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Kingston Business School, London <J N G S T Q N J N I Y E A S I T T THE RELATIONSHIP BETWEEN CORPORATE TRANSPARENCY AND COMPANY PERFORMANCE IN THE ISTANBUL STOCK EXCHANGE Mustafa Ozbay, k0804108 MSc Accounting & Finance, 2009 Supervisor: Dr. George Alexandrou Kingston Business School, London Dated: 5th^ October 2009 ABSTRACT The purpose of this research is to explore the relationship between corporate transparency and company performance. The empirical research is based on the sample companies selected from the firms listed on to the Istanbul Stock Exchange. The corporate transparency database of this study is created on a yearly basis for the period of 1995 and 2005 in accordance with the attributes defined by Standard & Poor's and Sabanci University Corporate Governance Forum. Transparency attributes, which are 105 in total for each company, are extracted from annual reports of the publicly held firms, afterwards converted into percentages in three different subcategories, which are ownership structure & investor relations, financial transparency & information disclosure and management structure & process. Transparency attributes consist of 11 years
(1995-2005) and 27 companies. Figures and financial ratios to create the database for company performance measures of the sample firms are downloaded from the website of the Istanbul Stock Exchange for the period of 1995 and 2005. Under the lights of this research, it is concluded that there is significant relationship between corporate transparency and company performance. The finding of the study are in conformance with the prior studies examining relationship between corporate governance and firm performance. According to results of this study, company performance measures proxied by MTBV, MASR and PTCF are statically significant at the 1% level. However, performance measure proxied by PE ratio shows no significant relationship between corporate transparency and firm performance. The findings of the study indicate that significant positive relationships between dependent variable (TTS) and independent variables (MTBV and MASR) exist and a significant negative relationship between TTS and PTCF exists, while a positive (but insignificant) relationship between TTS and PE exists. Key words: corporate governance, company performance, corporate transparency, disclosure, information asymmetry, firm valuation.
CONTENTS
ABSTRACT..............................................................................................
i DECLARATION......................................................................................ii ACKNOWLEDGEMENTS....................................................................iii LIST OF FIGURES AND TABLES........................................................vi LIST OF ABBREVIATIONS.................................................................vii
- INTRODUCTION................................................................................ 1 1.1. The Structure of The Dissertation..................................................... 3
- THE RESEARCH PROBLEM............................................................. 3
- REVIEW OF RELEVANT LITERATURE.......................................... 5 3.1.............................................................................................................I nformation Problem in Capital Markets and Corporate Transparency.... 5 3.2.............................................................................................................T ransparency in Financial Markets............................................................ 8 3.2.1..........................................................................................................C onceptual Framework............................................................................... 9 3.2.2........................................................................................................As suring Transparency in Publicly Held Firms.......................................... 11 3.2.3........................................................................................................Be nefits of Transparency............................................................................ 12 3.2.4........................................................................................................C osts of Transparency............................................................................... 13 3.2.5........................................................................................................En hancing Corporate Transparency............................................................ 13 3.3...........................................................................................................C orporate Governance and Company Performance.................................. 14 3.4...........................................................................................................C orporate Transparency and Disclosure Studies in Turkey...................... 16 3.5...........................................................................................................Fu rther Research and Filling the Gap......................................................... 18
- AN EMPIRICAL STUDY ON COMPANIES LISTED ON TO THE ISE.......................................................................................................... 19 4.1...........................................................................................................St ructures of Hypotheses........................................................................... 19 4.2...........................................................................................................Sa mple Selection........................................................................................ 20 4.3...........................................................................................................Se lection of Variables for Performance Measures...................................... 22
4.4...........................................................................................................R
