Which Characteristics Determine a Perfect Board of Directors? A Review of the Economic Literature


Academic Paper, 2020

8 Pages, Grade: 1,3


Excerpt

Table of Contents

1. Abstract

2. Introduction

3. BoardSize

4. Composition of the board: Outsiders vs. Insiders

5. Composition of the board: Busy boards and performance of the firm

6. Auditcommittee
i. Independence
ii. Size
iii. Experts

7. Conclusion

8. References

1. Abstract

The characteristics of a perfect board of directs are a controversial topic. However recent academic research suggests that the most important characteristics are that the board of directors is consisting of independent outside directors, which also do not have any social ties to the CEO, except professional ones. In addition to this, a smaller board size leads to superior financial performance as it reduces the agency problems within the board and increases their efficiency. Boards should also not have a large fraction of busy directors as this reduces their oversight quality and gives the management more freedom. The audit committee of a firm, which is especially important as their work affects important stakeholders of the company the most, should be independent of the CEO and have finance-expert directors as this increases their monitoring abilities. Furthermore, it is beneficial if the members of the audit committee have a seat on the other important committees as this increases their understanding of the firm and reduces the risk of fraud.

2. Introduction

The board of directors is an important organizational institution, whose purpose is to reduce the agency problem inherited by the management of a firm (Hermalin & Weisbach, 2001). However, because of various accounting frauds and failures in corporate governance in the history of larger corporations, there is increasing public attention regarding the effectiveness of a board and how a perfect board should be designed to increase their oversight quality. Because of these many researchers investigated this topic.

This paper reviews recent academic research regarding the characteristics of a perfect board of directors.

Firstly, the paper analyses different board characteristics, then it investigates the importance of the composition and size of the audit committee.

3. Board Size

The first characteristic in our examination is the size of the board and the impact on the performance of the firm. Several academic articles state that in general, a smaller board size leads to superior firm performance, due to coordination problems and directors free-riding in larger boards (Lipton & Lorsch, 1992). However, this issue is too complex to derive a general rule for the size of the board. Coles et al. (2008) mention that it is important to differentiate a company based on its complexity. Their findings suggest that either very small or very large boards are ideal, which means specifically complex firms need a larger board with more outside directors to match with their great advising requirements. This is also supported by Dalton et al. (1999) who suggest that a larger board also offers more experience and knowledge, therefore they can understand the complex business processes of larger firms and can monitor them better. However, small firms perform better with a small board as the agency problems within a board are minimized, this implies that the firm value increases by a reduction of the board size for small firms (Yermack, 1996).

4. Composition of the board: Outsiders vs. Insiders

There is a controversial debate about how high the fraction of insiders in a board should be or how much outsiders a board needs to be carefully monitored.

Firms with a higher level of outside directors make generally better decisions regarding management monitoring, as well as their compensation (Hermalin & Weisbach, 2001). This is also supported by Fich and Shivdasani (2006) who state that a board consisting of a majority of outside directors is more likely to replace a CEO for poor performance than a board consisting of a majority of inside directors. Core et al. (1999) mention that it is also important to investigate the independence of outsiders from the CEO, as they observe that if boards are interlocked (directors of a board of one firm are the CEO of another company in which the CEO sits as a director) they tend to pay the CEO higher compensations. However also in this case it is crucial to focus on the type of company. For R&D-intensive companies’ firm-specific knowledge is important and they, therefore, experience an increase in firm value if the fraction of insiders is higher on the board (Coles et al, 2008).

5. Composition of the board: Busy boards and performance of the firm

Board members generally see their position as a source for valuable experience as well as reputational benefit. However, the factor of reputational benefits becomes increasingly more significant to directors as it also represents the most important incentive for them to join a board (Fama & Jensen, 1983).

