An Alternative Measure of Corporate Governance using Discrete Principal

Component Analysis
Wendy Beekesa, Alex Hongb, Sian Owenc
a
Management School, University of Lancaster, Bailrigg, Lancaster, LA1 4YW, UK
b
UWA Business School, University of Western Australia, Perth, WA 6009, Australia
c
Australian School of Business, University of New South Wales, Sydney, NSW 2052, Australia

Abstract
How is corporate governance to be measured? Much past research has focused on forming an
index but this approach ignores the correlations between the variables forming the index and
may also carry redundant variables. Principal Component Analysis (PCA) is a possible solution
to these issues by distilling components from a Pearson correlation matrix. However, the
estimated correlation matrix may be biased when discrete governance variables are involved.
We use an alternative method known as discrete Principal Component Analysis which involves
applying PCA to a modified correlation matrix which takes into account the underlying
distribution of the governance variables. Using a sample of 760 firms in 2002, we find mixed
support for prior research. Larger boards are found to negatively impact future ROA of firms
whilst the proportion of old directors on the board has a negative relation with abnormal accruals
and abnormal returns.
1. Introduction

In the wake of corporate scandals of the 21st Century, corporate governance has never been more
importance. This leads to two questions, firstly, how is governance to be measured and,
secondly, does good corporate governance lead to better firm performance. Prior studies have
focused on self-constructed metrics such as the G-index of Gompers, Ishii and Metrick (2003)
which is composed of 24 external governance mechanisms. More recently, Bebchuk, Cohen and
Ferrell (2009) argued that a more concise entrenchment index, based on just six provisions, is
sufficient to determine equity returns. Brown and Caylor (2006) create a metric, the Gov-Score,
consisting of 51 internal and external corporate governance mechanisms before producing a
more parsimonious index, Gov-7, which they hold fully drives the relation between governance
and firm value.

Given the multi-dimensional nature of corporate governance, aggregating the variables into an
index ignores the correlations between these terms which could result in spurious inferences
(Agrawal and Knoeber (1996)). Further, these arbitrary constructs can also introduce bias and
measurement errors. Larcker, Richardson and Tuna (2007) deal with these issues by using
Principal Component Analysis (PCA) to distil 14 factors from 39 measures of corporate
governance which, they contend, embody a concise and reliable representation of corporate
governance.

Despite its usefulness as a data reducing technique, PCA as conventionally used has limitations
when applied to corporate governance variables, many of which are binary or discrete (count) in
nature. When applied to continuous variables, the Pearson correlations allow principal
components to be distilled in an unbiased setting provided the data is continuous. However,
when PCA is applied to binary and count variables, the correlation matrices from which the
principal components are derived underestimate the correlations between the variables1. This
bias results in a potential loss of explanatory power and could lead to incorrect conclusions
regarding the number of principal components and their associated variables (Beekes, Le and
Owen (2008)).

1
Appendix A illustrates this phenomenon.

2
Kolenikov and Angeles (2004) propose a more accurate estimate of the correlations in PCA
when discrete data is involved although they do not apply it to corporate governance data.
Beekes, et al. (2008) adopt this approach applying what they call discrete Principal Component
Analysis to corporate governance variables for UK firms. Discrete PCA employs a modified
correlation matrix to account for the nature of the pair of variables. For a pair of continuous
variables, the Pearson correlation coefficient is used as per prior studies. Tetrachoric correlations
as developed by Pearson (1901) are calculated for binary variable pairs. The correlations
between two count variables are estimated using polychoric correlations and for one discrete and
one continuous variable pairs, polyserial correlations are calculated (Pearson and Pearson
(1922)). 2

This paper addresses gaps in the literature by using discrete PCA on a large sample of US data to
distil components representing the majority of the underlying information. These components
are then used in the analysis of several regression models, following Larcker, et al. (2007)
relating governance to a variety of firm performance measures. We find that when discrete PCA
is applied to measuring corporate governance, some conclusions on the relation between
governance and firm performance measures change. This leads to the conclusion that the bias in
conventional PCA matters in some experimental settings.

The rest of this paper is constructed as follow: A discussion of corporate governance measures
and prior empirical research on the relation between corporate governance and firm performance
is provided in section 2. Section 3 covers a description of the dataset of governance measures
and firm characteristics. Section 4 shows the primary regression results with the four main
models and Section 5 concludes the paper.

2. Corporate Governance and its Measurement

Corporate governance mechanisms are intended to facilitate the effective exercise of power over
the management so as to increase the value provided to the organisation’s shareholders. Internal
2
Appendix A contains a mathematical derivation of the tetrachoric, polychoric and polyserial correlations.
governance mechanisms pertain to the structure of the board such as duality (in the role of
Chairman of the Board and Chief Executive of the company) and the proportion of independent
directors (Cremers and Nair (2005); Weir, Laing and McKnight (2002)). The main external
governance mechanism is the market for corporate control which functions as a mechanism of
last resort to keep the management from running the firm to the detriment of its shareholders
(Jensen (1986)). The confluence of these mechanisms leads to efficient corporate governance,
reducing the divergent interests of the principals and agents of the firm (Jensen and Meckling
(1976)). Ultimately, this re-alignment of interests should translate into superior firm
performance.

The purpose of measuring corporate governance is to develop a reliable proxy for the unseen
human element behind a firm’s decision making process. For example, board independence is
measured by the proportion of independent directors. The main use of this number is its
correlation with a certain type of behaviour. Independent directors, by definition should not be
aligned with managers, and should act in a more objective manner which, in turn, should
positively impact the wealth of the company’s shareholders.

Corporate governance metrics have been developed by both commercial governance ratings
firms and the research community. Past studies have made use of these various sources of
measures with varying degrees of success in establishing a link between corporate governance
and firm performance. In a seminal paper, Gompers, et al. (2003) construct their G-index using
the Investor Responsibility Research Center (IRRC) database of 24 anti-takeover provisions and
other governance measures. They find that well-governed firms with a low G-index have a
higher return on equity, higher firm value and higher stock returns. A hedge portfolio consisting
of a long position in firms with a low G-index and a short position in firms with a high G-index
yields significant abnormal returns of 8.5% per year between 1990 and 1999.

