Critical Perspectives on Accounting 19 (2008) 1135–1148 Do institutional shareholder services (ISS) corporate governance ratings reflect a company’s operating performance? Ruth W. Epps a,∗ , Sandra J. Cereola b a School of Business, Virginia Commonwealth University, Richmond, VA 23284-4000, United States b Virginia Commonwealth University, Richmond, VA 23284-4000, United States Received 1 August 2006; received in revised form 15 May 2007; accepted 30 June 2007 Abstract Little is known about the relation between the actual governance rating received by a firm and the firm’s performance. In this study, we examine the relation between the actual corporate gover- nance rating received by a firm and the firm’s performance during the years 2002–2004. We use the institutional shareholder services (ISS) corporate governance quotient (CGQ) rating of a firm’s corpo- rate governance structure and analyze this rating in relation to the firm’s operating performance. We compare the institutional shareholder services’ CGQ rating to two measures of the firm’s operating performance, return on assets (ROA) and return on equity (ROE). Based upon our results, we do not find statistical evidence suggesting that the firms’ operating performance is related to the firms’ ISS corporate governance rating. © 2007 Elsevier Ltd. All rights reserved. Keywords: Corporate governance; Firm operating performance; Governance rating; Return on assets; Return on equity 1. Introduction The Organization for Economic Cooperation and Development (OECD) 1 defines cor- porate governance as, “the way in which boards oversee the running of a company by its ∗ Corresponding author. Tel.: +1 804 828 7137; fax: +1 804 828 8884. E-mail address: rwepps@vcu.edu (R.W. Epps). 1 Found at http://www.oecd.org. 1045-2354/$ – see front matter © 2007 Elsevier Ltd. All rights reserved. doi:10.1016/j.cpa.2007.06.007 1136 R.W. Epps, S.J. Cereola / Critical Perspectives on Accounting 19 (2008) 1135–1148 managers, and how board members are in turn accountable to shareholders and the com- pany.” OECD elaborates that corporate governance “has implications for company behavior towards employees, shareholders, customers and banks”. Implicitly, this definition of cor- porate governance implies there is a relationship between a firm’s results of operations and the governance rating score received. In response to the corporate scandals during the period 2000 and 2001, Congress enacted the Sarbanes-Oxley Act (SOX) on July 30, 2002 2 . The act specifically targets corporate gov- ernance reform and has created a reporting system that now makes corporate governance more transparent to the public. SOX requires firms to disclose annually the structure, compo- sition, and size of its board and whether it has adopted a code of ethics for its senior financial officers in its Form 10-K. Additionally, both the New York Stock Exchange (NYSE), and the National Association of Securities Dealers (NASDAQ) have corporate governance rules regarding the role and authority of independent directors (Lander, 2004). A corporation’s corporate governance structure is important to today’s market par- ticipants. Investors view corporate governance as an important criterion when making investment decisions and are willing to absorb higher costs for corporations that are well governed and have boards of directors with a high degree of independence. According to a survey conducted by McKinsey and Company (2002), 14% of the investors in the U.S. say they are willing to pay a premium for a well-governed company. The requirements of SOX are meant to address the concerns of investors and to restore investor’s confidence in the corporate governance mechanism. SOX has imposed requirements on public firms to improve their governance practices, to increase director independence and to create boardroom structures that hold management accountable. The overall impact of SOX along with the regulations imposed by the major U.S. stock exchanges should be reflected in the improvements of the corporate decision-making process, improve- ments in the organization’s accountability system and ultimately improvements in the firm’s overall efficiency and performance. Thus, if the regulations achieve the desired results of improved corporate governance, investors should expect to see an overall increase in cor- porate governance ratings from 2002 to 2005. Additionally, investors should also be able to identify a positive relationship between the corporate governance ratings and firms overall operating performance. Although our study is not the first to examine the impact of corporate governance structure on firm performance, our approach differs from previous studies. First, we are studying one corporate governance rating system, institutional shareholder services (ISS). ISS is the most widely known and used governance rating system, rating over 5000 U.S. firms and 2000 global firms. This system is chosen because of the size of the database and the potential pervasive impact of the findings of the research. Second, while previous research uses various components of the corporate governance rating metrics as indicators of corporate governance, we use the actual aggregate corporate governance score obtained by the firm as our indicator of corporate governance. We believe this aggregate measure is important in the investor decision-making process because this information is more readily available for comparative firm analysis. 