esearch Tools.......................................................................................... 24 4.5...........................................................................................................R elationship Between Corporate Transparency and Firm Performance... 25 4.5.1. Relationship Between Total Transparency and Company Performance............................................................................................ 28 4.5.1.1.....................................................................................................C orporate Transparency is Dependent Variable........................................ 28 4.5.1.2.....................................................................................................M arket to Book Value is Dependent Variable............................................ 31 4.5.1.3.....................................................................................................Pr ice to Cash Flow is Dependent Variable................................................. 32 4.5.1.4.....................................................................................................Pr ice Earning Ratio is Dependent Variable................................................ 33 4.5.1.5.....................................................................................................M arket Adjusted Return is Dependent Variable......................................... 34
Table 1: Equations Table ........................................................................ 20 Table 2: Total Transparency Scores........................................................ 26 Table 3: Aggregate Tranparency Scores as Subsections (%).................. 27 Table 4: Regression Analysis, Corporate Transparency is Dependent Variable .................................................................................................. 29 Table 5: Regression Analysis, MTBV is Dependent Variable................ 31 Table 5: Regression Analysis, PTCF is Dependent Variable.................. 32 Table 6: Regression Analysis, PE is Dependent Variable ...................... 33 Table 7: Regression Analysis, MASR is Dependent Variable................ 34 Table 8: Regression Analysis, MTBV is Dependent Variable ............... 36 Table 9: Regression Analysis, PTCF is Dependent Variable ................. 37 Table 10: Regression Analysis, PE is Dependent Variable .................... 38 Table 11: Regression Analysis, MASR is Dependent Variable.............. 39 Table 12: Regression Analysis, MTBV is Dependent Variable ............. 41 Table 13: Regression Analysis, PTCF is Dependent Variable................ 42 Table 14: Regression Analysis, PE is Dependent Variable .................... 43 Table 15: Regression Analysis, MASR is Dependent Variable.............. 44 Table 16: Regression Analysis, MTBV is Dependent Variable ............. 45 Table 17: Regression Analysis, PTCF is Dependent Variable ............... 46 Table 18: Regression Analysis, PE is Dependent Variable .................... 47 Table 19: Regression Analysis, MASR is Dependent Variable.............. 48 LIST OF ABBREVIATIONS CMB : Capital Market Board of Turkey FT : Financial Transparency IFRS : International Financial Reporting Standards ISE : Istanbul Stock Exchange MASR : Market Adjusted Stock Return MT : Management Transparency MTBV : Market to Book Value OT : Ownership Transparency PE : Price Earning PTCF : Price to Cash Flow ROA : Return on Assets ROE : Return on Equity S&P : Standard and Poor's Company T&D : Transparency and Disclosure TTS : Total Transparency Score
1. INTRODUCTION
"Wall Street people learn nothing and forget everything" Benjamin Graham Econonomic theory states that effective use of economic resources are provided by investing savings into securities markets to finance business projects through money markets and capital markets. The effective use of economic resources to finance real economy is likely when expected functions of financial markets are fulfilled. As important players of financial markets, investors need information to make economic decisions. Therefore, corporate disclosure is the basis for their decisions since investment flows are provided in the markets where publicly held companies disclose required information to the investing community. Corporate transparency and information disclosure are important elements of corporate governance, investors confidence and investment flows. The firms that do not adopt good transparency and information disclosure policies may suffer agency costs, defined as the value reduction in welfare experienced by the shareholders. This is due to managerial behaviour that diverges interests from shareholders (principals) (Jensen and Meckling, 1976). Jensen and Meckling (1976) describe the agency costs as the sum of monitoring costs by principle, bonding costs by agent and the residual loss. It is more likely that in a firm where a weak transparency and disclosure policy is practiced, managers may use their information advantage to pursue their self-interests (Chen, Chung, Lee and Liao, 2007). Therefore, the firms that are able to control and reduce the agency costs by increasing corporate transparency; might also be able to increase the shareholders' value. Publicly held companies raise funds through capital markets by issuing their shares and debentures, which is not allowed by the law for other type of business entities. However, this privilege of publicly held companies result to certain responsibilities on them as well. Publicly held companies are obliged of disclosing information that
sample firms are selected from the companies listed on to the Istanbul Stock Exchange. The findings of the empirical reseach are analysed in this chapter as well. Chapter 5: It is all about conclusions of the research, and recommendation about the future study on the research area. Chapter 6: It includes references. Chapter 7. This chapter contains all relevant appendices of the dissertation such as transparency attributes, company performance figures and outcomes of the regression analysis.