Bebchuk, et al. (2009) investigate the relative importance of the provisions used by Gompers et
al. (2003). An entrenchment index consisting of six of the 24 provisions of the G-index is
constructed and the authors believe that it fully explains the results of Gompers, et al. (2003).
The first component of the entrenchment index is the presence of a staggered board. The second,

4
third and fourth entrenchment provisions are the limitations on amending corporate bylaws and
corporate charters, and in gaining approval of mergers respectively. The fifth entrenchment
mechanism is the golden parachute and the sixth provision is the poison pill.

Brown and Caylor (2006) examine a more comprehensive set of 51 internal and external
governance mechanisms and construct an index, the Gov-Score. Better governed firms with a
higher Gov-Score are found to have higher Tobin’s Q, higher returns on equity and higher
returns on assets, when compared to firms with lower Gov-Scores. The authors then identify
seven factors underpinning the Gov-score that are sufficient to explain the relationship with firm
value. The first factor is whether the average options granted in the past three years exceeded
3% of basic shares outstanding. The next factor is the absence of a staggered board, meaning
that board members are elected annually. The absence or presence of a shareholder approved
poison pill constitutes the third factor. The fourth factor reflects whether option re-pricing
occurred within the last three years. The fifth factor is whether directors are subject to stock
ownership guidelines. The sixth factor is the attendance of 75% of board meetings by all
directors or the presentation of a valid excuse for non-attendance. Finally, the seventh factor
reflects the presence of board guidelines in each proxy statement

In spite of the extensive evidence that corporate governance is associated with firm performance,
there is another branch of literature which proposes the opposite. Extending Gompers, et al.
(2003), Core, Guay and Rusticus (2006) examine the relationship between corporate governance
and stock returns over the period of 1990 to 2003. They find that from 2000 to 2003, an
investment in firms with weak governance yields an annualised return of 4.3% while an
investment in firms with strong governance yields an annualised return of -5.8%. This
significant reversal from the trends in the 1990s lead Core, et al. (2006) to conclude that time-
period-specific factors caused the relationship between abnormal returns and governance that
was observed by Gompers, et al. (2003). Cremers and Ferrell (2009) extend the time series used
for studying the G-index backward to 1978 and forward to 2006. The authors note that from
1978 to 1990, an equal-weighted extreme decile portfolio of low minus high G-index firms has a
statistically significant spread of 7.54%, but from 1990 to 2007 this spread declines to 1.43%.
This weakens the proposition in Core, et al. (2006) that the G-index is sensitive to the time-
period in which it is applied. An alternative explanation for this phenomenon may be that
corporate governance was largely ignored by the market until after 2000, when corporate
collapses and academic interest brought to light its importance. Efficient markets then sought to
incorporate the benefits of good governance and the detriments of bad governance into equity
prices, thus weakening the predictive power of the G-index as far as stock performance is
concerned.

Creators of academic indices may not always have the incentive to generate proprietary value. It
is appropriate, therefore, to turn to those with a direct incentive to generate profits out of
corporate governance measures to see if their measures have greater predictive powers. Epps and
Cereola (2008) provide an assessment of the Institutional Shareholder Services Corporate
Governance Quotient (ISS CGQ) ratings. Instead of constructing their own metric, they use the
actual CGQ rating as a measure of corporate governance. Two financial performance measures
are used, namely, return on assets (ROA) and return on equity (ROE). Using these two
measures, the authors estimate six regressions for the years 2002 to 2004 but only one shows a
positive and significant relation between the CGQ rating and ROE, suggesting governance and
performance are not linked.

In more a comprehensive study, Daines, Gow and Larcker (2008) evaluate the metrics of three
governance ratings firms for 2005, (1) the Institutional Shareholder Service Corporate
Governance Quotient (ISS CGQ), (2) Governance Metrics International (GMI) rating, and (3)
The Corporate Library (TCL) rating. A measure of accounting risk, the Audit Integrity’s
Accounting and Governance Risk (AGR) rating is also included in the study. The firm
performance measures in the model are, (i) accounting restatements, (ii) class-action Lawsuits,
(iii) future operating performance as measured by ROA, (iv) firm value as measured by Tobin’s
Q, and (v) future excess stock returns (Alpha). They find that governance ratings in 2005 have
only weak predictive power with the firm performance measures.

Bhagat, Bolton and Romano (2007) analysed all the above-mentioned corporate governance
metrics across the commercial and academic fields and find no consistent relation between
governance metrics and stock returns, ROA, and CEO turnover from 2000 to 2002. Bhagat, et

6
al. (2007) conclude that no single index can predict all the performance measures valued by
shareholders. Indices are often constructed to treat corporate governance mechanisms as
complements, with Cremers and Nair (2005) lending support to this approach. Bhagat, et al.
(2007) disagree, however, and posit that governance measures are actually substitutes for each
other and, further, that the relation varies across firms and industries.

These inconsistencies in the literature raise questions about the reliability and validity of
constructs such as the G-index. Larcker, et al. (2007) question the ability of typical structural
indicators used in prior research to adequately capture the essence of corporate governance.
Econometric problems arise when corporate governance indicators are summed up in an index,
causing measurement errors and inconsistencies in the regression coefficients. For example, the
choice of certain governance provisions for inclusion in an index and the exclusion of others
may lead to the omission of correlated dimensions of corporate governance. If that occurs, the
resulting regression coefficients will be inconsistent and will not be interpretable. To overcome
these biases Larcker, et al. (2007) use PCA to develop a construct from the various dimensions
of corporate governance taking into account the correlations between the corporate governance
measures. Given the lack of theory on the structure of corporate governance, PCA seems to be a
more appropriate process of constructing a measure of corporate governance since it identifies
the governance indicators which are highly correlated (Dey (2008)).

