462 Int. J. Corporate Governance, Vol. 9, No.

4, 2018

Does good governance lead to better financial

performance?

Supriti Mishra*
International Management Institute Bhubaneswar,
Gothapatna, Malipada, Bhubaneswar – 751003, India
Email: mishrasupriti@imibh.edu.in
*Corresponding author

Pitabas Mohanty
XLRI – Xavier School of Management,
CH Area, East, Jamshedpur, 831001, India
Email: pitabasm@xlri.ac.in

Abstract: The relationship between corporate governance and financial

performance of firms has been a widely debated topic. More particularly, the
direction of the relationship, whether better corporate governance leads to
better financial performance or the vice versa has often been debated. More
often, firms decide whether to have better governance standards within the
company and this self-selection gives biased OLS regression results. In this
paper, using data for Indian companies, we adjust for this endogeneity and find
that corporate governance is positively related to financial performance. We
finally find that the average ROA of well-governed firms would have decreased
by almost 40% if they were poorly-governed.

Keywords: corporate governance in India; counter-factual outcomes;

endogeneity; financial performance; switching regression.

Reference to this paper should be made as follows: Mishra, S. and Mohanty, P.

(2018) ‘Does good governance lead to better financial performance?’,
Int. J. Corporate Governance, Vol. 9, No. 4, pp.462–480.

Biographical notes: Supriti Mishra’s experience spans over 25 years with a

mixed bag of experience from academic, industry, and non-profit sectors. She
teaches in IMI Bhubaneswar in the areas of strategy and CSR. She has widely
published in the areas of CSR, sustainability and corporate governance in
reputed refereed journals. She was a Visiting Fulbright Scholar at Leonard N.
Stern School of Business of New York University in 2009–2010.

Pitabas Mohanty has around 20 years of teaching experience in investments

and corporate finance. He was a Visiting Fulbright Scholar at Leonard N. Stern
School of Business of New York University in 2009–2010. His research
interests include corporate governance in emerging markets, market for
corporate control and asset pricing. He has many publications in books and
refereed journals to his credit.

This paper is a revised and expanded version of a paper entitled ‘Corporate

governance and financial performance’ presented at World Finance and
Banking Symposium, Beijing, China, 16–17 December 2013.

Copyright © 2018 Inderscience Enterprises Ltd.

 Does good governance lead to better financial performance? 463

1 Introduction

The relationship between corporate governance and financial performance has been a
widely debated topic in the last three decades. Some researchers argue that corporate
governance reduces information asymmetry between the investors and the firm
(Kanagaretnam et al., 2007; Gul and Qiu, 2002). As investors dislike information
asymmetry, low information asymmetry should translate into high shareholders’ value.
Low information asymmetry is found to be correlated with post-IPO stock value run-up
(Cohen and Dean, 2005) and with high valuation in general (Krishnaswami and
Subramaniam, 1999). Researchers have also documented a high correlation between
corporate governance and better bond ratings and lower bond yields (Bhojraj and
Sengupta, 2003; Ashbaugh-Skaife et al., 2006). Firms with poor quality of reporting
(higher accruals and less transparent earnings) have also been found to have a higher cost
of equity (Ashbaug et al., 2004) and hence lower equity value.
The direction of causality between corporate governance and firm performance is,
however not very clear (Lehn et al., 2005; Chidambaran et al., 2006; Core et al.,
2006). While some research papers document a positive relationship between corporate
governance and firm performance (Core et al., 1999; Gompers et al., 2003; Klapper and
Love, 2004; Rechner and Dalton, 2006; Goncharov et al., 2006; Black et al., 2006a,
2006b), other research papers document either a negative or no relationship between
corporate governance and financial performance (Dalton et al., 1998; Johnson et al.,
2009; Cremers and Nair, 2005; Rob et al., 2004; Chhaochharia and Grinstein, 2007).
Few studies have used the simple OLS regression model to test the relationship
between corporate governance and firm performance (Claessens, 1997; Mishra and
Mohanty, 2014). However, there may be endogeneity issues because of missing variables
or sample selection bias. In the presence of endogeneity, the OLS regression estimates
will be biased (Kennedy, 2009). Firms with better and worse corporate governance
standards differ in unobservable dimensions (Bertrand and Mullainathan, 2003). So, if we
compare the financial performances of firms with good and poor corporate governance
standards, we may be capturing the effect of these unobservable dimensions. There is
also evidence of sample selection bias because industry clustering is found in the sample
of firms having better and worse corporate governance standards (Johnson et al., 2009).
Research papers that adjust for endogeneity in the sample find a substantial difference in
the regression results (Black et al., 2006b; Goncharov et al., 2006).
In this paper, we, therefore, attempt to see if corporate governance creates value after
adjustment for endogeneity. We use data from India, an emerging economy, where to the
best of our knowledge this type of study has not been conducted before. Indian economy
provides a unique dataset to test any hypothesis on corporate governance because of the
role played by the business groups. As per 2017 data, Indian business groups control
almost 54% of corporate assets and own more than 50% of the total equity shares in
India. Indian business groups fill the void created by lack of proper institutions in India
and the affiliated firms perform better than the non-affiliated firms (Khanna and Palepu,
1997, 1999, 2000). Research also talks about the negative aspects of business groups by
pointing evidence of tunnelling of funds between firms affiliated to these business groups
(Bertrand et al., 2000) and the negative spillover due to intra-group loans (Gopalan et al.,
2007).
464 S. Mishra and P. Mohanty