2. THE RESEARCH PROBLEM There have been number of regulatory changes in response to corporate scandals from 2002 and onwards internationally, most prominent of which appeared in the USA. Disclosure rules have been adopted to increase levels of corporate transparency. Detailed reporting of off- balance sheet transactions, arrangements, obligations and operations of special purpose vehicles are required by the Sarbanes-Oxley Act of 2002, which is a regulatory reaction to corporate scandals such as Enron, Worldcom and other publicly held companies failures in the USA. Furthermore, the Sarbanes-Oxley Act of 2002 imposes high penalties on the executives of publicly held companies for misreporting. Hermalin and Weisbach (2007) states that there is a link between corporate governance and transparency, and increased transparency and disclosure have some direct costs, which may offset the benefits. They show that increased transparency can reduce corporate profits and increase executive remuneration. From the regulators perspectives, there is a common belief that good governance practices are required to protect equity investors and corporate transparency is increased to improve good governance practices. Therefore, the Sarbanes-Oxley Act of 2002 is an act "to protect investors by improving accuracy and reliability of corporate disclosures made pursuant to the securities laws and for other purposes" (the Sarbanes-Oxley Act of 2002). Healy and Palepu (2000) find that contracting costs, political costs and capital market considerations have influence on managers' financial reporting and disclosure choices. Increased transparency reduces information asymmetry, and lowers the firm's cost of capital (Poshakwale and Courtis, 2005), since investors will pay less for information disseminated under disclosure rules. It has been known that increased transparency requires some organisational change, which is to form a team dealing with production of information to the investing community, and thus this change has operational and financial costs. Therefore, apart from corporate governace issue and information
asymmetry problem, increased transparency may have influence on financial performance of the company. As a result, a research to investigate the relationship between transparency and corporate performance will shed light on how specific agency problems faced by ISE firms affect their transparency scores (Aksu and Kosedag, 2006) and help understand whether the management should increase transparency level for the benefits of present and potential investors. There is a debate on the causal direction of company financial performance and increased transparency and disclosure level. By considering the ongoing debate, the research problem of this study is to explore whether there is an association between corporate transparency and company performance by using univariate tests having concerned corporate transparency attributes and company performance measures. This research also tries to explore whether transparency increases after a successful year and if proportional change in financial transparency affects corporate performance by examining correlation between transparency and company performance using multivariate regression analysis. Therefore, the following hypotheses are put forth in this study: H1: Firms with higher transparency scores are expected to have higher financial performance. This is due to potentially lower cost of capital. H2: After a successful year, firms tend to inrease their transparency and disclosure level and become more informative to the shareholders and general public. Given that transparency is likely to affect the cost of capital, we expect to observe a significant link between transparency scores and company performance measures.