2 http://www.sec.gov, Publication L. No. 107-204, 116 Stat. 745. R.W. Epps, S.J. Cereola / Critical Perspectives on Accounting 19 (2008) 1135–1148 1137 Thus, using the corporate governance ratings provided by the institutional shareholder services and financial data obtained from Compustat for companies listed on the Standard and Poor’s (S&P) 500 as of February 2006, we compare the actual ISS governance ratings from 2002 to 2004 and examine the relationship (if any) between those ratings and a firms’ operating performance. 2. Literature review A central issue to corporate governance is how to ensure accountability of senior man- agers to their stakeholders while simultaneously providing executives with the autonomy and incentives they need to produce wealth-producing strategies. Much of the responsibility for providing a governance structure that aligns the interest of the managers with that of the shareholders depends on the due diligence of the board of directors. A board has two primary roles, that of decision-making and that of oversight. However, O’Reilly et al. (1990) suggest that boards are not effective as a monitoring device. Other empirical evidence shows that firms adjust their board structure and increase the level of board activity in response to poor performance, Vafeas (1999). There is disagreement on how good or bad the existing governance mechanisms are in the U.S. Jensen (1993) provides evidence that the U.S. corporate governance system is deeply flawed and that a major move from the corporate form to a much more highly leveraged organization is on the horizon. In contrast, Easterbrook and Fischel (1991) provide a very optimistic assessment of the U.S. corporate governance system. Additionally, Core et al. (1999) indicate that firms with weaker governance structures have greater agency problems. Corporate governance issues arise in an organization due to the separation of ownership and management. In most large corporations, there is a separation between those who control and those who own the residual claims (Fama, 1980; Demsetz and Lehn, 1985). Agency theory explains how to best address the problems of goal congruency and information asymmetry between the principals (shareholders) and agents (managers). Effective corporate governance structures help to prevent agency conflicts by acting as a monitoring device designed to align management’s goals with those of the shareholder. The structure allows for compensation packages, which provide managers with an incentive to maximize the value of the firm. Hence, agency theory suggests better corporate performance established through measured corporate governance will lead to lower agency costs, higher stock prices and better long-term performance as managers are better supervised because a system of accountability, i.e. corporate governance, exists. In a similar manner, Himmelberg et al. (1999) examine the link between managerial ownership and firm performance and find no relationship between changes in managerial ownership and firm performance. Mehran (1995) finds that firm performance is positively related to the percentage of equity held by managers and to the percentage of compensation that is equity based. Bushman et al. (2004) find that strong governance systems characterized by high ownership concentration, strong directors’ and executives’ equity-based incentives and the strong reputation of outside directors vary inversely with timeliness of earnings. Other studies have examined the relation between operating performance and certain corporate governance provisions. Botosan and Plumlee (2001), using Fortune list of the 1138 R.W. Epps, S.J. Cereola / Critical Perspectives on Accounting 19 (2008) 1135–1148 100 fastest growing companies as of September 1999 and computing the effect of expens- ing stock options on operating performance, find a substantial effect of expensing stock options on operating performance. Similarly, Fich and Shivdasani (2006) using Fortune 1000 companies find that firms with director stock option plans are relatively more prof- itable as measured by using operating return on assets, return on sales and asset turnover as proxies for profitability. 