We use the measure suggested by Mishra and Mohanty (2014) to measure corporate
governance of the Indian companies. This measure looks at the way the boards are
structured and the way they function (board dimension), by studying if Indian firms
comply with regulatory norms (legal dimension) and by studying if the firms are
proactive while taking decisions that affect the investors (proactive dimension). Using a
probit model, we first find that while the degree of competition and size negatively
determine an Indian firm’s decision to adopt particular governance norms, exports, group
membership and financial performance positively affect the firm’s governance decisions.
We subsequently compare the actual performance of firms with good (poor)
governance records with their counterfactuals [what the performance would have been,
had these firms adopted worse (better) governance norms]. In Section 3, we develop our
model and data and then discuss the key findings in Section 4. In Section 5, we conclude
our paper.

2 Literature review and hypothesis development

Whether corporate governance is related to contemporaneous and subsequent firm

performance is a hotly debated topic. Firms with poor corporate governance system
(having high agency problems) have been found to perform poorly (Core et al., 1999).
An investment strategy that takes long positions in companies with high corporate
governance index (constructed using 24 governance indicators) was found to have earned
abnormal returns of 8.5% per year (Gompers et al., 2003). Better corporate governance is
found to be correlated with better operating financial performance and market valuation
(Klapper and Love, 2004). Firms with independent CEOs consistently outperform firms
that rely on CEO duality (Rechner and Dalton, 2006). Compliance with the German
corporate governance code is found to be positively related to stock market valuation
(Goncharov et al., 2006). Emerging markets having stronger rules to protect the interests
of minority shareholders have reported better financial performance during the Asian
crisis of 1997–1998 (Johnson et al., 2000). The return on asset (ROA) in countries with
the highest level of shareholders’ rights is found to be around twice as high as in
countries with lowest shareholders’ rights (Claessens and Fan, 2003).
A few studies also report either a negative relationship or no relationship between
corporate governance norms and the firm performance. Empirical evidence from the UK
shows that companies that complied with the Cadbury Committee recommendation
experience improved performance in comparison to firms that did not (Dahya and
McConnell, 2007). However, firms which did not follow a comply-or-explain guideline
but consistently adopted optimal governance standards over the years also performed
well (Arcot and Bruno, 2007). No relationship is found between board composition and
financial performance (Dalton et al., 1998). Though poor governed firms report poor
operating performance, the market does not react negatively. Hence, the poor stock
market performance of the poorly governed firms is not caused by poor governance (Core
et al., 2006). Governance is not found to be related to future stock market performance
(Bhagat and Bolton, 2008). Portfolios sorted by governance have generated zero excess
returns (Johnson et al., 2009). Portfolios with a long position in firms which are
vulnerable to hostile takeovers are found to generate excess returns (Cremers and Nair,
2005). As firms with poor governance are usually subject to hostile takeovers, this
suggests a negative relationship between poor governance and stock returns. A negative
 Does good governance lead to better financial performance? 465

