CHAPTER 1

INTRODUCTION

1.1 Background of Study

Today, numerous organisations have a collective need of having creativity, competitive

advantage and bold flexibility. The significance of the need for competitiveness and productivity to
deal with future risks related to organizational changes has been increased every day. Physical and
intangible assets are considered as the most important component of company resources, however
intangible assets are more important because they are scarce, valuable and matchless in nature
(Soyehli, Moeinaddin & Nayebzadeh, 2014). Due to the revolutions of economic transformation,
companies must adapt to the changing competition circumstances. In this modern era, product is no
longer plays such an important role in the process of building competitive advantage because of its
features can be straightforwardly copied and transferred to other products of the production.
However, these days, the strength of the existing products and services are determined by the
intellectual capital.

Intellectual capital can be considered as a new tool to perceive organizational hidden values.
Prior study done by Lonnqvist and Mettanen {2002) identified Intellectual capital as a critical success
factor, not only for knowledge-intensive organizations, but also for most other types of
organizations. They also mentioned that the intellectual capital of an organization includes the
knowledge and skills of employees, the culture and values as well as its immaterial properties and it
also includes the organizational infrastructure that supports the efforts of the employees. In the
process of finding a method for measurement and evaluation of intangible assets, intellectual capital
can provide a completely new model to observe organizational value (Soyehli, Moeinaddin &
Nayebzadeh, 2014).

ntellectual capital is a critical

success factor, not only for
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knowledge-intensive
organizations, but also for
most other types of
organizations. The intellectual
capital of an organization
includes e.g. the knowledge
and skills of employees, the
culture and values as well as
its immaterial properties. It
also includes the
organizational infrastructure
that supports the efforts of
employees.
Nowadays, the reputation of intellectual capital is highly recognized as a successful factor
not only in knowledge-intensive organizations but also for most other types of organizations
(Lonnqvist and Mettanen, 2002). In knowledge-based economy, modern and high-tech enterprises
not only focus on innovation of new products, services, and marketing, research and development
activities but also pay attention to the development and management of organization intellectual
capital.

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1.1.1 Intellectual Capital

Financial distress is the condition where a company is facing difficulty or cannot meet
the financial obligations towards its creditors or lenders. When a business is highly leveraged,
assets are illiquid, its breakeven point is high, or its revenues are too sensitive to economic
declines, the chances of falling into financial distress are high
(https://www.investopedia.com/terms/f/financial_distress.asp). If a company is deemed to be
under financial distress, and no necessary actions are taken to improve its performance, the
company may fall into bankruptcy or be liquidated (Khaliq et al., 2014). Should the incident
occur, the business reputation will be gone and may face with the risk of losing the existing
or future investors.

Bankruptcy prediction is a challenging task for any type of businesses in different

industries around the world (Rajkumar, 2015). The effort taken in developing a model of
bankruptcy prediction has started more than half a decade ago. A well-known bankruptcy
prediction model was developed by Edward Altman in 1968. The study investigates a set of
financial and economic ratio in a bankruptcy prediction by employing a multiple discriminant
statistical methodology (Altman, 1968). A sample of 33 bankrupted and 33 non-bankrupted
companies were used in his first study. Altman choose five best ratios among a various
number of ratios for bankruptcy prediction and compared between bankrupted companies
with non-bankrupted companies. The result from his study found there is 95% accuracy one
year prior to bankruptcy and 72% accuracy two years prior to bankruptcy. This widely used
bankruptcy prediction model is known as Altman Z-score or multiple discriminate analysis
model (MDA). The findings from his study had encouraged many people to use this model in
various countries of the world.
Even though the bankruptcy detection models have been developed since the sixties
(Beaver, 1967; Altman, 1968), most of the later researchers (Fijorek & Grotowski, 2012;
Karami et al., 2012) look at accounting and financial data as only a justifying factors. Thus,
some researchers (Hambrick & D'Aveni, 1988, 1992; Gilson, 1990; Daily & Dalton, 1994;
Gales & Kesner, 1994) started to examine the link between financial distress and corporate
governance attributes. Findings of these studies affirm that corporate governance variables
undoubtedly boost the predictive power of broadly used bankruptcy prediction models.
Further to the above research, more studies been conducted to investigate the influence of

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corporate governance attributes towards financial distress situation (Donoher, 2004; Fich &
Slezak, 2008; Chang, 2009; Lajili & Zéghal, 2010; Platt & Platt, 2012).