3. REVIEW OF RELEVANT LITERATURE The review of prior studies and relevant literature illustrate the concepts, scope, and determinants of corporate governance, corporate transparency as an important element of corporate governance and proxies for corporate performance in general. The matter of whether capital markets reward the well governed and transparent companies or not will also be examined throughout the prior researches. In particular, the relevant studies that relate corporate governance and transparency to firm performance will be provided and the corporate governance and transparency culture and practice in Turkey will be discussed briefly in this section. Finally, the factors that affect corporate transparency and also motivate this study are going to be discussed as well. 3.1. Information Problem in Capital Markets and Corporate Transparency
with each other. There are two main reasons that make the information problem complicated. First, companies are usually in a superior position than investors and savers in relation to the real value of their business projects and they are able to appraise the investment opportunities better than savers can. Second, investors and savers think that companies have an inducement to inflate the worth of their business projects, which leads to an integrity problem between companies and savers in their communication. The information disparity and incompatible motivations create the "lemons" problem, which is likely to lead the failure of effective functioning of the capital market (Akerlof, 1970). It has been argued that both investors and entrepreneurs are rational and can assess investment projects depending on their own knowledge and information level. If investors are not able to make distinction between investment opportunities, the "bad" quality business ideas will be valued as the "good" quality business ideas by investors and investors will assess the both ideas at an average level ultimately. For that reason, capital markets will reasonably undervalue several good quality business projects and overvalue several bad quality business projects corresponding to the existence of information to savers and entrepreneurs, if the problem of asymmetrical information (lemons problem) is not entirely resolved. Therefore, information asymmetry problem is an important issue in finance literature and it has been suggested that the regulatory or voluntary disclosure of private information from managers to investors to overcome biased valuation problem could be a solution to the lemons problem. Afterwards, increased disclosure and transparency level of companies would help clear off superior position of directors and managers to accessing information (Healy and Palepu, 2000). Since the problem of information asymmetry is one of the key issues related to market efficiency and regarded as important matter in allocation of resources, there are number of studies examining the relationship between cost of equity and levels of transparency and information disclosure. Botosan and Plumlee (2002) examine the relationship between the cost of equity capital and levels of annual report disclosure and timely disclosure, and investor relations activities. The researchers estimate the cost of equity capital using the classic dividend discount model and find that the cost of equity capital decreases in the annual report disclosure level but increases in the level of timely disclosures. They also find no relation between the cost of equity capital and the level of investor relations activities. Another study by Poshakwale and Courtis (2005) provides evidence that there is a relationship between the level of voluntary disclosures and the cost of equity capital. The higher the level of voluntary disclosures, the lower the investor uncertainty. With lower uncertainty, investors would be willing to accept a lower required rate of return. With a lower required rate of return, a firm would decrease the cost of equity capital since a lower risk premium would be anticipated by the equity investors. Therefore, a lower risk premium required by shareholders would provide a lower cost of
equity capital for the firm and increase firm value at the end. Poshakwale and Courtis (2005) examined the relationship between cost of equity capital and transparency level for 135 banks from Europe, North America and Australia and found that European banks had showed greater decrease in the cost of equity capital from advanced disclosure levels compared to their non-European counterparts. The firms that would lower cost of equity capital would also increase shareholders value and show better corporate performance for the investors. The increase in market value would lead to increase in the ratio of market-to-book value, which is supposed to provide important information about financial performance at the company. 3.2. Transparency in Financial Markets Transparency in financial markets refers to the process of accessibility, comprehensibility, and perceptibility of information pertaining to the current status and events. Transparency helps market participants to distinguish good firms from bad firms by providing them the information they need to make economic decision. In addition, transparency contributes to the stability of markets in times of uncertainty by providing information to market players and helps ensure stability and efficiency of the described policies. Figure 1 displays illustrative roles of market players in capital markets. It shows the flows of surplus savings from savers to companies in the course of different forms, either directly or through financial intermediaries, which is more common. Private equity financing is a typical way of direct funding. Initial public offerings, bonds and debentures are typical ways of indirect financing in capital markets. Therefore, firms need to communicate with investors and financial intermediaries and they disclose information to the investing community in the form of financial reports and/or press releases. Figure 1: Financial and Information Flows in a Capital Market Economy Figure shows different agents of an economy and flows of information and funds among them. 3.2.1 Conceptual Framework