3. Metrics for corporate governance ratings The most commonly used services that provide metrics that rank the quality of a firm’s corporate governance system are the institutional shareholder services, Standard and Poor’s (S&P, discontinued 2005), Governance Metric International (GMI), and The Corporate Library (TCL). The ISS includes a composite of 225 variables based on 61 rating criteria across eight governance topics. It rates the corporate governance of over 5200 U.S. compa- nies and 2300 international companies and provides ratings based on a percentage scale. The S&P includes four categories and it provides scores on a range from 1 to 10; however, the list is not currently published. The GMI includes 600 variables based on seven categories; it provides scores based on a range from 1 to 10 and provides ratings for nearly 3400 U.S. and international companies. The TCL includes approximately 120 variables based on six categories, provides letter scores ranging from an A to an F and provides ratings for over 2000 U.S. companies. When deciding on which rating service to use, researchers and firms must be cautious as each service has its advantages and disadvantages. The ISS database appears to be the most recently developed rating service and one that is currently the most widely used in corporate governance research literature. According to a Wall Street Journal article, Langley (2003) identified the ISS rating service as the one that carries the most clout. Brown and Caylor (2005) use the ISS database to create a summary index called “Gov-Score” and argue that this index is a broad measure of governance and one that is positively linked to both return on equity and return on assets. Van den Berghe and Levrau (2004) argue that an evaluation of corporate governance must include a wide variety of factors in order to capture the real value of the board. The categories included in the ISS database are, board characteristics, audit characteristics, charter/bylaws, anti- takeover practices, executive and director compensation, progressive practices, ownership and director education. Within each of the ISS categories are various subsets resulting in a total of 225 corporate governance variables. We use the ISS database because it covers a broad range of public companies, it contains a comprehensive list of corporate governance variables and it appears to be the most widely accepted rating system being used in current practice. ISS first created its corporate gov- ernance quotient (CGQ) in July of 2002 as a product intended to improve the interaction between shareholders and companies. The CGQ rating system was changed in early 2003 in anticipation of the impact of the Sarbanes-Oxley Act. In September 2005, ISS released an updated version of its CGQ rating methodology 3 . The current CGQ rating methodology 3 http://www.issproxy.com. R.W. Epps, S.J. Cereola / Critical Perspectives on Accounting 19 (2008) 1135–1148 1139 factors in the evolving regulatory and dynamic market environment and aligns the ratings methodology with lower risk (as a result of SOX Section 404) and improved financial per- formance. The CGQ ranges from 0 to 100% and firms are rated individually and within the firm’ industry sector. The present research examines the relation between the aggregate ISS governance rat- ing received by a company and the company’s operating performance. Individual rating factors are not examined; the premise of the researchers is that the overall interaction of shareholders to companies and their corporate governance is based initially upon the overall corporate governance rating received by the company. Why are these ratings important to corporations? Among the many reasons is the reliance of the institutional investment com- munity on agencies such as ISS, the Corporate Library, and GMI for guidance and counsel on shareholder issues. To ignore institutional investors, the largest aggregate holders of corporate equity for US-based corporations would be quite unwise. 4. Metrics for firm performance Empirical research on corporate governance use either market-based measures or accounting-based measures to assess firm performance. There is much debate as to which measures are the more reliable. Klein (1998) and Core et al. (1999) use ROA as an oper- ating performance indicator. Return on equity (ROE) is used by Shrader et al. (1997) and Lo (2003). Brown and Caylor (2005) use return on equity and return on assets as their two operating performance measures. Barnhart et al. (1994), Dowen (1995) and Vafeas (1999) use market to book value ratios as performance indicators. Lang and Stultz (1994), Mehran (1995), Yermack (1996) and Himmelberg et al. (1999) use Tobin’s q as an operating per- formance indicator. Dalton et al. (1998) indicate in a meta-analytic review of corporate governance literature that there is no consensus as to which measures are more efficient. The current research examines firm’s operating performance and the effect (if any) of corporate governance rating on that performance. Return on assets and return on equity are the variables selected as measures of operating performance with the log of book-to-market added as an independent control variable. 