1.1.2 The Concept of Intellectual Capital

The topic of corporate governance is a boundless subject that enjoys a long and rich
history. Corporate governance consolidates managerial accountability, board structure and
shareholder rights. The power and decision making symmetry between board directors,
managers of firms and shareholders has been advancing for centuries. It has been an
intriguing issue among academics experts, regulators, executives and investors.
Corporate governance presents a structure of control components that help the
organization in accomplishing its objectives, while anticipating undesirable clashes. The
pillars of corporate governance like moral conduct, responsibility, transparency and
sustainability are vital to the governance of companies and stewardship of investors’ capital.
Organizations that grasp these standards will probably create long term value than those that
are deficient in one or all.
Corporate governance provides balance between the shareholder interests and the
needs of other stakeholders, for example the employees, customers, suppliers, society and the
communities within the organization business activities. Good governance recognizes the
dispersal of rights and responsibilities among diverse members in the organization and
outlines among others the guidelines and processes for decision-making, internal control and
risk management. Good corporate governance also followed the processes of disclosure and
transparency in providing the exact and accurate information regards to the financial,
operational, as well as other aspects of the company to the regulators, shareholders and the
general public.

1.1.3 Development of Intellectual Capital

East Asia’s economy was shocked by the financial crisis in 1997. The crisis had
transformed the economic landscape of East Asian countries, including Malaysia. It was
started out in Thailand as a localized currency crisis, which then spread rapidly and become a
regional financial and economic crisis. There are several factors which contributed to the
collapse of the Malaysia economy (at the time), such as economic factors, poor corporate
governance practices, ineffective enforcement and public institutions.

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 As a reaction to the 1997 financial crisis, the government took an initiative to set-up
the Malaysian High Level Finance Committee on Corporate Governance (FCCG) in early
1998. The committee was given the responsibility to review the corporate framework and
give recommendations to improve the level of corporate governance in Malaysia. The
committee perceived serious corporate governance weaknesses especially in the area of
transparency and disclosure requirement, corporate monitoring responsibilities and
accountability of company directors including the rights of minority shareholders. It brought
into the establishment of the code of corporate governance for the corporate participants,
which listed out the principles and best practices in the corporate administration. The primary
aimed of this code is to encourage transparency management of a company besides providing
relevant information to the investors to change them to guide the company’s direction.
The core of the corporate governance reform agenda focuses on the areas of the
development of a Code on Corporate Governance, reform of laws, as well as training and
education. The Malaysian Institute of Corporate Governance (MICG) was formed in March
1998 as a non-profit public company limited by guarantee to complement and strengthen the
existing corporate governance structures in Malaysia. The founding members of MICG
consist of the Federation of Public Listed Companies (FPLC), the Malaysian Institute of
Accountants (MIA), the Malaysian Association of Certified Public Accountants (MICPA),
the Malaysian Institute of Chartered Secretaries and Administrators (MAICSA), and the
Malaysian Institute of Directors (MID). It promotes and encourages corporate governance
development, provides training and guidance on good corporate governance for its members
and other interested institutions or bodies in Malaysia.
The Minority Shareholder Watchdog Group (MSWG) was later formed in August
2000 following recommendation by the Finance Committee on Corporate Governance as part
of a broader capital market framework to protect the interests of minority shareholders
through shareholder involvement. It is one avenue of market discipline to encourage good
governance amongst public listed companies with the objective of raising shareholder value
over time. The MSWG creates awareness among minority shareholders of their rights and the
body act on behalf of minority shareholders to hinder abuses by majority shareholders who
often control the decision making process.
In Malaysia, the Securities Commission (SC) is the key corporate governance
regulator and watchdog. The statutory body that holds the investigative and enforcement
powers was incorporated in March 1993 under the Securities Commission Act 1993. The SC
report to the Minister of Finance and tables its account in Parliament annually. As a statutory