relationship is found between corporate governance standards and accounting

performance measures such as ROE and net profit margin (Rob et al., 2004). Firms that
are less compliant with the Sarbanes-Oxley Act earned more abnormal returns compared
to firms that are more compliant (Chhaochharia and Grinstein, 2007).
Few studies used the simple OLS estimation to determine if good governance is
related to better financial performance (Claessens, 1997; Mishra and Mohanty, 2014).
However, a simple OLS specification may not be the appropriate method for various
reasons. There may be some missing variables that affect both the financial performance
and the corporate governance practices of a company. If better and worse corporate
governance firms differ in some unobservable dimensions, then the difference in financial
performance of such firms may capture the effect of those unobservable dimensions
(Bertrand and Mullainathan, 2003). For example, firms operating in highly competitive
industries may not suffer from managerial slack, whereas managerial slack (and
hence corporate misgovernance) is a problem in non-competitive industries (Giroud and
Mueller, 2010).
The sample of firms having better and worse corporate governance problems may not
be a random sample. Cram and Shin (2013) advocate the use of matching samples while
comparing the financial performance of firms with different governance practices.
Corporate governance may be adopted as a strategy by a company as a response to the
environment in which it operates. It may also be used as a response to any threat from the
external environment. The threat of takeover is related to the incidence of corporate
restructuring which in turn results in the correction of poor corporate governance
mechanisms (Hoskisson and Turk, 1990). Corporate governance structures are
endogenous responses to the costs and benefits the firms face when they choose the
mechanisms that choose these structures (Gillan et al., 2003).
Substantial differences in the industry clustering have been observed in the case of
firms with strong and weak shareholders’ rights (Johnson et al., 2009). Bishnoi and
Godara (2016), for example, document evidence of tunnelling in the IT and real estate
sectors. It is also found that firms propose and pass bad governance measures following
periods of good financial performance (Schoar and Washington, 2011). So, a particular
corporate governance structure may arise endogenously concerning firm performance.
Good governaned firms have been found to follow conservative accounting norms (Lara
et al., 2009). As firms following conservative accounting norms often understate their net
worth (vis-à-vis the true net worth), their ROE and ROA get overstated. Moreover, most
studies use accounting profit measures to study firm performance, hence, the OLS
regression estimates measuring the relationship between firm performance measures (like
ROE) and corporate governance may be misspecified.
A few studies have attempted to test if any relationship between corporate governance
and financial performance exist after adjusting for endogeneity. A positive relationship
is found between corporate governance and firm performance after adjusting for
endogeneity in Russia (Black et al., 2006b). Significant differences in the slope
coefficients are reported in the OLS regression and the fixed-effects regression (with
some sign reversals). Compliance with the German corporate governance code is found
to be value-relevant after controlling for endogeneity bias (Goncharov et al., 2006).
A positive relationship is similarly found between corporate governance and firm
performance after adjusting for endogeneity in Korea (Black et al., 2006b).
466 S. Mishra and P. Mohanty

India offers a unique dataset to study corporate governance. Indian corporate

governance system is a mixture of the outsider-dominated market-based systems found in
the USA and the insider-dominated bank-based systems found in Germany and Japan
(Sarkar and Sarkar, 2003). India is a fast-growing economy and Government of India
understands the value of a good governance system in increasing investors’ confidence.
Both the Securities Exchange Board of India (SEBI) and the Companies Act of 2013
have mandated corporate governance systems comparable with the best practices
followed in the developed countries [Shikha (2017) discusses most of these norms]. Most
of the corporate assets in India are controlled by three types of promoters, namely the
Indian business groups, the foreign business houses and the central and state governments
(Varma, 1997). The prominence of the business groups makes the corporate governance
system in India different (Khanna and Palepu, 1997). We find the Indian business groups
control more than 54% of the total corporate assets and more than 50% of the
total equity shares in India. Positive orientation towards corporate governance is found to
be positively associated with better firm performance (Mohanty, 2003; Mishra and
Mohanty, 2014).
Any attempt to link corporate governance and financial performance must address the
endogeneity issues present in the sample. If unobservable factors affect both the
corporate governance system and the financial performance of the company, then a
simple OLS regression will always give biased estimates. We, therefore, propose our first
hypothesis:
H1 Better corporate governance will lead to better financial performance after
adjustment for endogeneity.
Our second hypothesis is closely related to the first hypothesis. If better corporate
governance is related to better financial performance, then companies with better
governance standards must outperform companies with poorer governance standards
regarding financial performance. If corporate governance is adopted as a response to the
external environment, then it is possible that the same external environment is also
responsible for the better financial performance of these companies. We, therefore, adopt
a novel method where we compare the actual financial performance of the companies
with their counterfactual financial performance.
In particular, we compare the financial performance of well (poorly) governed
companies with their counterfactual outcomes. A company has the choice of adopting a
particular governance standard. If we find no difference in financial performance, then
our test of Hypothesis 1 will be relatively weak. We, therefore, propose our second
hypothesis:
H2 Well (poorly) governed companies will report worse (better) financial performance
if they become poorly (well) governed.

3 Discussions of our model and data descriptions

An OLS specification to determine if companies with good governance systems report

better financial performance (FP), as given in equation (1) would yield biased estimates:
FP = X β + CGγ + ε (1)
 Does good governance lead to better financial performance? 467