4.1. Return on assets Return on assets is a measure of operating performance, which shows an investor what earnings a firm has generated from its invested capital assets. ROA in the current study is defined as income before extraordinary items for the fiscal period divided by total assets for that same period. Managers are directly responsible for the operations of the business and therefore the utilization of the firms’ assets. Thus, ROA allows users to assess how well a firms’ corporate governance system is in securing and motivating efficient management of the firm. 4.2. Return on equity One of the primary reasons for operating a corporation is to generate income for the benefit of the common stockholders. Return on equity is a measure that shows an 1140 R.W. Epps, S.J. Cereola / Critical Perspectives on Accounting 19 (2008) 1135–1148 investor how much profit a company generates from the money invested from its share- holders. ROE in the current study is defined as the income before extraordinary items available for common equity divided by the sum of the book value of equity and deferred taxes. 5. Data description The purpose of the study is to examine the corporate governance ratings of a sample of large U.S. public companies from a wide range of industries. Thus, firms were selected using the S&P 500, since the S&P 500 represents a list of the top 500 U.S. companies in terms of market value and performance. Approximately 70% of the value of the U.S. equity market is tracked by the S&P 500 (Investorwords. com, 2005). Corporate governance ratings were collected from the ISS database for the study periods 2002–2004. The present sample is based on a complete set of firms on the S&P 500 with (a) December 31st year-end, (b) a complete set of the required financial data on Compustat for each of the years—2002–2004, and (c) ISS corporate governance quotient score (CGQ) for each of the years—2002–2004. For the year 2004 there were 359 S&P 500 firms with December 31st fiscal year-end. Seventeen of these firms were dropped because they are not rated by ISS, 67 of the remaining 342 firms were eliminated due to incomplete financial data on Compustat and 2 of the remaining 275 firms were eliminated because of the negative value of their book-to-market ratio; hence, the natural log of the control variable could not be determined. The total sample size for the year 2004 consists of 273 firms. For the year 2003, there were 359 S&P 500 firms with fiscal year-end December 31st. Twenty-three of these firms were dropped because they are not rated by ISS. Sixty-seven of the remaining 336 firms were eliminated due to incomplete financial data on Compustat. Hence, the total sample size for the year 2003 consists of 269 firms. For the year 2002, there were 357 S&P 500 firms with 12/31 fiscal year-end. Thirty-two of the firms are dropped because they are not rated by ISS and 65 firms were eliminated due to incomplete data on Compustat. Additionally, 5 firms were eliminated due to negative ratios for their book-to-market values. Thus, the research sample size for the year 2002 consists of 256 firms. 6. Methodology We use the ISS company corporate governance quotient (CGQ) rating which is a com- posite of 61 rating criteria across eight categories of governance topics from the institutional shareholder services data set for the periods 2002–2004. We relate the actual CGQ rating to two measures of the firm’s operating performance, return on assets (ROA) and return on equity (ROE). The objective of the research is to assess whether a firm’s ISS corporate governance rating has an effect on its operating performance. To this end, we compare cor- porate governance ratings of the firms to two measures of the firm’s operating performance, return on assets (ROA) and return on equity (ROE). Simultaneously, we control for other attributes that are likely to affect performance by using the control variable, natural log R.W. Epps, S.J. Cereola / Critical Perspectives on Accounting 19 (2008) 1135–1148 1141 of book-to-market. If performance has a positive effect on governance rating, then high corporate ratings would equate to large rates of returns. Thus, our hypothesis is H1. Corporate governance rating is positively associated with firm’s performance. The following model is used to investigate the above hypothesis: ROE it = β 0 + β 1 CoISS it + β 2 log BM it + ε (Model 1A) ROA it = β 0 + β 1 CoISS it + β 2 log BM it + ε (Model 1B) where CoISS it is the company i’s ISS corporate governance quotient (rating) in year t,ROE it the company i’s return on equity in year t,ROA it the company i’s, return on assets in year t, log BM it the natural log of book-to-market for company i in year t, We investigated H1 using ordinary least squares (OLS) regression for each of the years, 2002–2004. 