ranked Sweden as the second most competitive country in the world, after Switzerland. So we suppose that social affairs of the Swedish banks should be on high level. After that we needed to compare rankings of the banks according to our index and according other professionally maid indexes of CSR. Into the initial sample 65 Swedish commercial banks were included. There are several indexes of CSR that provides information on Swedish banking institutions. Among them we could indicate Dow Jones Sustainability Indexes that are the first global indexes tracking the financial performance of the leading sustainabilitydriven companies worldwide; corporate social responsibility index conducted by the Swedish insurance company Folksam; FTSE4Good index and Ethibel CSR index. According to our hypothesis we suppose that: 1) the results of the research will indicate the direct correlation between the size of the bank and its CSR index as in Ukraine so in Sweden; 2) nonresident banks that operate on Ukrainian market will score more points of the index than resident ones because they are influenced by the politics implemented in their mother companies; 3) Ukrainian banks will score quite low (lower than the half of the maximum) that of course will be much lower of the Swedish banks result. 7. Results The results of the analysis on Ukrainian banks occurred controversial. Appendix 2 contains table with index weights for all Ukrainian banks in the initial sample. Figure 2 depicts percentage of the banks that showed different results of the index. Figure 1. Percentage of the Ukrainian banks according to different index weights 5% 3% 8% 15 5% 14 8% 13 10% 11 10% 10 9 8 18% 7 18% 6 5 5% 4 13% We found some correlation between the size of the bank and its corporate social performance (CSP) but it is not homogeneous and could not be taken as an absolute. The average result is “10” based on this 42,5% of all banks showed results above it and 12,5% showed exactly “10”. The majority of the Ukrainian banks scored “8” and “11” points (18% equally). The highest rank is “15”. Only 8% of the banks showed the best result and all of them do not belong to top 10 banks. Even in top ten not all banks scored higher than average, 3 of 10 obtained lower index. However 70% of top 20 banks scored higher than “10” and only 25% in lower 20 banks. Moreover their average index (11,1) is higher than the average in 20 lower banks (8,6). So our hypothesis about correlation of the banks size and CSP is partially approved because the majority of bigger banks showed better results, but some of them failed to score higher than average and some smaller banks showed results mush higher than each of top 10. Among resident Ukrainian banks 76% scored lower than average. And average result inside the group is “9,15” that is lower compared to the whole sample. Nonresident banks’ group average is higher – “10,4? and 50% of banks performed lower than average, that is 26% less, compared to resident banks (figure 2). 430 Corporate Ownership & Control / Volume 10, Issue 4, 2013, Continued - 4 Figure 2. Resident and nonresident banks scorings compared to average 120% 100% 80% 60% 40% 20% 0% Higher than average Resident banks 29% Nonresident banks 55% Lower than average 76% 50% Based on the abovementioned results we could make a conclusion, that our second hypothesis about differences in CSP of resident and nonresident Ukrainian banks was confirmed. But we should admit, that the majority of nonresident banks are in top 20 ranked by size. And there is no possibility on this stage of the research to indicate which factor influences banks’ CSP more: size or residence. But we conclude that both these factors in synergy made their contribution into the final result. What about our third hypothesis we can conclude, that only 25% of the total 40 banks scored higher than the half of the maximum index weight (25), that confirm the first part of the hypothesis. Examining Swedish banks we excluded from the initial sample: - branches of the foreign banks; - banks that in majority belongs to Swedbank (because they hardly have their own CSR strategy); - former savings banks (because they operate similar and do not provide full range of services); - banks that do not provide last financial reports on their websites or