Here, X is the vector of publicly observable firm attributes that affect the firm
performance and CG is the corporate governance indicator. This regression specification,
however, assumes CG to be an exogenous variable. If CG and ε are correlated (because
of some missing variable or because of sample selection bias), then the OLS regression
will give biased estimates of β.
We argue that companies self-select themselves into the sample of companies having
good (or poor) corporate governance. We argue that:
1 companies that operate in an overcrowded industry (hence, want to distinguish
themselves)
2 companies that are large in size
3 companies that operate in industries where reputation plays a leading role in
determining firm performance
4 companies that have high growth prospects (but have less cash) and hence, need to
raise capital from the capital market
5 companies that are listed abroad
6 companies that have done well financially in the past, adopt better and stricter
corporate governance norms.
It is possible that these immeasurable factors also affect the current financial performance
of the firms and hence, CG and ε in equation (1) are correlated.
We follow the method suggested by Heckman (1979) to correct this bias. In our
model, a firm chooses to adopt better governance if the benefit of doing so [Zλ + υ in
equation (2)] exceeds 0. We write the selection variable CG as a function of publicly
available variables Z. We first use the following probit specification as our sample
selection model.
CG = Zλ + υ (2)
Here, CG takes a value of 1 for firms with good governance and 0 for the remaining
firms. Then, we modify equation (1) as suggested by Heckman (1979):
φ( Zλ) −φ( Zλ)
FPi = X β + ω CG + ω (1 − CG ) + u (3)
Φ( Zλ) 1 − Φ( Zλ)

The additional regressors in equation (3) are the inverse Mills ratios. We propose to use
the following variables in the probit regression model [equation (2)]:
• The degree of competition in the industry (COMP): Governance makes sense in
highly competitive industries. Firms in non-competitive industries benefit more from
good governance than firms in competitive industries because of the increase in
managerial slack in non-competitive industries (Giroud and Mueller, 2011). We use
the Herfindahl-Hirschman index (HHI) to capture the degree of competition in the
industry as is the standard practice in the industrial organisation literature (Tirole,
1988). We use four-digit NIC code to classify companies into various industries
while computing the HHI figures for each industry. We compute the net revenue
figure for all the companies for which data are available in the Prowess database of
468 S. Mishra and P. Mohanty

CMIE. Then, for every possible four-digit NIC code, we compute the HHI and use
(1 – HHI) as the measure of the degree of competition (COMP) in the industry.
• Size of the companies (SIZE): Institutional investors prefer to invest in large
companies as stocks of large companies are highly liquid. Higher institutional stake
holding makes these large companies highly researched. As any corporate
misgovernance is more likely to be noticed if committed by a large company, we
believe that the size of the company will affect the decision of a company to have
better corporate governance standards. When SEBI announced its plans to adopt
governance reforms in the country, the stock prices of large firms (these reforms
applied to large firms first) increased by 4% more as compared to the smaller firms
(Black and Khanna, 2007). We use the natural logarithm of the average net sales
over the previous year of the company as a proxy for the size of these companies.
• Dependence on external capital market (EXTFUND): Companies that need external
funding benefit more from good governance rules (Black and Khanna, 2007). Better
governed firms get a better credit rating and hence enjoy a lower cost of debt
(Bhojraj and Sengupta, 2003; Ashbaugh-Skaife et al., 2006). Firms with good quality
of reporting (lower accruals and more transparent earnings) also enjoy a lower cost
of equity (Ashbaugh et al., 2004). Therefore, firms that depend on the external
capital market to raise funds stand to gain from better governance practices. We use
the average capital raised through both debt and equity (standardised by total
revenue) during the previous year as a proxy for EXTFUND.
• Listing of shares outside India (CROSSLIST): Firms from developing economies that
have access to global capital markets have more incentives for better governance
(Doidge et al., 2007). Cross-listing of shares in the USA is found to provide better
protection to minority shareholders and decreases the private benefits of control
(Doidge, 2004). We use the GDR/ADR listing of the shares issued by a company as
a proxy for EXTLIST. This variable takes the value of 1 if the depository
receipts/shares issued by the company trade in international exchanges like
NASDAQ, NYSE, LSE, etc.
• Dependence on exports (EXPORTS): Consumers outside the country face
information asymmetry problem while taking any purchase decision. The corporate
governance standards followed by the company can mitigate the risks perceived by
the consumers. We, therefore, include this as an additional regressor in the probit
equation. We measure EXPORTS as the ratio of total exports and the total revenue
of the company in the previous year.
• Part of business groups (BUSGRP): Companies that are part of large business
groups need to have good corporate governance practices as the bad reputation of
one company can affect the business prospects of other affiliated companies. The
competitive advantage of family-controlled businesses arises from their corporate
governance system (Carney, 2005). In our model, BUSGRP is a dummy variable that
takes a value of 1 if the company belongs to a business group.
• Past financial performance (FINPERF): It is argued that companies that are doing
financially well can afford to have better governance standards. Stronger governed
firms exhibit a higher degree of accounting conservatism (Lara et al., 2009). Firms
following conservative accounting practices usually understate their total assets and
 Does good governance lead to better financial performance? 469

hence their ROA figures get overstated. That is why we include FINPERF as a
regressor in the probit regression. We compute FINPERF as the ROA of the firm in
the previous year.