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body, it releases its obligations by carrying out the orders embraced by Parliament including
investors’ protection; guaranteeing appropriate and productive market lead; and enforcement
of securities laws and rules such as those authorized to promote good corporate governance
practices. As an enforcement agency it has capacity to investigate and take administrative,
civil or criminal actions in cases of maladministration in fund raising activities and takeovers
and mergers, market manipulation, insider trading, false and misleading disclosures as well as
compliance with Malaysian accounting standards.
Bursa Malaysia (formerly known as the Kuala Lumpur Stock Exchange – KLSE)
operates under the Securities Commission as an exchange holding company approved under
Section 15 of the Capital markets and Services Act 2007. Bursa Malaysia operates and abides
strictly to the Malaysian Stock Exchange Rules and Malaysian Stock Exchange Listing
Requirements. Bursa Malaysia influences corporate governance practices through issuing and
enforcing its listing requirements and trading rules by suspending, de-listing, issuing cautions
and imposing fines to defaulters. The stock exchange in its revamped listing requirements
issued in January 2001, requires all directors of listed companies to undergo continuous
training for properly releasing their duties as directors. This was a primary attempt to
standardize corporate governance rules and regulations into the day to day business practices
and culture through the processes of ‘normative’ isomorphism. In July 2003, directors of
listed companies were also required to attend the Continuing Education Programme (CEP) to
further regulate good corporate governance practices. Most institutions, including
professional bodies across the world, are increasingly simulating the CEP by demanding their
members to continuously attend training programmes. Under this improved corporate
governance framework, listed companies have to disclose in the annual reports, whether their
directors have attended training.
Previous financial crises that happened across major emerging economies had drawn
an attention on how the poor corporate governance performance may cause the company’s
financial instability. The consequence from the financial crisis has placed a heavier focus on
best practices for corporate governance principles. Boards of directors feel more pressure
than ever before to be transparent and accountable. A study conducted by Li & Zhong (2013)
found that many firms fell into distress and filed for bankruptcy during the financial crisis.
The timely and accurate prediction of business failures is important and useful to the
stakeholders in order for them to take appropriate actions in avoiding a potential financial
loss. This study undertakes the Altman’s model to identify the listed companies in the main
market of Bursa Malaysia (formerly known as Kuala Lumpur Stock Exchange – KLSE) that
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show the signs of financial distress. After extracting those companies with the financial
distress indication, this study will analyse the corporate governance attributes focusing on the
board of directors’ characteristics. This study is an attempt to examine whether the corporate
governance characteristics contribute to the business failure as claimed by Altman (1968) that
mostly bankruptcy occurs due to poor management, not due to economic recession, severe
competition.

1.2 Problem Statement

Although the importance of intellectual capital (IC) has increased greatly in the last
two decades (Bontis et al., 2002; Edvinsson and Malone, 1997), many organisations are still
struggling with better management of IC due to measurement difficulties (Dzinkowski,
2000). Many authors have argued that in the knowledge economy IC, which represents the
stock of assets generally not recorded on the balance sheet, has become one of the primary
sources of competitive advantage of a firm (Bontis, 1998; Edvinsson and Malone, 1997; Roos
et al., 1998; Stewart, 1997; Sveiby, 1997). Given the remarkable shift in the underlying
production factors of a business within the new knowledge economy (Drucker, 1993), it is
important for the firms to be aware of the elements of IC that could lead to value creation.
Apparently, due to negative reactions of the poor corporate governance standards in
Malaysia, the high level “Finance Committee on Corporate Governance” (FCCG) was
formed in March 1998. The Committee is responsible in reviewing the current corporate
governance environment in a comprehensive manner and build up another corporate
governance code and models for Malaysian organizations. The Malaysian Code on Corporate
Governance (MCCG) contained the FCCG indicated wide standards of good corporate
administration and proposed itemized code of best practice for organizations. Since the
initiation of the FCCG in 1998, corporate governance has been viewed as a significant
investment foundation in Malaysia. Both international and local financial investors tend to
move their investment to stocks and markets with better administration since they are
prepared to pay a premium for organizations that are seen to have great governance practices.
In Malaysia, many corporate scandals involving the corporate governance issues are
being discussed for decades. The Malaysian International Shipping Corporation (MISC),
Malaysian Airline System (MAS), United Engineers Malaysia (UEM), and Renong, are
among the examples of which were ‘too-big-to-fail’ cases with large socio-economics

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implications. The features of corporate governance structure of these companies is seems to
have an association with their relatively poor performance.
Most of the previous studies examined the link between financial distress and
corporate governance characteristics among the PN17 (Practice Note 17) companies.
However, the relationship between corporate governance influence and prediction of distress
companies are not being dealt with sufficiently. The findings from this study would add to the
current literature of corporate governance influence in the financially distress company
predicted through the employment of Altman’s Z-score model. PN17 stands for Practice Note
17/2005 and was issued by the Bursa Malaysia. Companies that are categorized under PN17
in Bursa Malaysia are mostly financially troubled companies and poorly managed.
Companies are classified under PN17 due to several reasons such as the shareholders’ funds
are less than 25% of their total paid-up capital; receivers have been appointed to take control
of the companies’ assets; the winding-up of some of their subsidiaries and associated
companies; the auditors have expressed adverse opinions on the companies; default in loan
interest and principal repayments; the companies have suspended or ceased their operations;
and companies do not have any significant businesses or operations. Company that fall within
the definition of PN17 is required to submit their regularisation plan to the Securities
Commission to address its PN17 status and to report its business improvement result.
A study conducted by Kim-Soon, Mohammed, & Agob (2013) found that not all the
PN17 companies listed are financial failure and there are financial difficulties companies
listed among the non-PN17 companies. The study employs financial liquidity ratios (cash
ratio, current ratio, quick ratio) and Altman’s model in determining the financial situation of
companies. Therefore, the aim of this study is to examine whether the corporate governance
of financial distress company listed among the non-PN17 underlying board size, board
independence, board meeting frequency and CEO duality influence the financial health of
non-PN17 companies.