7. Analysis and results Figs. 1–3 show the histogram of ISS corporate governance ratings for the sample firms in 2002–2004. The figures show a slight insignificant increase in the governance ratings with a mean value of 52.099 in 2002 to a mean value rating of 52.672 in 2003 for the sample firms. A more significant increase in the governance ratings is shown in the 2004 histogram in Fig. 3, where the mean of the governance rating is 55.472 and the bars indicate a greater percentage of firms are in the upper percentiles. Tables 1–3 show the results of the regressions of the operating performance metrics, return on equity and the return on assets on the firms’ ISS corporate governance rating Fig. 1. Distribution of ISS corporate governance ratings in year 2002 histogram distribution of ISS corporate governance ratings (Co ISS) in 2002 for the S&P 500 firms in the sample. Normal curve is superimposed. 1142 R.W. Epps, S.J. Cereola / Critical Perspectives on Accounting 19 (2008) 1135–1148 Fig. 2. Distribution of ISS corporate governance ratings in year 2003 histogram distribution of ISS corporate governance ratings (Co ISS) in 2003 for the S&P 500 firms in the sample. Normal curve is superimposed. (Co ISS) along with the control variable, natural log book-to-market. Panel A of Table 1 shows that the regression results for (Model 1A) for the return on equity in the year 2002 is significant at p < 0.001 with an adjusted R 2 of 0.25. Both the intercept and the control variable, log of book-to-market, are significant at the 0.05 level and 0.01, respectively. However, the result for the corporate governance rating variable is not significant. Fig. 3. Distribution of ISS corporate governance ratings in year 2004 histogram distribution of ISS corporate governance ratings (Co ISS) in 2004 for the S&P 500 firms in the sample. Normal curve is superimposed. R.W. Epps, S.J. Cereola / Critical Perspectives on Accounting 19 (2008) 1135–1148 1143 Table 1 Linear regression results for firms’ governance ratings in year 2002 Panel A: ROE Statistical results Model RR 2 Adjusted R 2 S.E. of the estimate Durbin-Watson Model summary a,c 1 0.505 b,c 0.255 0.250 0.57621 1.985 Sum of squares d.f. Mean square F Sig. ANOVA a,c Model 1 Regression 28.711 2 14.355 43.237 0.000 b,c Residual 83.668 252 0.332 Total 112.379 254 Performance measure Intercept Co ISS rating Log book-to-market Adj. R 2 Operating performance measure Return on equity −0.193 0.000 −0.399 25.0% (−2.330) ** (0.250) (−9.290) *** Panel B: ROA Statistical results Model RR 2 Adjusted R 2 S.E. of the estimate Durbin-Watson Model summary b,c 1 0.251 b,c 0.063 0.056 0.16166 1.294 Sum of squares d.f. Mean square F Sig. ANOVA b,c Model 1 Regression 0.442 2 0.221 8.466 0.000 b,c Residual 6.586 252 0.026 Total 7.028 254 Performance measure Intercept Co ISS rating Log book-to-market Adj. R 2 Operating performance measure Return on assets −0.015 0.000 −0.399 5.6% (−0.668) (0.830) (−4.105) *** Panel A: ROE statistical results (256 S&P Firms), Panel B: ROA statistical results (256 S&P Firms). a Dependent variable: Return on Equity. b Dependent variable: Return on Assets. c Predictors: (Constant), Natural Log Book-to-Mkt, Co ISS. *** Indicates significance at 0.01 level, ** Significance at 0.05 level, * Significance at 0.10 level, Student t-statistics in parenthesis. Similarly, the statistical results for the return on assets shown in Panel B of Table 1 (Model 1B) for the firms in year 2002 indicate that the model is significant at p < .001 with an adjusted R 2 of 0.056. The control variable, log of book-to-market, is significant at the 0.01 level and the intercept is not significant. Similar to the ROE results above, we 1144 R.W. Epps, S.J. Cereola / Critical Perspectives on Accounting 19 (2008) 1135–1148 Table 2 Linear regression results for firms’ governance ratings in year 2003 Panel A: ROE Statistical results Model RR 2 Adjusted R 2 S.E. of the estimate Durbin-Watson Model summary a,c 1 0.304 b,c 0.092 0.085 0.23400 1.860 Sum of squares d.f. Mean square F Sig. ANOVA a,c Model 1 Regression 1.478 2 0.739 13.497 0.000 b,c Residual 14.565 266 0.055 Total 16.043 268 Performance measure Intercept Co ISS rating Log book-to-market Adj. R 2 Operating performance measure Return on equity −0.027 0.001 −0.094 8.5% (−0.813) (1.974) ** (−4.918) *** Panel B: ROA Statistical results Model RR 2 Adjusted R 2 S.E. of the estimate Durbin-Watson Model summary b,c 1 0.277 b,c 0.077 0.070 0.05950 1.787 Sum of squares d.f. Mean square F Sig. ANOVA b,c Model 1 Regression 0.078 2 0.039 11.070 0.000 b,c Residual 0.942 266 0.004 Total 1.020 268 Performance measure Intercept Co ISS rating Log book-to-market Adj. R 2 Operating performance measure Return on assets 0.023 −0.000 −0.023 7.0% (2.657) *** (−0.327) (−4.665) *** Panel A: ROE statistical results (269 S&P Firms), Panel B: ROA statistical results (269 S&P Firms). a Dependent variable: Return on Equity ROE. b Dependent variable: Return on Assets. c Predictors: (constant), Natural Log Book-to-Mkt, Co ISS. *** Indicates significance at 0.01 level, ** Significance at 0.05 level, * Significance at 0.10 level, Student t-statistics in parenthesis. [...]