This leads to a trend that directors start serving on more and more boards, which increases their reputation, their salary, and their expertise. But what is on the one hand good for the directors is on the other hand bad for the companies, which they are monitoring. As the probability of committing accounting fraud increase by a higher number of directorships held by directors of a company (Beasley, 1996). Another negative effect is that these busy directors tend to give higher CEO compensation packages, which than lead to poor firm performance (Core et al., 1999). Fich and Shivdasani (2006) detect in their research empirical evidence that if a majority of outside directors hold more than three directorships the firm has a significantly lower market-to-book ratio than firms with a majority of board members who hold less than three directorships. Busy boards also do not monitor the management properly as a forced CEO turnover is not affecting the firm's performance when the majority of outside directors are classified as busy (Fich & Shivdasani, 2006).

Therefore, if a board consists of a high number of busy directors, the corporate governance will suffer and thus implies a lower firm value, as the board members are not able to monitor the company properly which gives the management more freedom in their behavior.

6. Audit committee

The audit committee is one of the three basic committees (nominating, audit, and compensation), which all boards have. However, this committee is one of the most important ones, as their task is to oversight the auditing process and ensure a high quality of financial reporting. Their work is crucial for several stakeholders of a company.

i. Independence

The first factor in our analysis is the independence of the members of the audit committee. Because of their important position in the corporate governance of firms, legislators have imposed stricter rules for their independence to improve the quality of their outputs. This is also supported by the research of Klein (2002) who states that the abnormal accruals decrease with an increase of independent committee members, this effect is even stronger when the majority of the members are outside directors.

However, it is not enough that the audit committee consists of formal independent members, it is also necessary to investigate if the directors are fully independent or if there are any informal ties between the CEO and the directors. Bruynseels and Cardinaels (2014) state that social ties, in forms of friendships, lead to a poor oversight quality, so that earnings management activities increase, and the number of audit services decreases. Moreover, this affects the effectiveness of the auditor’s work, as it reduces the reports of internal control weaknesses (Bruynseels & Cardinaels, 2014). Although friendship ties are considered to affect the audit committee work negatively, social ties from an educational or professional background do not decrease the oversight and monitor the quality of the committee.

ii. Size

As we investigate the size for the overall board previously, we consequently consider this characteristic also for the audit committee. The size of the audit committee divers a lot between firms and ranges from one up to 12 directors, although the average size is between 4 and 5 directors. Anderson et al. (2004) observe in their empirical research that based on the average audit committee size an additional director decreases the cost of debt by 10.6 percent. Moreover, the yield spreads are negatively related to the frequency of the committee meetings (Anderson et al.,2004). These findings underline the importance of the audit committee in the financial accounting process and that a larger committee can divide their responsibilities better and achieve a superior oversight quality.

iii. Experts

In a complex process such as the audit and accounting procedures for a larger firm, it might be an advantage to have an audit committee consisting of members with a background in finance. Chan and Li (2008) assert that if an audit committee consists of a minority of independent directors a finance-expert does not increase the quality of the committee work. But if the finance-expert directors serve on an audit committee with a majority of independent directors the firm value is positively affected, and this effect is five times larger for these committees thenjust for an independent audit committee (Chan & Li, 2008).

Furthermore, if directors hold memberships in all the three important committees they can use their power to influence the composition and independence of the audit committee positively, as well as develop a greater understanding of the overall firm processes and are therefore able to work more effectively in all committees (Chan & Li, 2008).

[...]

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Details

Title
Which Characteristics Determine a Perfect Board of Directors? A Review of the Economic Literature
College
Maastricht University
Grade
1,3
Author
Year
2020
Pages
8
Catalog Number
V1119129
ISBN (eBook)
9783346485144
Language
English
Tags
board of directors, corporate governance, independent outside directors, CEO, agency problem, audit comittee
Quote paper
Felix Pütz (Author), 2020, Which Characteristics Determine a Perfect Board of Directors? A Review of the Economic Literature, Munich, GRIN Verlag, https://www.grin.com/document/1119129

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