In the development of their corporate governance construct, Larcker, et al. (2007) identify 39
mechanisms of corporate governance and use PCA to reduce them to 14 principal components,
accounting for 61.7% of the total variation of the original data. Using an oblique rotation to
allow the 14 components to be correlated, the interpretability of the PCA solution is enhanced.
The 14 components are taken to represent the underlying dimensions of corporate governance.
Four models are then used to test the relation between governance and the 14 principal
components. The dependent variables are abnormal accruals (Klein (2002)), earnings
restatements which is often linked to weak corporate governance (Beasley (1996); Dechow,
Sloan and Sweeney (1996); Faber (2005)), future operating performance as measured with
return on assets (ROA) (Barber and Lyon (1996); Core, et al. (2006)) and future abnormal stock
return (Alpha) as estimated using the Carhart (1997) four factor model. The 14 principal
components exhibit a mixed association with abnormal accruals and a weak relationship with
accounting restatements. The principal components also show some explanatory power when
return on assets and future excess stock returns are the dependent variables in the regressions.

Dey (2008) examined corporate governance factors in the context of agency costs by applying
PCA to 22 governance variables. Seven principal components representing the internal and
external governance mechanisms are distilled accounting for 62.4% of the total original
variation. Dey (2008) contends that corporate governance is associated with the level of agency
conflicts within a firm and she classifies agency conflicts into three levels: high, medium and
low. The classification is based on cluster analysis of seven characteristics of the firms. These
seven characteristics include firm size, complexity, ownership by non-executive and non-
institutional shareholders, growth prospects of the firm measured by book to market ratio,
leverage, risk denoted by the standard deviation of quarterly operating cash flows in the prior
year, and free cash flow of the firm. High agency conflicts are found to be significantly
associated with the seven principal components which reflect good governance. In firms with
high agency conflicts, a significant positive relationship is found between good governance and
Tobin’s Q. Lastly, good governance also has a positive impact on future ROA, with the
relationship being the strongest in firms with high agency conflicts. The findings illustrate the
relative importance of corporate governance amongst firms with different levels of agency
conflicts.

PCA derives the principal components by eigenvalue decomposition of the correlation matrix. It
reduces the dimensions in the data by retaining the factors which contribute most to the variation
of the data. The accuracy of the correlation matrix determines the validity of the principal
components which in turn determines the reliability of the conclusions. When the variables of
interest follow a continuous distribution, the Pearson product-moment correlations estimated in
the matrix are appropriate for PCA. However, corporate governance data usually include
variables which are discrete in nature. Pearson correlations coefficients among such variables
are neither meaningful nor interpretable. Furthermore, there is evidence that the Pearson’s
correlation coefficients tend to be underestimated for pairs of variables which involve discrete

8
data (Beekes, et al. (2008)). Similar problems are presented by count variable pairs with less
than 12 categories (Kolenikov and Angeles (2004)).

Kolenikov and Angeles (2004) modify the PCA methodology to suit the discrete socio-economic
variables in their study. This method solves the eigenproblem for a polychoric correlation matrix
which accounts for the continuous and discrete distributions underlying the variables. Beekes, et
al. (2008) refer to the modification as discrete PCA. In deriving the correlation matrix, these
authors estimate Pearson’s correlations for variable pairs which follow continuous distributions.
Tetrachoric correlations are estimated for two binary variables (Pearson (1901)). For a pair of
count variables, polychoric correlations are estimated (Pearson and Pearson (1922); Olsson
(1979)). For a pair of variables with one following a discrete distribution and another a
continuous distribution, polyserial correlation are estimated according to Pearson and Pearson
(1922). Beekes, et al. (2008) study 383 firms from March 2002 to September 2003. They
decompose 23 governance variables into four principal components using 13 of the 23 variables.
Governance factors in the principal components are found to have no explanatory power for
buy-and-hold abnormal returns.

The existing body of literature where PCA and discrete PCA are applied to corporate
governance research represents inconsistency and uncertainty as to the effectiveness of the
principal components as measures of corporate governance. Correlation coefficients of discrete
variables estimated under standard PCA are often lower than correlation coefficients estimated
under discrete PCA. Prior research applying PCA to corporate governance measures rests on the
assumption that this difference does not matter (Dey (2008); Larcker, et al. (2007)). With the
above framework in mind, this paper attempts to fill the gap in the literature by applying
Discrete PCA to a dataset similar to that in Larcker, et al. (2007). Thereafter, the principal
components are tested against the firm performance and accounting variables identified by
Larcker, et al. (2007).

3. Data and Methodology

3.1 Sample size and time period
We employ a similar sample and research setting of Larcker, et al. (2007) but use discrete PCA
rather than the standard approach. The primary analyses will span the year ended 31 December
2002 which is deemed the closest to the Larcker, et al. (2007) study. Data on 23 of the 39
corporate governance variables used by Larcker, et al. (2007) were obtained, giving a sample
size of 760 firms.

The RiskMetrics Directors Dataset serves as a source of governance variables related to the
Board of Directors. The Thompson Reuters Institutional Holdings (13f) Database is the source
of institutional ownership variables. Debt related variables are obtained from COMPUSTAT.
Lastly, the anti-takeover variables are found in the RiskMetrics Governance Dataset. Descriptive
statistics for the corporate governance variables are presented in Table 1. All control variables
are obtained from COMPUSTAT. The firm performance measures are also obtained from
COMPUSTAT and CRSP. Table 2 provides descriptive statistics for the performance measures
used as the dependent variables.