provide them only in Swedish. So in the final sample 14 banks left (Table 4). Table 4. Final sample of the Swedish banks № 1 2 3 4 5 6 7 8 9 10 11 12 13 14 11 Size of the Balance sheet 11 (2010) 1 2 3 4 6 8 10 11 12 15 17 18 32 33 Bank name Handelsbanken SEB Nordea Bank Swedbank SBAB Bank Länsförsäkringar Bank Sparbanken Öresund GE Money Bank Volvofinans Bank Nordnet Bank Avanza Bank Carnegie Investment Bank Forex Bank EFG Bank According to data of http://www.swedishbankers.se 431 CSR index 20 21 21 19 19 16 13 19 11 13 15 16 9 13 Corporate Ownership & Control / Volume 10, Issue 4, 2013, Continued - 4 Results of the Swedish banks’ CSR index also confirmed second part of our 3rd hypothesis. Average CSR index among them is “16” and 13 from 14 banks scored higher than the average in Ukrainian sample. Inside the group of Swedish banks same percentage - 43% of banks scored as higher so lower than the average and 14% showed exactly middle results. Correlation between size and CSP in Sweden is more clear and stronger. Top 5 banks from the sample scored much higher than the average index. Such differences in results between Ukrainian and Swedish banks could be explained by lower social initiatives in the countries and attitude of the banks management to CSR. Next stage of the research was in checking the adequacy of the index through the comparing to the already made professional indexes. On this stage it became clear that choosing Swedish banks for this purpose was not so good idea. The only index that is in open access and which we’ve got is Folksam sustainability index. But this index counts company’s performance separately by two parameters: environmental performance and human rights protection (table 5). Table 5. Folksam CSR index Folksam 2011 Environmental perfomance Human rights protection Swedbank 4,78 4,41 Handelsbanken 4,48 4,62 SEB 3,85 4,48 Nordea 3,69 4,48 Nordnet 2,05 1,72 Avanza 0,35 1,23 Name It is evident that according two indexes top 4 banks scored good, but their ranks according Folksam do not match scorings according our index. This is simple to explain. We’ve analyses much wider sample of parameters and aspects of CSR so for checking our index for adequacy we need to get more complex index of CSR. Conclusions The objective of our paper was to solve a problem of CSR performance measurement in Ukrainian financial market. The point is that there was no index or other benchmark of the CSR in Ukraine earlier. Thus, to have more or less clear picture we decided to develop our own index of CSR so this work became the first ever made attempt to evaluate CSP in the region. As a basis for our CSR index was chosen one of the most fundamental and most cited works in this sphere – “The Pyramid of Corporate Social Responsibility: Toward the Moral Management of Organizational Stakeholders” by A. Carroll. According to this paper and other works in the field of CSR we’ve substantiated and picked up 25 indicators, which as we believe, reflect CSR in the bank most of all. Those indicators were divided into groups according to the CSR pyramid and moral management approach for better understanding of theirs nature. In the research we’ve analyzed 40 banks which operate on Ukrainian market (17 “resident banks” and 23 with foreign capital). To calculate the final index of CSR we’ve summarized all indicators taken for our research. Afterwards we’ve analyzed a sample of Swedish banks to compare their index scorings with the existing professionally made indexes of CSR. The results of the analysis on Ukrainian banks occurred controversial. During our investigation 3 hypotheses were made. The first hypothesis supposed that Average 4,595 4,55 4,165 4,085 1,885 0,79 Our CSR Index 19 20 21 21 13 15 there is a correlation between the size of the bank and its CSR index as in Ukraine so in Sweden. We found some correlation between the size of the bank and its corporate social performance (CSP) but it is not homogeneous and could not be taken as an absolute. It was partially approved because the majority of bigger banks showed better results, but some of them failed to score higher than average and some smaller banks showed results mush higher than each of biggest banks. At the same time correlation between size and CSP in Sweden is more clear and stronger. Top 