... Data availability All financial data are obtained from publicly available sources, Compustat, EDGAR and Standard and Poor’s All corporate governance data ratings are obtained from institutional shareholder services Acknowledgements The authors acknowledge the helpful procedural comments received from Lawrence Brown of Georgia State University and Gregory Jonas of Case Western Reserve University We thank... equity (ROE) as the predictor variables with the log of book-to-market as a control variable We examine the relation of ROA and ROE to the actual CGQ rating to determine if any relation exists between actual corporate governance ratings and firm’s operating performance Our findings are reported in aggregate using firms listed on the S&P 500 as of February 2006 We provide evidence using a year-by-year regression... organizational complexity and corporate governance systems Journal of Accounting and Economics 2004;37(2):167–201 Core JE, Holthausen RW, Larcker DF Corporate governance, chief executive officer and firm performance Journal of Financial Economics 1999;51:371–406 Dalton DR, Daily CM, Ellstrand AE, Johnson JL Meta-analytic reviews of board composition, leadership structure, and financial performance Strategic... to provide ratings of corporate governance and it is not surprising that these ratings are important to corporations Among the many reasons for importance is the reliance of the institutional investment community on agencies such as the ISS, the Corporate Library, and the GMI for guidance and counsel on shareholder issues The governance rating industry is still in the emerging stage and admittedly... level and the intercept is not significant Also, similar to the results of the ROA analysis in 2002 and 2003, we find no significant relation between the ISS corporate governance rating and the operating performance variable, return on assets, for the year 2004 8 Summary and conclusion We use the institutional investor services (IIS) company corporate governance quotient (CGQ) rating, which is a composite... 2006 Found at http://www.oecd.orgon7/1/2006 O’Reilly III CA, Wade J, Chandratat I Golden parachutes: CEOs and the exercise of social influence Administrative Science Quarterly 1990:35 Shrader CB, Blackburn VB, Iles P Women in management and financial performance: an exploratory study Journal of Managerial Issues 1997;9:355–63 Vafeas N Board meeting frequency and firm performance Journal of Financial Economics... industrial revolution, exit, and the failure of internal control systems Journal of Finance 1993;48:831–80 Klein A Firm performance and board committee structure Journal of Law and Economics XLI 1998:275–303 Lander GP What is Sarbanes-Oxley? New York: McGraw-Hill; 2004 Langley M Making the grade: want to lift your firm’s rating on governance? buy the test – ISS ranks corporations – and sell a road map for... 2003 indicate that the model is significant at p < 001 with an adjusted R2 of 0.07 Both the intercept and the control variable, log of book-to-market, are significant at the 0.01 level Also, similar to the results of the ROA analysis in 2002, we find no significant relation between the ISS corporate governance rating and the operating performance variable, return on assets, for the year 2003 Table 3 provides... **Significance at 0.05 level *Significance at 0.10 level Student t-statistics in parenthesis a Dependent variable: return on equity b Dependent variable: Return on Assets c Predictors: (constant), Co ISS, Natural Log Book-to-Mkt 1146 R.W Epps, S.J Cereola / Critical Perspectives on Accounting 19 (2008) 1135–1148 find no significant relation between the ISS corporate governance rating and the operating performance... composite of 61 rating criteria across eight categories of governance topics from the institutional shareholder services data set for the periods 2002–2004 The CGQ ranges from 0 to 100 and firms are rated individually and within the firm’s industry sector We use the firm’s individual rating and relate the CGQ rating to two measures of the firm’s operating performance using both return on assets (ROA) and return . remember that a ‘good governance rating’ does not imply ‘good firm performance’. Data availability All financial data are obtained from publicly available sources, Compustat, EDGAR and Standard and Poor’s 19 (2008) 1135–1148 managers, and how board members are in turn accountable to shareholders and the com- pany.” OECD elaborates that corporate governance “has implications for company behavior towards. the corporate governance rating metrics as indicators of corporate governance, we use the actual aggregate corporate governance score obtained by the firm as our indicator of corporate governance.