[Insert Table 1 here]

[Insert Table 2 here]

3.2. Methodology
To obtain the measure of corporate governance, We employ the criteria described in Hair,
Anderson, Tatham and Black (1998) in selecting variables to include in the discrete PCA3. In
spite of these criteria, PCA still involves a substantial amount of discretion on the part of the
researcher. We begin by creating the two types of correlation matrices, the Pearson correlation
matrix and the Polychoric correlation matrix. The latter consists of pair-wise correlations
generated according to the underlying distribution of the corporate governance variables. The
Stata command for calculating the polychoric correlations is obtained from Kolenikov and
Angeles (2004).4

3
See Appendix B for a description of these criteria.
4
The program used here is available from Kolenokov and Angeles at http://www.unc.edu/~skolenik/stata/ and is the same
one used in their paper.

10
Of 23 governance variables in our initial sample, six are excluded because they do not meet the
criteria laid out by Hair, et al. (1998). Variables which have an anti-image correlation of under
0.5 fail the sampling adequacy criteria. These include, Percent Busy Affiliated, State
Incorporated, Percent Largest Institutions, CC Chair Affiliated. The Debt to Market variable is
removed because its communality value is below 0.5. Percent Board Insiders variable is also
omitted because it cross loads on multiple components. The exclusion of these variables is
inconsistent with Larcker, et al. (2007) finding that all the variables meet criteria to be included
in standard PCA.

The discrete PCA methodology as employed in Beekes, et al. (2008) is applied to the remaining
corporate governance variables. The correlation matrix of continuous, count and binary variables
is estimated according to the nature of the underlying distributions of the governance variables.
The eigenproblem of the correlation matrix is then solved to yield the principal components.
Components with eigenvalues greater than unity are again retained for analysis. The governance
variables are found to load on seven principal components, explaining 66.43% of the variance.
Columns 1 to 7 of Table 3 present the principal components derived under discrete PCA. DPC1
stands for “Discrete Principal Component 1” where “1” refers to the first component distilled. 5

[Insert Table 3 here]

As seen in Table 3, DPC1 (Board Size) has three variable loadings related to board size. The
three loadings are all positive, meaning that the compensation committee, audit committee, and
board, all increase in size together. Given the sensible interpretation of these loadings, DPC1
(Board Size) possesses content validity (Hair, et al. (1998)) as a measure of corporate
governance. DPC2 (Affiliated Directors) has three variables loading on it, namely, Percent AC
Affiliated, Percent CC Affiliated, and AC Chair Affiliated. Three variables pertaining to anti-
takeover mechanisms load on DPC3 (Anti-takeover). They are Staggered Board, Poison Pill,
and Supermajority.

5
We also use standard PCA on the same data and compare the results. As can be seen in Appendix C, the principal
components generated under the standard approach are very different to those produced by the discrete technique.
This illustrates the issues involved in using the incorrect PCA methodology with discrete data.
DPC4 (Busy Directors) contains two variables, Percent Busy Insiders and Percent Busy
Outsiders. DPC5 (Institutional Blocks) consist of two variables pertinent to institutional block
holdings, Percent Block Owned and Percent Block Own. DPC6 has two variables which measure
the proportion of insider directors, Insider Chairman and Percent Old Insiders. Lastly, DPC7
has variables measuring the proportions of old directors on the board, Percent Old Affiliated and
Percent Old Outsiders.

Before the metrics are calculated, the corporate governance variables are normalised because the
original data has different scales. We follow Larcker, et al. (2007) and calculate the corporate
governance metrics by adding up the normalised variables which load on a component and
taking their average. For example, DPC1 (Board Size) is calculated by taking the normalised
values [(CC Size + AC Size + Board Size6) / 3]. Some components, such as DPC2, contain
negative loadings on all variables. The variables are still summed up in the same manner
[(Percent CC Affiliated + Percent AC Affiliated + AC Chair Affiliated) / 3]. The component can
be interpreted as follows: the larger the component, the more affiliated directors on the audit and
compensation committees. Adding a negative sign to each of the three variables just because of
their negative loadings would merely complicate the interpretation of the component. As a
result, we refrain from doing so.

3.4 Regression models

Following Larcker, et al. (2007), a series of cross-sectional regressions are employed to test the
relationship between the measures of corporate governance under discrete PCA against
abnormal accruals (signed and absolute values), earnings restatements, return on assets, and
Alpha.

The principal components representing the governance factors are regressed as independent
variables with dependent variables being the performance measures employed by Larcker, et al.
(2007). Model 1 is the governance only specification which makes the assumption that

6
Note that this Board Size refers to the corporate governance variable and should be distinguished from DPC1 (Board
Size) which is the principal component.

12
governance factors have a direct impact on the dependent variables and have no impact on the
controls. Model 2 is the governance and controls specification which investigates the possibility
that the governance variables may also interact with the controls. Finally, Model 3 and 4 are
added, where appropriate, to include the governance variables that were previously excluded
from the earlier discrete PCA.

4. Regression Results

4.1 Future operating performance

Prior corporate governance studies have used return on assets (ROA) as an accounting based
measure of future operating performance (e.g. Cremers and Nair (2005); Epps and Cereola
(2008)). We follow Larcker, et al. (2007) and use future operating performance (ROAt+1) as a
dependent variable as specified in equations 1 to 4. The results can be seen in Table 4.

∑ , (1)

∑ , ∑ , (2)

∑ , ∑ , (3)

∑ , ∑ , ∑ , (4)

Where:
: The principal components created from the governance variables
, : Regression coefficients
: The industry adjusted ROA created by subtracting the median industry ROA
from firm ROA, using two-digit identifiers.
: Other control variables. In this case, the natural logarithm of a firm’s market
capitalisation is used to control for firm size.
: Other governance variables that were excluded from the principal component
analysis
[Insert Table 4 here]

Consistent with Larcker, et al. (2007), the coefficient of DPC1 (Board Size) is negative and
significant in both Model 1 and 2. This finding indicates that smaller boards see increased future
operating performance in the year after these particular corporate governance measures are
observed. This result is consistent with the literature that firms with smaller board sizes tend to
display better performance (Yermack (1996)).