3.1 Measuring corporate governance (CG)

In the probit model, we use the firm’s orientation towards corporate governance as the
dependent variable. We use the method used by Mishra and Mohanty (2014) to measure
corporate governance in this study. We use board indicators, legal indicators and
proactive indicators to measure corporate governance practices followed by a firm. We
use five measures (all dummy variables taking a value of either 1 or 0) of the board
indicators, two measures each for the legal and proactive indicators. Then, we take a
simple average of these nine measures and assign a value of 1 to CG if the average is
more than 0.75. Else, it takes a value of 0. The maximum value of this simple average in
our sample is 1 and the lowest value is 0.28. Subsequently, we assign a CG score of 1 to
any company, whose average score exceeds 0.75. Other companies are assigned a CG
score of 0. There are 43 companies that have got a CG score of 1. The remaining
83 companies got a CG score of 0. As the methodology is discussed in detail in Mishra
and Mohanty (2014), we do not explain it here.

3.2 Measuring financial performance

In both equations (1) and (3), we need a measure of the financial performance of the
company. Extant research on corporate governance uses either accounting-based
measures such as ROA, ROE, net margin or the capital market-based measures like the
stock returns (Kang and Sivadasani, 1995; Kaplan, 1997; Rob et al., 2004; Bhagat and
Bolton, 2008). In this paper, we use the ROA as the measure of financial performance
because this is the best measure of management performance that is not contaminated by
the degree of leverage present in the firm (Koller et al., 2005). Both ROE and net margin
are correlated with the leverage present in the firm. Family firms are also known to use a
lower level of debt (Latrous and Trabelsi, 2012). Leverage is sometimes suggested as a
solution to the agency problems in the firm (Jensen, 1986) and is sometimes seen as the
source of agency problems (Kim and Sorensen, 1986). We use ROA that is not directly
affected by the degree of leverage. We do not use stock-returns as a measure of financial
performance because dissident shareholders use poor accounting earnings rather than
poor stock price performance as the basis for waging a proxy contest (DeAngelo, 1988).
In any case, as ROA is positively correlated with the economic value added of a
company, it is highly correlated with the enterprise value. We compute ROA as shown in
equation (4).
Net operating income × (1 − tax rate)
ROA = (4)
Average operating assets

Net operating income is computed as the operating earnings before income and taxes,
before extra-ordinary items and prior-period adjustment. We use the marginal tax rate
while computing ROA.
To test our second hypothesis (H2 as stated in Section 2), we use the switching
regression with endogenous switching. To know if corporate governance improves the
470 S. Mishra and P. Mohanty

financial performance of a company, we compare the financial performance of poorly

governed companies with their counterfactual outcomes. The matching regression models
help us in finding the counterfactual outcomes (Li and Prabhala, 2007). We, therefore,
modify equation (3) into the following two switching regression equations:
φ ( Zλ)
FP1i = X β1 + θ1 + u1i (5)
1 − Φ( Zλ)

φ ( Zλ)
FP2,i = X β 2 + θ2 + u2 i (6)
1 − Φ( Zλ)

Equation (5) shows the financial performance of firm i if it adopts good governance
practices. Equation (6) shows the financial performance of firm i if it adopts poor
governance practices. We can now use equation (7) to find out what the financial
performance of the poor-governance companies would be if they adopt good governance
practices. Following Golubov et al. (2012), the counter-factual outcome can be estimated
using equation (7)
E [ FP2,i | Good_governance] = E [ X β 2 + u2i | Ziλ + υ > 0]
⎡ φ( Ziλ) ⎤ (7)
= E ⎢ X β 2 + u2i + cov ( u2,1 , υ ) .
⎣ Φ( Ziλ) ⎥⎦

3.3 Our sample

We decide to use the same sample of 141 companies that Mishra and Mohanty (2014)
used in their study to make our results comparable. We collect all the required data from
the Prowess database of CMIE. The database provides all the required financial data from
the fiscal year 1991. We find that some of the companies that Mishra and Mohanty
(2014) used in their sample have merged with other companies. We had to remove those
companies from our sample. This reduced our sample size to 126 firms. Secondly, the
study by Mishra and Mohanty (2014) used only three years’ data in their study. We have
extended the study by considering financial information from 1991 till 2017. Since our
objective was not to see the change in the governance scores of the firms over time, we
have performed all the regression analysis using the pooled data.
Table 1 compares some key financial statistics of the firms in our sample with all the
listed firms in India over this sample period. As can be seen, firms in our sample are
larger (generate higher revenue each year) and are more profitable (have higher ROA and
ROE). Firms in our sample also generate a higher percentage of the revenue from
exports. They are also more dependent on external capital than a typical listed Indian
firm. We find the degree of competition to be the same between the firms in our sample
and an average listed Indian firm.
Table 2 compares some key financial statistics between the firms with high and low
CG scores (from firms in our sample). Better governed firms are more profitable (higher
ROA and ROE) compared to poorly governed firms. Well governed firms also are more
dependent on exports compared to poorly governed firms. Well governed firms also
operate in industries with higher Herfindahl index (lower degree of competition)
compared to poorly governed firms. However, firms with higher governance scores are
smaller in size (lower revenue) compared to poorly governed firms.
 Does good governance lead to better financial performance? 471