1.3 Research Questions

With respect to the problem statement explained in the previous section, this study
examines whether there is a relationship between Intellectual Capital and firm performances
listed on the main market of Bursa Malaysia. This study mainly focusing on the human
capital, structural capital and capital employed. These three independent variables will be

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verified against the dependent variable which is the firm performance listed on the main
market of Bursa Malaysia. Therefore, it will take advantage of the following research
questions;

 What is the relationship between human capital and firm performances?

 What is the relationship between capital structured and firm performances?
 What is the relationship between capital employed and firm performances?

1.4 Research Objectives

Generally, this study aims at examining the relationship between Intellectual Capital and firm
performances listed on the main market of Bursa Malaysia. In exploring those relationship, it
comes out with three main research objectives which are;

 To investigate the relationship between human capital and firm performances?

 To investigate the relationship between capital structured and firm performances?
 To investigate the relationship between capital employed and firm performances?

1.5 Significance/Contributions of the Study

This study is new in the corporate governance area as it is exploring on the corporate
governance characteristics of the active companies with financial distress indication listed on
the main market of Bursa Malaysia. Company that triggered any of the criteria pursuant to
Practice Note 17 of the Main Market Listing Requirements of Malaysian Stock Exchange are
said to be reprimanded under the PN17 list as financial distress companies. However, there
are companies traded normally in the official Bursa Malaysia Securities Berhad or the
Malaysian Stock Exchange market but facing with the financial distress situation. This study
used Altman’s formula to calculate the Z-score of these companies, which then categorizing
them into financial or non-financial distress situation. Even though these active companies
have yet to be listed as PN17 company, we could already assess their likelihood of going
bankrupt. Through its empirical results, it would determine whether there are any significant
relationships between the corporate governance characteristics and financially distress of

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non-PN17 companies. Thus, this study contributes by providing insights into the link between
corporate governance variables and financially distress in Malaysian non-PN17 companies.
The result from this study is also hoped to assist the companies in developing a more
effective and efficient corporate governance framework and mechanisms, which would
contribute to a better management of the companies, thus minimizing the risk of being
distressed.
Potential investors would normally follow the market sentiment when deciding to
invest in their money and hardly conducted in-depth financial analysis of the potential
investment portfolios. Thus, the used of Altman’s formula in calculating financial soundness
of companies in this study will assist the potential investors in assessing the durability of
investment portfolios before they venture into such investment. It will also benefit the
stakeholders by allowing them to predict the financial health of their investment companies.
Finally, this study is conducted with an anticipation to assist the policy maker in
evaluating the current practice of corporate governance, thus such improvement could be
taken towards a better governance of public listed firms. The Altman’s formula in calculating
the Z-score of company is a reliable method in assessing the financial soundness of company.
It implies an actual condition of financial health of the company and the disclosure of the Z-
score in Bursa Quarterly Reporting can be viewed as a good suggestion to compliment to the
existing policies.

1.6 Organization of the Chapters

This study is divided into five chapters. Chapter one explains on the
introduction/background of the study, the problem statement, the research questions and the
research objectives that motivates this study. Chapter one also enlightens on the
significance/contributions of the study.
Chapter two review and examine the existing theoretical and empirical evidence on
corporate governance characteristics and their relationship to financial distress. It also
discusses the underpinning theory, the development of research framework, and hypotheses
development in this study.
Chapter three describes on the research methodology undertaken in conducting this
study as the validity of any research findings lies on the use of applicable methodological
procedures. This chapter also discusses on the sampling design, data collection procedures,

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operational definition and measurement of independent and dependent variables, as well as
the data analysis procedures.
Chapter four concentrates on analysing the data collected and discussing on the
research findings in both descriptive and statistical tests.
Finally, chapter five provides a summary on the findings, contributions, and
limitations of this study. This chapter also offers recommendations for future research.

Lönnqvist A. and Mettänen P. 2002. Criteria of Sound Intellectual Capital Measures. Proceedings of
the 2 nd International Workshop on Performance Measurement, Hanover, June 6-7.

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