DPC7 (Old Directors) shows a negative relation with future ROA in both Models 1 and 3 but is
insignificant in the regression models using the industry adjusted ROA as the dependent
variable. The coefficient suggests that more old directors on the board and its committees has a
negative impact on future operating performance. This is inconsistent with Larcker, et al.
(2007) whose measure of old directors has a positive but insignificant relation with future ROA.
The control variable Log (Market Cap) is positive and significant. This could indicate that firms
with old directors and larger boards tend to have higher market capitalisations. In these models,
the variable DPC7 (Old Directors) loses its statistical significance although it retains the
negative sign whilst DPC1 (Board Size) remains statistically significant. All other principal
components show no substantial changes in signs or significances from the previous governance
only specification (Model 1).

We now consider the impact of the governance variables that were excluded earlier. These are
added in Models 3 and 4. The previously excluded governance variable, Percent Board
Insiders, is positive and significant in these models implying that an increased proportion of
executive directors can lead to a higher future ROA. In initial discrete PCA analysis, which is
not reported here for reasons of brevity, it was found that Percent Board Insiders loads
negatively on DPC1. If that variable had been incorporated into the principal component, it
would be interpreted as larger boards have a lower proportion of inside directors, which makes
intuitive sense. However, this variable was excluded from analysis due to multiple cross
loadings on other principal components. The findings here, however, point to the possibility that
the component DPC1 (Board Size) may be a proxy for board independence also, thus explaining

14
its loss of significance when a more direct measure of board independence is included in the
regression.

Model 4 presents the results of the governance and controls specification. After adjusting for
industry affiliation and controlling for firm size, all components except DPC3 (Anti-takeover)
are insignificant. The results here show that when discrete PCA is used as a measure of
governance, interactions with the excluded variables increases the significance of DPC3 (Anti-
takeover). Among the other corporate governance variables included in the regression, Percent
Board Insiders is again significant at the 1% level.

4.2 Abnormal accruals

Previous studies such as Klein (2002) use abnormal accruals as a measure of earnings quality.
Larcker, et al. (2007) also note that “flexibility afforded through accrual accounting makes the
accrual component of earnings less reliable than the cash flow component and therefore a
potentially useful measure for examining the quality of financial reports”. The modified Jones
(1991) model developed by Dechow, Sloan and Sweeney (1995) is used to estimate abnormal
accruals. Following Larcker, et al. (2007), two additional independent variables are added to the
modified Jones model. The book to market ratio (BM) is included as a proxy for expected
growth in firm operations and current operating cash flows (CFO) are also included. The model
is as follows:

, ∆ ∆ , , , , , (5)
Where:

, : Total accruals, the difference between operating cash flows

: Regression coefficients
∆ , : Change in sales from the previous year to the current year
∆ : Difference in accounts receivable from the start to the end of the year
, : End of the year value of property, plant and equipment
, : Book-to-market ratio
, : Current operating cash flows
Abnormal accruals are the residual values from this model. The signed (Model 1) and absolute
values (Model 2) of the abnormal accruals are then regressed as dependent variables using the
discrete principal components generated earlier. Table 5 contains the results.

[Insert Table 5 here]

Table 5 shows the results of regressions under these two models. Model 1 reports the result
using the signed values of the abnormal accruals and, amongst the principal components, only
DPC7 (Old Directors) is significant. The negative coefficient suggests that as the proportion of
old directors increases, the abnormal accruals become more negative. This finding is
inconsistent with Larcker, et al. (2007) but these authors do note that results of this type could
be due to unreliable measures of abnormal accruals. Further, old directors are a characteristic of
less effective boards, according to Core, Holthausen and Larcker (1999), which may offer an
explanation for the negative relation. Model 2 shows the regression of the corporate governance
measures with the absolute value of abnormal accruals in which there are no significant principal
components.7

4.3 Earnings restatements

Earnings restatements are thought to be a reflection of weak corporate governance mechanisms
to keep management behaviour in check (Dechow, et al. (1996)). Using a hand collected sample
of earnings restatements from the Accounting and Auditing Enforcement Releases of the
Securities and Exchange Commission, we construct a binary dependent variable Earnings
Restatements where “1” indicates that the company has restated earnings and “0” otherwise.
Only companies where corporate governance variables are available are used in the model. For
example, if corporate governance data is available for a firm in the fiscal year beginning January
2002, any restatements which occur from January 2002 up to December 2008 are recorded as
“1”. This leaves a sample of 19 restatement firms and 435 non-restatement firms, or 4.18% of
the sample showing “1” observations.8 We match restatement firms and non-restatement firms
using the percentages in each year. A logistic regression model is employed to analyse the

7
As a robustness test, models are also estimated adding the previously excluded governance variables to the
models. The results are unchanged from those reported here and are not include here for reasons of brevity.
8
This is consistent with Larcker, Richardson and Tuna (2007) who code 5.64% of their sample in the same way.

16
characteristics of firms that restate their earnings as compared to non-restating firms and the
results can be seen in Table 6.

The governance factors used here are the same principal components as were used previously.
In this instance, however, the list of control variables is rather more extensive. The control
variables are: (1) BM is the book to market ratio at the end of the fiscal year prior to the
restatement year; (2) Log (Market Cap.) which is the natural logarithm of the market
capitalisation at the end of the fiscal year prior to restatement; (3) Leverage defined as the total
debt divided by total assets at the end of the fiscal year prior to restatement; (4) External
Financing defined as the net equity financing plus net debt financing, deflated by the beginning
market value of equity of the fiscal year where the restatement occurred and (5) Acquisitions
which refers to the total cash spent on acquisitions spent on acquisitions during the fiscal period
in which there was a restatement. As before, we then also report a model (Model 3) in which the
previously excluded governance terms are featured.