Table 1 Sample profile

Firms in sample All firms

Mean Median Mean Median
Return on assets ROA (%) 8.11 7.52 –1.34 1.93
Return on equity ROE (%) 26.50 25.10 13.90 11.40
Revenue (million INR) 81,121 9,193 3,692 198
Exports (% of revenue) 0.13 0.05 0.11 0.00
External funding (% of revenue) 3.52 –0.02 2.07 –0.01
Business group affiliated (no.) 88 88 1,326 1,326
HHI 0.02 0.01 0.02 0.01
Number of firms 126 126 4,520 4,520

Table 2 Profile of firms with high and low corporate governance (CG) scores

High CG score Low CG score

Mean Median Mean Median
Return on assets ROA (%) 11.30 9.14 6.56 6.81
Return on equity ROE (%) 27.40 26.00 26.10 24.40
Revenue (million INR) 29,425 5,471 105,909 11,239
Exports (% of revenue) 0.18 0.08 0.11 0.04
External funding (% of revenue) 0.00 –0.03 5.26 –0.02
Business group affiliated (no.) 31 31 57 57
Cross-listed firms (no.) 4 4 11 11
Herfindahl index 0.02 0.01 0.01 0.01
Number of firms 43 43 83 83

4 Discussions of results

We use the two-stage regression method suggested by Heckman (1979). In the first stage,
we run the probit regression to estimate the inverse Mills ratio and in the second stage,
we use the inverse Mills ratio as an additional regressor in the standard OLS regression.
We first compute the CG index value for all the 126 firms. Then, we regress CG on the
seven variables (COMP, SIZE, EXTFUND, EXTLIST, EXPORTS, BUSGRP and
FINPERF) using binary probit regression model. We use the sampleSelection package
(Toomet and Henningsen, 2008) in the R software to estimate all the models in this
paper.
Table 3 shows the output of the probit regression model where we regress the CG
indicator on seven variables that are hypothesised to influence the decision of a company
to adopt a particular orientation towards corporate governance. In order to compute CG
(the dependent variable), we first estimate the average of nine corporate governance
indicators, namely, CEO duality, number of directors in the board, percentage of
independent directors in the board, percentage of independent directors in the audit
committee, number of board meetings, adverse auditors’ report, default in tax payment
472 S. Mishra and P. Mohanty

and provision of earnings forecast and provision of additional information in the annual
reports to the investors.
Table 3 Output of the probit regression (selection model)

Parameter Estimate Std. Error z value Significance

Intercept 7.46 1.74 4.30 0.00
COMP –7.07 1.76 –4.03 0.00
SIZE –0.14 0.01 –10.19 0.00
EXTFUND 0.00 0.00 –0.53 0.59
CROSSLIST 0.02 0.08 0.23 0.82
EXPORTS 0.80 0.12 6.58 0.00
BUSGRP 0.16 0.06 2.68 0.01
FINPERF 0.01 0.00 5.95 0.00
Chi-square 213.25 0.00

From Table 3, we can see that variables other than EXTFUND and CROSSLIST turned
out to be significant in the model. While the degree of competition and size were
negatively related, other variables were found to be positively related to corporate
governance. First, we find that firms operating in highly competitive industries are poorly
governed. This is consistent with our simple bivariate relationship stated in Table 2. This
finding is also consistent with the findings of Giroud and Mueller (2010, 2011) who
argue that firms operating in less competitive industries use governance as a
differentiator. However, the negative relationship between size and CG is not consistent
with the past literature. Arora and Bhandari (2017) found evidence of a positive
relationship between size (measured by market capitalisation) and the CG index. Large
firms are more visible and hence one would expect them to adopt better governance
mechanisms. Black and Khanna (2007) find that with the introduction of corporate
governance rules in India by SEBI, the large-cap stocks experienced an abnormal return
of 4% as compared to the smaller firms. Institutional investors also prefer to invest in
large companies. This probably puts pressure on these companies to have better corporate
governance standards within the company. One may, therefore, argue that our result goes
against the extant literature. We, however, believe that this is not necessarily the case.
Mishra and Mohanty (2014) restrict their sample to all the ‘A’ group companies listed in
the Bombay Stock Exchange (BSE) (which are larger companies). So, our results simply
show that among the large-cap firms, those who are relatively smaller in size are better
governed.
Other variables, including exports-dependence, business group affiliation and past
financial performance are positively related to the firm’s governance orientation. This is
consistent with the reputation theory. Firms that are more visible have greater reputation
at stake (Rhee and Valdez, 2009), hence adopt better governance practices. Lack of any
relationship between the cross-listing of firms and CG is surprising. Firms that are
cross-listed in the US stock markets follow stricter regulatory norms and hence one
should expect a positive relationship between CROSSLIST and CG. Abdallah and
Goergen (2008) report that firms that are listed in countries with better shareholder
protection, pay higher dividends. Of course, it is possible that firms that are more
 Does good governance lead to better financial performance? 473