and source. Investors are under flood of information since the Internet, TV, radio and other mass media sources disseminate overloading information, and it seems to be a challenging work to make that information classified and put in a user-friendly form. Reliability - Information providers should ensure that information is reliable. For that reason, firms should present information of financial operations and figures prudently. The information disclosed should be carried on in good quality, timely and a complete manner. In some cases, firms should balance between reliability and conformity with rules and regulations. For instance, information about income projections for the future is usually relevant but not reliable. In addition, risk profiles of firms may frequently change and as a result, disclosing information timely becomes crucial for decision-making. Various supervisory authorities, which are accounting firms, governmental authorities (watchdogs), or any other stakeholders outside the firm, do enforcement activities and try to detect fraudulent reporting. They give assurance on a reasonable base about quality and reliability of financial reporting of firms. However, external or independent enforcement of information, which is one of the methods that ensure reliability, could lead to delay in accessing to information (Vishwanath and Kaufmann, 2001). 3.2.2 Assuring Transparency in Publicly Held Firms. The phenomenon of companies issuing securities to raise funds from capital markets gives rise to the importance of disclosing information to the public, which is a combination of shareholders, creditors, and other stake holders. Therefore, regulatory institutions in capital markets require that publicly held firms inform their shareholders and other stakeholders at regular intervals. It has been supposed that corporations perform better as they become more transparent and are governed well since they encounter a less risk premium by reducing uncertainities about their operations. On the other hand, investors will expect higher required rate of returns from the corporations that have higher business risks and disclose less information to their stakeholders. Higher risks and returns go hand in hand. It is stipulated that firms would lower the cost of information asymmetry by adopting good accounting systems, which are able to produce financial reports in compliant with international standards. In this wise, investors will be better protected and integrity between shareholders and firm management will be enhanced. 3.2.3 Benefits of Transparency
Market mechanism rewards firms that handles their business and financial risks effectively. The economics theory supports the notion of increasing transparency and argues that better information would build up allocation of resources and effectiveness in an economy. The most productive projects would get chance of accessing funds through financial information disclosure and consequently welfare and growth would be ensured (Vishwanath and Kaufmann, 1999). Transparency is a necessary element of financial stability in capital markets. Lack of transparency may adversely affect financial stability and integrity of entire financial system in an economy, which appeared in recent credit crunch in terms of transparency of financial transactions such as credit derivatives. Free market mechanism discipline will perform earlier and efficiently while information flow carries on from firms to investors. Timely information disclosure may lessen the cost of market crash and crises since decision makers get to know about what happens in the market. As a result, they can distinguish bad firms from good firms and detect the firms that are more vulnerable in financial turmoil. In addition, corporate transparency can improve democratic culture in publicly held firms where bigger groups of shareholders participate in and have active control on the management. This will lead to firms do business sensibly while investing shareholders' capital into risky projects. Therefore, timely information disclosure can reinforce shareholders' monitoring systems that encourage firms act prudently. Arguments against more transparency are ranging from privacy and confidentially of corporate information to national security. However, they should be highly limited and significantly the limits showing to public concern (Vishwanath and Kaufmann, 1999). There may be conflict of interests between public stakes and private stake, conversly, total gain can be achieved by compromising public and private interests for the sake of the general public welfare. Gelos and Wei (2002) provide evidence that emerging market equity funds hold relatively smaller amount of assets in less transparent markets and emerging market funds took their investments more quickly from less transparent countries. The authors plainly make a distinction between government and corporate transparency in their study. Similarly, a recent study by Chipalkatti, Le and Rishi (2007) reveals that there is a positive relationship between public governance, corporate transparency and portfolio flows. The researchers employ a cross-sectional model for 17 emerging capital markets over the 1998 and 2002 periods in their empirical study. As mentioned above, the most considered benefit of firm transparency is to reduce information asymmetry on a company, and it helps lower the cost of trading securities of the firm and consequently the firm's cost of