[Insert Table 6 here]

As can be seen here, there appears to be no relation between earnings restatements and corporate
governance variables under Model 1. Model 2 shows the results under the corporate governance
and controls specification. Again, all coefficients of the corporate governance metrics remain
insignificant but the controls for size (Log (Market Cap.)) and external financing are both
significant suggesting that large firms that have problems raising external funds are more likely
to restate their earnings. Finally, Model 3 shows the regression results including principal
components, controls and previously excluded variables. Whilst none of the components are
significant, the control variables are consistent with Model 2 and now the dummy variable CC
Chair Affiliated shows a positive relationship with earnings restatements suggesting that having
the Chair of the Compensation Committee affiliated to the firm increases the probability of
restatements.

4.4 Future Abnormal Returns (Alpha)

Finally we test the link between corporate governance and equity returns. Following Larcker, et
al. (2007), future abnormal returns are estimated for each firm in the 24 months after their fiscal
year end. The abnormal returns are estimated using the Carhart (1997) four factor model, as in
equation 6.

, (6)
Where:

: Raw stock returns of a company

: Intercept term denoting abnormal returns (Alpha)
: Regression coefficients
:
: The average return on three small portfolios minus the average return on three big
portfolios
: The average return on two value portfolios minus the average return on two
growth portfolios
: The average return on the two high prior return portfolios minus the average
return on the two low prior return portfolios

Alpha is estimated from the intercept coefficient of the above regression model and used as a
dependent variable in a regression model with the seven discrete principal components derived
above. The results can be seen in Table 7.

[Insert Table 7 here]

DPC7 (Old Directors) show a negative relationship with Alpha which is inconsistent with
Larcker, et al. (2007) but consistent with the characteristics of less effective management as in
Core, et al. (1999). All other coefficients in the regression are insignificant.9

5. Conclusion
Using data similar to Larcker, et al. (2007), we investigate the relation between corporate
governance and firm performance. We reduce the governance data down to seven principal

9
As before, a robustness test was run using the governance variables previously excluded from the principal
components. The results remain unchanged and are not reported for reasons of brevity.

18
components and we extend on the previous literature by using discrete PCA to correct for the
bias introduced when standard correlation matrices are used in this process. Using discrete PCA
as a measure of corporate governance increases the validity of the measure and gives researchers
more confidence in interpreting their results.

We use these components in an analysis of the relation between governance and firm
performance for the year 2002. We find mixed support for the findings of Larcker, et al. (2007)
when discrete PCA is used. Larger boards are found to have a significantly negative impact on
future ROA for firms in our sample. Another interesting finding is the impact of old directors.
We see that the proportion of old directors on the board has a negative relation with signed
abnormal accruals. Old directors also negatively impact abnormal returns, perhaps reflecting the
lower efficiency of boards with larger numbers of old members (Core, et al. (1999)).

A question that arises is whether discrete PCA alone has adequately captured all the meaningful
aspects of corporate governance in their loadings. To answer this question, we include both
control variables and the governance variables which were excluded as being unsuitable for use
in principal components. The variable Percent Board Insiders, representing the proportion of
insider directors on the board, was excluded from the principal component analysis but was
found to have a significant impact on firm performance. This highlights the need to include
other variables even if they are not suitable for use in PCA.

The primary analysis points to the fact that the use of discrete PCA leads to some conclusions
which do not support the findings of past research. When measures of corporate governance are
constructed using principal component analysis, it is clear that researchers should acknowledge
the presence of possible biases and correct for these using discrete PCA. However, given the
many insignificant measures of corporate governance in the various models, it seems that the
there is no single approach in structuring governance mechanisms to optimise firm performance,
an argument also made by Bhagat, et al. (2007).
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Table 1: Descriptive Statistics for Corporate Governance Variables, 2002, N=760 Firms
Panel A: Count and Continuous Variables
Variable Distribution Mean Std Dev Min Q1 Median Q3 Max
CC Size Count 3.62 1.21 1.00 3.00 3.00 4.00 11.00
AC Size Count 3.77 1.09 2.00 3.00 3.00 4.00 11.00
Board Size Count 9.91 2.92 4.00 8.00 10.00 12.00 24.00
Percent Board Insiders Continuous 19.71 10.67 5.56 11.11 16.67 25.00 69.23
Percent Busy Outsiders Continuous 4.40 9.37 0.00 0.00 0.00 0.00 66.67
Percent Busy Affiliated Continuous 5.33 19.50 0.00 0.00 0.00 0.00 100.00
Percent Busy Insiders Continuous 14.07 30.51 0.00 0.00 0.00 0.00 100.00
Percent Old Outsiders Continuous 11.18 17.39 0.00 0.00 0.00 20.00 100.00
Percent Old Affiliated Continuous 12.49 28.25 0.00 0.00 0.00 0.00 100.00
Percent Old Insiders Continuous 2.50 11.21 0.00 0.00 0.00 0.00 100.00
Percent AC Affiliated Continuous 15.05 19.17 0.00 0.00 0.00 33.33 100.00
Percent CC Affiliated Continuous 13.73 19.99 0.00 0.00 0.00 25.00 100.00
Percent Block Owned Continuous 15.93 12.63 0.00 6.43 13.85 22.85 67.84
Number of Blocks Count 1.90 1.40 0.00 1.00 2.00 3.00 7.00
Percent Largest
Continuous 9.15 4.81 2.01 6.08 8.27 11.34 55.70
Institution
Debt to Market Continuous 0.70 1.60 0.00 0.07 0.27 0.73 16.40
Panel B: Indicator Variables
No. of
Variable Distribution Value Proportion (%)
Observations
0 702 92.37
AC Chair Affiliated Binary
1 58 7.63
0 697 91.71
CC Chair Affiliated Binary
1 63 8.29
0 160 21.19
Insider Chairman Binary
1 595 78.81
0 286 37.63
Staggered Board Binary
1 474 62.37
Supermajority Binary 0 617 81.18

22
 1 143 18.82
0 681 89.61
State Incorporated Binary
1 79 10.39
0 702 92.37
Poison Pill Binary
1 58 7.63

Table 1 presents the descriptive statistics for corporate governance factors in the sample. Panel A consists of the count and continuous variables. The
first column shows the name of the governance variable. The second column describes the distribution underlying the particular variables. The third
and fourth columns show the Mean and Standard Deviations respectively. The fifth to ninth columns show the Minimum (Min), First Quartile (Q1),
Median, Third Quartile (Q3) and Maximum (Max) values respectively. Panel B shows the indicator variables. Columns one and two show the
variable name and the underlying distributions respectively. The third column shows the possible values taken by the variables, 0 or 1. The number
of observations for each value is then shown in the fourth column. The fifth column shows the proportion of each value, 0 or 1, in the sample. The
description of each factor is as follows.