profitable go for cross-listing. Studying the governance practices of cross-listed Indian

firms would be interesting and we leave it to our future research.
We subsequently compute the inverse Mills ratio for all the 126 firms using the
estimates from the probit regression. Then, we regress the ROA of the firms (using
pooled data for 1992–2017) on the size, business group affiliation and cross-listing. We
run the regression again after including the inverse Mills ratio as an additional regressor,
as specified in equation (3). We show the output in Table 4.
Table 4 presents the output of the following regressions:
φ ( Zλ)
FP = β 0 + β1SIZE + β 2 BUSGRP + β3CROSSLIST + ω CG
Φ( Zλ)
−φ ( Zλ)
+ω (1 − CG ) + u
1 − Φ( Zλ)

FP = β 0 + β1SIZE + β 2 BUSGRP + β3CROSSLIST + u

Table 4 Financial performance and corporate governance indicators

Model 1 Model 2
Parameter
Estimate Estimate
Intercept –10.19 –5.27
(–10.41) (–6.26)
SIZE 1.27 1.07
(15.00) (12.86)
BUSGRP 0.72 1.52
(1.86) (3.93)
CROSSLIST –2.17 –2.13
(–4.03) (–3.90)
IMR 5.34
(9.45)
Adjusted R2 0.09 0.06
F-statistic 67.69 58.63
Note: The figures in the parenthesis represent the t-statistics.
We first discuss the regression results when the inverse Mills ratios are included as an
additional regressor. Since IMR is computed from the probit model where the CG
variable serves as the dependent variable, we do not include CG as an independent
variable in this outcome model to avoid multi-collinearity in the regression model. First,
IMR has a statistically significant effect on the financial performance of the firm. As this
serves as a proxy for the missing variable (captures the unmeasurable benefits that the
management perceives to get due to better governance), our study shows that simple OLS
regressions will be misspecified. Thus, for example, we find that business group
affiliation loses its significance once IMR is included as an additional variable.
Size is positively related to firm performance. There is ample evidence in finance
literature to suggest that size (measured by market capitalisation) is negatively related to
the stock returns (see, for example, Fama and French, 1993). We measure size in terms of
474 S. Mishra and P. Mohanty

revenue and financial performance with the help of ROA. One would expect larger
companies to have higher market capitalisation and high return generating firms to be
more profitable. We believe that the positive relationship between size and ROA is
specific to our sample which consists of group A stocks of BSE and may not be
generalised. We also find a negative association between cross-listing status of the firms
and financial performance. Research has documented a higher market valuation of cross-
listed firms around the time of cross-listing (Lang et al., 2003). However, this higher
valuation around the time of cross-listing occurs due to higher analyst coverings.
From the probit regression, we find that past financial performance is related to
corporate governance choices made by the company. From the second-stage regression,
we find that higher inverse Mills ratio is related to better financial performance (both
when endogeneity adjustment is done and when it is not done). This shows that the
relationship between corporate governance and firm performance is not one-sided and
both seem to affect each other.
These results support our first hypothesis that postulates a positive relationship
between financial performance and corporate governance of the firms, after adjusting for
possible endogeneity issues. We do not attempt to infer a causal relationship between the
two variables, as that requires a separate study and this is beyond the scope of this paper.
Companies that get a CG score higher than 0.75 report an average ROA of 11.3%
during the 1992–2017 sample period. We attempt to find out what the average ROA
would have been had these companies got a CG score lower than 0.75. This will be an
indirect test of whether corporate governance improves the financial performance of the
companies or not. We perform similar calculations for firms having CG score lower than
0.75. We use the switching regression model to estimate the counter-factual outcomes for
these companies.
We first estimate the regression equations specified in equations (5) and (6). Then,
we compute the counter-factual outcome for these companies by using equation (7). In
Table 3, we show the regression output [for equations (5) and (6)] in Table 5. We show
the possible improvements from the counterfactual outcomes in Table 6.
Table 5 Switching regression output

Model 1 Model 2
Parameter
High CG score Low CG score
Intercept 8.04 –50.64
(7.28) (–35.04)
SIZE 3.53 3.57
(24.76) (34.97)
BUSGRP –1.02 –1.06
(–1.98) (–2.76)
CROSSLIST –0.26 –1.47
(–0.34) (–3.01)
IMR –30.65 43.34
(–26.35) (35.27)
Adjusted R2 0.48 0.45
F-statistic 210.50 383.60
Note: The figures in the parenthesis represent the t-statistics.
 Does good governance lead to better financial performance? 475