stock market performance has been concerned. Renders and Gaeremynck (2006) state that econometric problems make the studies examining the link between corporate governance and performance troubled in their research which investigates the association between corporate governance and firm performance from an accounting standpoint. They prove how endogeneity and sample selection bias change the coefficient of corporate governance by using panel data for the FTSE Euro top 300 companies. The authors show that there is insignificant and negative coefficient on corporate governance under ordinary least squares method. However, they find that the coefficient turns out to be positive and highly significant after controlling for sample selection bias and endogeneity. Brown and Caylor (2004) designed a measure of corporate governance, which is a composite measure of 51 factors covering eight categories: audit, board of directors, charter/bylaws, director education, executive and director compensation, ownership, progressive practices and state of incorporation. They link corporate governance score to operating performance, valuation, and shareholder payout for 2.327 firms and find that better governed firms are relatively more profitable, more valuable, and pay out more cash dividend to their shareholders. A recent study by the same researchers (Brown and Caylor, 2009) reveals that the governance regulations imposed by the U.S. stock exchanges in recent years are less closely related to firm operating performance than those are not so mandated. The firm operating performance is proxied by return on assets (ROA) and return on equity (ROE) in their study. Gompers, Ishii and Metrick (2003) demonstrate that the firms with stronger shareholder rights have higher firm value, higher profits, higher sales growth and lower capital expenditures in their study, in which they build a Governance Index to proxy for the level of shareholder rights at about 1500 large firms during the 1990s. Economic impacts of corprorate transparency is questioned in earlier studies. An earlier study by Leuz and Verrecchia (2000), in which a sample of German firms that have adopted International Accounting Standards (IAS) or US-GAAP in their consolidated financial statements is examined, proves that firms committing to increased levels of disclosure acquire economically and statistically significant gains. However, Healy and Palepu (2000) prove that economic consequences of disclosure choices are mixed. Turkey has a relatively well-built regulatory framework for corporate governance, notably among emerging market countries. Developments in the are of corporate governance had urged Turkish regulatory authority, Capital Market Board (CMB), and the CMB promulgated the corporate governance principles for publicly held companies with the "comply or explain" basis in the year 2003. The corporate governance principles for listed companies have been effective since the beginning of 2004 in Turkey. Additionaly, higher auditing standards were introduced in 2003
and international financial reporting standards (IFRS) became mandatory in 2005. However, there are challenges as well. Family groups control vast majority of companies, cross ownership between companies exists, and therefore controlling shareholders dominate and affect the management of companies listed on to the Istanbul Stock Exchange (ISE). Issuance of the corporate governance principles by the CMB has also triggered the corporate governance studies about Turkish companies. The ISE launched ISE Corporate Governance Index at the end of August
- The index is created to measure the price performances and returns including dividend payments of the companies listed on the ISE by considering corporate governance scores determined according to the corporate governance principles issued by the CMB. Corporate governance scores of the listed companies are given by the authorised rating agencies on voluntary basis. The rating scores ranging between 1 and 10 are given to the degree of compliance with corporate governance principles as a whole and separately with regard to the titles of shareholders, public disclosure and transparency, stakeholders, board of directors. Price and return performance of the relevant listed company's stocks are included into the corporate governance index if the company's corporate governance score is 6 or above out of ten. Standard & Poor's (S&P), which is a leading provider of financial market intelligence and the world's principal source of credit ratings company, expanded its transparency and disclosure (T&D) study in 2003 to include the companies listed on to the ISE. The S&P created a T&D scoring methodology for Turkish companies listed on to the ISE, in conjunction with Corporate Governance Forum of Turkey at Sabanci University in Istanbul, Turkey. The S&P has launched its T&D rankings to supply an objective, transparent, globally consistent, and replicable measurement of the levels of disclosure provided by the largest and liquid companies in more than 30 countries (Patel and Dallas, 2002). The T&D study of the S&P includes 106 attributes extracted from publicly available sources under three subcategories, which are transparency level of ownership, financial disclosure, and board and management process. The S&P has been doing Turkish Transparency and Disclosure Survey for each year since 2003. Aksu and Kosedag (2006) provide evidence that the transparency and disclosure quality of Turkish firms is moderate by investigating the transparency and disclosure practices of the 52 largest and liquid firms listed on to the Istanbul Stock Exchange. The two researchers from Sabanci University of Turkey state that sound corporate governance practices play important role in reducing the agency costs of the firms having efficient allocation of financial resources in capital markets. Notably, they state that transparency and disclosure practices adopted by the firms are important elements and indicators of corporate governance