CC Size: Number of members on the compensation committee

AC Size:
Board Size:
Percent Board Insiders:
Percent Busy Outsiders:
Percent Busy Affiliated:
Percent Busy Insiders:
Percent of Old Outsiders:
Percent of Old Affiliated:
Percent of Old Insiders:
Percent AC Affiliated:
Percent CC Affiliated:
Percent Block Owned:
Number of Blocks:
Percent Largest Institution:
Debt to Market:
Preferred to Market:
AC Chair Affiliated:
CC Chair Affiliated:
Insider Chairman:
otherwise
Staggered Board:
Supermajority:
State Incorporated:
and 0 otherwise
Number of members on the audit committee
Number of members on the Board of Directors
Percentage of the board who are insiders (employee)
Percentage of independent (outside) directors who sit on four or more boards
Percentage of affiliated (linked) directors who sit on four or more boards
Percentage of insider (employee) directors who sit on two or more boards
Percentage of independent (employee) directors who are older than 70
Percentage of affiliated (linked) directors who are older than 70
Percentage of insider (employee) directors who are older than 70
Percentage of audit committee members who are affiliated (linked)
Percentage of compensation committee members who are affiliated (linked)
Percentage of company’s ordinary shares owned by institutional block holders
Number of institutional block holders
Percentage of ordinary shares held by the largest institutional shareholding
Ratio of book value of debt to the market value of equity
Ratio of book value of preferred equity to the market value of equity
Indicator variable equal to 1 where audit committee chairman is affiliated (linked), and 0 otherwise
Indicator variable equal to 1 where compensation committee chairman is affiliated (linked), and 0 otherwise
Indicator variable equal to 1 if an executive holds the position of the role of chairman of the board, and 0
Indicator variable equal to 1 if the firm has a staggered board, and 0 otherwise
Indicator variable equal to 1 if the firm has a supermajority provision for takeovers, and 0 otherwise
Indicator variable equal to 1 if the firm is incorporated in Pennsylvania, Ohio, Wisconsin or Massachusetts,
Unequal voting: Indicator variable equal to 1 if there are unequal voting rights across common shareholders, and 0 otherwise
Poison Pill: Indicator variable equal to 1 if the firm has adopted a poison pill, and 0 otherwise

An affiliated director is one who is a former employee; is an employee of or is a service provider, supplier, or customer; is a recipient of charitable
funds; is considered an interlocking or designated director; or is a family member of a director or executive.

24
 Table 2: Descriptive statistics of dependent variables
Industry
Abnormal |Abnormal
ROAt+1 Adjusted Alpha
Accruals Accruals|
Dependent variables ROAt+1

Mean 0.0775 0.0574 -0.0082 0.0637 0.0049

Sample size 740 731 644 644 648

Table 2 presents descriptive statistics for the dependent variable employed in the empirical results. Mean gives the
average value for each variable and sample size denotes the number of firms for which each measure could be
calculated.
Table 3: Principal Components Derived under Discrete PCA
Principal Components
DPC1 DPC2 DPC3 DPC4 DPC5 DPC6 DPC7
Aspect of Corporate Affiliated Anti- Busy Institutional Insider
Board Size Old Directors
Governance Directors takeover Directors Blocks Directors
Panel A: Total Variance
Variance Retained (%) 16.54 11.79 9.3 8.65 7.4 6.76 5.98
Cumulative Variance (%) 16.54 28.33 37.63 46.28 53.68 60.45 66.43
Panel B: Factor Loadings
Variables
CC Size 0.882
AC Size 0.806
Board Size 0.721
Percent AC Affiliated -0.856
Percent CC Affiliated -0.526
AC Chair Affiliated -0.815
Staggered Board 0.777
Poison Pill 0.704
Supermajority 0.624
Percent Busy Insiders 0.743
Percent Busy Outsiders 0.708
Percent Block Own 0.976
Number of Blocks 0.970
Insider Chairman -0.781
Percent Old Insiders -0.734
Percent Old Affiliated 0.840
Percent Old Outsiders 0.638
Table 3 presents the principal components derived using Discrete PCA. Panel A represents the total variance, showing the percentage of the variance represented
by each component and then the cumulative variance. Panel B shows the factor loadings for each component. The description of each factor is as follows.