Table 5 presents the estimation results of the following regression equations:

φ( Zλ)
FP1i = β 0 + β1SIZE + β 2 BUSGRP + β3CROSSLIST + θ1 CG + u1i
Φ( Zλ)

−φ( Zλ)
FP2,i = β 0 + β1SIZE + β 2 BUSGRP + β3CROSSLIST + θ2 CG + u2i
1 − Φ( Zλ)
Table 6 What-if analysis

High CG score Low CG score

ROA 11.30 6.56
Hypothetical ROA 6.93 5.12
Improvements 4.37 –1.44

Table 6 compares the actual ROA of the high and low CG firms from our sample with
their counterfactual outcomes. The hypothetical ROA of the firms are estimated using
switching regression models [similar to Equations B9 and B10 of Golubov et al. (2012)].
If the firms having higher CG scores follow poor governance practices, then the average
ROA value would have dropped by 4.37% per annum during the sample period. The
figures for the low CG score firms are interpreted similarly.
We find that well-governed firms are in fact getting the benefits from better
governance. The average ROA of these firms would have decreased to 6.93% had these
firms adopted poorer governance practices. This shows that governance indeed affects
firm performance. However, we find contrasting results when we look at the
counterfactual ROA figures for the firms with poorer governance practices. We find that
the average ROA for these firms would also have decreased by 1.44% had these firms
been well-governed. The study partially supports the second hypothesis. This result does
not invalidate our finding that well-governed firms are more profitable. However, Table 6
puts a question mark on our ability to draw causal inferences from the study. It would be
interesting to perform a causal study using panel data. We leave it to our future research.

5 Conclusions and scope for further research

In this paper, our objective is two-fold:

1 We test if corporate governance and financial performance are related after adjusting
for endogeneity often cited in corporate governance literature.
2 We attempt to find out to what extent the actual financial performance of well
(poorly) governed companies will change if they change their corporate governance
practices.
We use the two-stage regression suggested by Heckman (1979) to adjust for possible
endogeneity in the data. In the first stage, we use the probit regression to estimate the
inverse Mills ratio. We follow the method suggested by Mishra and Mohanty (2014) to
measure corporate governance. In the second stage, we regress the firm performance
(ROA) on corporate governance measures and the inverse Mills ratio using OLS
regression.
476 S. Mishra and P. Mohanty

Finally, we compare the actual ROA of well (poorly) governed companies with what
their counterfactual ROA – what the ROA would have been had they been poorly (better)
governed – to see the actual benefit of better governance. We find the average ROA of
well-governed firms would have decreased from 11.3% to 6.93% had these companies
adopted poorer corporate governance norms. However, we did not obtain similar results
from the poorly governed firms and hence the findings do not convincingly support a
causal relationship between governance and firm performance. The study, therefore,
supports our first hypothesis fully, while it only partially supports our second hypothesis.
We find two interesting research questions that need to be explored further. First, our
probit results show that size is negatively related to corporate governance. Larger firms
adopt stricter disclosure rules as compared to smaller firms (Hermalin and Weisbach,
2012). Larger firms also have greater reputational stake for any adverse publicity they
might receive for poor governance. Since this is not the main objective of this paper, we
did not explore this issue further in this paper. We leave it to our future research.
Second, we find that the average ROA of poorly governed firms would have
decreased further had they been better governed. This result is surprising and may
probably be explained by looking at the sample of poorly governed firms in more detail.
In addition to these major research issues, we also need to explore a few smaller
issues. Normally, corporate governance is measured by using corporate governance
indices. These indices are constructed by giving scores to different dimensions of
corporate governance (Larcker et al., 2004; Bebchuk et al., 2009; Gompers et al., 2003;
Brown and Caylor, 2004). In this paper, we used only nine measures of corporate
governance to estimate CG. It would be interesting to see if our results still hold by
including additional measures of corporate governance. One may also consider using
principal component analysis to create the CG score, instead of simply adding up the
binary scores. We intend to use this method in a future version of this paper.
Though ROA is a better measure of operating performance of the company, it does
not capture the risk in the investment. Stock returns would capture the effect of both the
cash flow and the risk inherent in any decision taken by the company. It would be
interesting to see if our second stage regression results will still hold if we use stock
returns as a measure of corporate performance.
Finally, we do acknowledge that our sample size is small. The nature of our research
and the CG measure that we used forced us to use the same sample that Mishra and
Mohanty (2014) used. Use of a larger sample with both mid-cap and small-cap stocks
would help us understand the corporate governance practices followed by the Indian
firms better.

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