5 banks from the sample scored much higher than the average index. Such differences in results between Ukrainian and Swedish banks could be explained by lower social initiatives in the countries and attitude of the banks management to CSR. The second hypothesis about differences in CSP of resident and nonresident Ukrainian banks was confirmed. But we should admit that the majority of nonresident banks are in top 20 ranked by size. And there is no possibility on this stage of the research to indicate which factor influences banks’ CSP more: size or residence. But we conclude that both these factors in synergy made their contribution into the final result. Finally, our last hypothesis predicted that Ukrainian banks will score lower in CSR index than Swedish banks. The hypothesis was proved. As we expected, the average CSR index for Ukrainian banks stood at “10” points, while Swedish banks got “16” as an average. Though all hypotheses were proved, it is still arguable weather such methodology can be taken as an absolute for Ukrainian banks. The main problem is rather declarative character of CSR activities in Ukrainian banks. Besides, it has been concluded from the researches that checking the adequacy of our index by comparing it with professional indexes was not as successful as we expected. The only index on which we could get data - 432 Corporate Ownership & Control / Volume 10, Issue 4, 2013, Continued - 4 Folksam CSR index did not match our CSR bank ranking. Though, it can be explained by much wider sample of indicators taken by us, than while calculating Folksam CSR index. It also leaves an open question about the correlation between CSR and CFP of the banks and further improvement of the CSR index for Ukrainian financial institutions. That leaves a space for new more in depth researches in this field of study. 18. References 20. 1. 2. 3. 4. 5. 6. 7. 8. 9. 10. 11. 12. 13. 14. 15. 16. 17. Alexander, J. (1997) ‘On the Right Side’, World Business, 3(1) Jan/Feb: 38-41. 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United States Council for International Business (2000) Corporate Codes of Conduct: Overview and Summary of Initiatives, United States Council for International Business. www.uscib.org/index.asp?documentID=1434 (17 March 2004) Corporate Ownership & Control / Volume 10, Issue 4, 2013, Continued - 4 Appendix 1. Parameters of the CSR index Group name/ parameter name Marking Economic Components (Responsibilities) - Ec profit p - dividends paid dp - taxes paid tp Lc Legal Components (Responsibilities) - regulative compliance rc - law obedience lo Ethc Ethical Components (Responsibilities) - socially responsible investments Ir - Ex>av - expenditures on 1 employee higher than average employee support programs - environmental responsibility Enr - remuneration disclosure Dr - information on the board of directors Dbd - general disclosure to stakeholders Dst - CSR report Rcsr - GRI comppliance (or similar) CGRI esp Phr Philanthropic Components (Responsibilities) - philanthropic activity ph - arts support arts - education support eds - employees volunteering activity vaemp MMc Moral management components (Responsibilities) - independent directors in the board Di - committees of the board Cb - audit committee Ca - CSR committee Ccsr - corporate governance committee Ccg - code of conduct Cc CSRd CSR development 434 Corporate Ownership & Control / Volume 10, Issue 4, 2013, Continued - 4 Appendix 2. Results on CSR index (Ukrainian banks) № 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 26 27 28 29 30 31 32 33 34 35 36 37 38 39 40 Size 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 17 18 19 21 22 23 24 25 26 27 29 30 32 33 34 35 40 50 51 52 53 54 57 58 59 Name Privatbank Oshadbank Ukreximbank Raiffeisenbank Aval Ukrsybbank Ukrsocbank Prominvestbank OTP Bank VTB bank Alfa bank Nadra Finansy ta Kredyt Forum PUMB Rodovid bank Swedbank Kreditprombank Ukrgasbank ING bank Universal bank Unicredit Erste Delta Pravex VAB Chreshatyk Sberbank Index bank Kredobank Finansova iniciatyva Morfinbank Kyiv Express bank Tavryka Ukrajinskyy profesiynyy bank Ekspobank Aktyvbank Ukrinbank Diamant Evrogasbank 435 View publication stats CSR Index11 8 13 14 11 13 10 11 14 10 15 15 13 11 5 11 9 9 8 8 15 14 8 6 13 7 8 8 4 5 11 8 7 10 7 6 10 10 11 7