26
CC Size:
AC Size:
Board Size:
Percent AC Affiliated:
Percent CC Affiliated:
AC Chair Affiliated:
Staggered Board:
Poison Pill:
Supermajority:
Percent Busy Insiders:
Percent Busy Outsiders:
Percent Block Owned:
Number of Blocks:
Insider Chairman:
Percent of Old Insiders:
Percent of Old Affiliated:
Percent of Old Outsiders:
Number of members on the compensation committee
Number of members on the audit committee
Number of members on the Board of Directors
Percentage of audit committee members who are affiliated (linked)
Percentage of compensation committee members who are affiliated (linked)
Indicator variable equal to 1 where audit committee chairman is affiliated (linked), and 0 otherwise
Indicator variable equal to 1 if the firm has a staggered board, and 0 otherwise
Indicator variable equal to 1 if the firm has adopted a poison pill, and 0 otherwise
Indicator variable equal to 1 if the firm has a supermajority provision for takeovers, and 0 otherwise
Percentage of insider (employee) directors who sit on two or more boards
Percentage of independent (outside) directors who sit on four or more boards
Percentage of company’s ordinary shares owned by institutional block holders
Number of institutional block holders
Indicator variable equal to 1 if an executive holds the position of the role of chairman of the board, and 0 otherwise
Percentage of insider (employee) directors who are older than 70
Percentage of affiliated (linked) directors who are older than 70
Percentage of independent (employee) directors who are older than 70

An affiliated director is one who is a former employee; is an employee of or is a service provider, supplier, or customer; is a recipient of charitable funds; is
considered an interlocking or designated director; or is a family member of a director or executive.
Table 4. Regression Models for Future Operating Performance
Model 1 Model 2 Model 3 Model 4
Variable Industry Industry

ROAt+1 Adjusted ROAt+1 Adjusted

ROAt+1 ROAt+1
Intercept
0.0774*** -0.1446** 0.0774*** -0.1437**
(0.0000) (0.0281) (0.0000) (0.0292)
Principal Components
DPC1 (Board Size) -0.0114*** -0.0098** -0.0046 -0.0026
(0.0216) (0.1038) (0.3748) (0.6770)
DPC2 (Affiliated Directors) 0.0074** 0.0046* 0.0059 0.0009
(0.2623) (0.5250) (0.3610) (0.8880)
DPC3 (Anti-takeover) 0.0074 0.0112 0.0084 0.0124*
(0.2844) (0.1323) (0.1919) (0.0809)
DPC4 (Busy Directors) -0.0015 -0.0062 0.0017 -0.0029
(0.7726) (0.2665) (0.7696) (0.6246)
DPC5 (Institutional Blocks) 0.0033 0.0020 0.0004 -0.0012
(0.5729) (0.7235) (0.9484) (0.8330)
DPC6 (Insider Directors) -0.0026 -0.0005 -0.0057 -0.0041
(0.6921) (0.9342) (0.3737) (0.5118)
DPC7 (Old Directors) -0.0121** -0.0055 -0.0133*** -0.0070
(0.0214) (0.3655) (0.0148) (0.2617)
Control Variables
Log (Market Cap) 0.0259*** 0.0258***
(0.0013) (0.0014)
Previously Excluded Governance Variables
Percentage Board Insiders 0.0135** 0.0156***
(0.0238) (0.0140)
Percentage Busy Affiliated 0.0051 0.0067
(0.1582) (0.1510)
Percent Largest Institution 0.0066 0.0073
(0.2038) (0.1733)
State Incorporated -0.0001 -0.0005
(0.9820) (0.9094)
Debt to Market -0.0099 -0.0092
(0.3179) (0.3208)
CC Chair Affiliated 0.0004 0.0046
(0.9048) (0.2541)
Number of Observations 740 731 740 731
Adjusted R2 0.29% 7.89% 1.17% 8.93%
p-value (F-statistic) 0.2450 0.0000 0.0625 0.0000

28
Table 4 shows the regression results of the future operating performance model. DPC refers to “Discrete Principal
Component” derived under Discrete PCA. The numbers represents the respective component numbers. The aspect
of corporate governance covered by the component is included in brackets. Model 1 shows the governance only
specification with no control variables. The dependent variable is the future operating performance, measured by
return on assets in the year after the corporate governance measure is obtained, ROAt+1. Model 2 shows the
governance and control specification of the regression models. The controls are the industry adjusted ROAt+1 which
is obtained by subtracting the median ROAt+1 from firm ROAt+1. The median ROAt+1 is that of firms belonging to
the same two-digit SIC code for industries with at least 5 firms. Log (Market Cap) is the natural logarithm of a
firm’s market capitalisation. Model 3 shows the governance only specification adding the previously excluded
governance variables and Model 4 combines all the governance terms and the control variable.

Percent Board Insiders: Percentage of the board who are insiders (employee)
Percent Busy Affiliated: Percentage of affiliated (linked) directors who sit on four or more boards
Percent Largest Institution: Percentage of ordinary shares held by the largest institutional shareholding
State Incorporated: Indicator variable equal to 1 if the firm is incorporated in Pennsylvania, Ohio, Wisconsin
or Massachusetts, and 0 otherwise
Debt to Market: Ratio of book value of debt to the market value of equity
CC Chair Affiliated: Indicator variable equal to 1 where compensation committee chairman is affiliated
(linked), and 0 otherwise

An affiliated director is one who is a former employee; is an employee of or is a service provider, supplier, or
customer; is a recipient of charitable funds; is considered an interlocking or designated director; or is a family
member of a director or executive.

*, **, *** denotes two-tailed significance level of 10%, 5% and 1% respectively. P-values are reported in the
parentheses.
Table 5. Regression Models for Abnormal Accruals
Model 1 Model 2
Variable |Abnormal
Abnormal
Accruals Accruals|
Intercept
-0.0083 0.0638***
(0.1319) (0.0000)
Principal Components
DPC1 (Board Size) 0.0023 -0.0010
(0.7581) (0.8826)
DPC2 (Affiliated Directors) -0.0084 0.0115
(0.3766) (0.1692)
DPC3 (Anti-takeover) 0.0052 -0.0015
(0.5354) (0.8352)
DPC4 (Busy Directors) 0.0029 -0.0049
(0.5000) (0.1718)
DPC5 (Institutional Blocks) 0.0023 0.0022
(0.7622) (0.7459)
DPC6 (Insider Directors) 0.0005 -0.0110
(0.9512) (0.1125)
DPC7 (Old Directors) -0.0131* 0.0039
(0.0733) (0.5632)
Number of Observations 644 644
Adjusted R2 -0.15% 0.02%
p-value (F-statistic) 0.5381 0.4151
Table 5 shows the regression results of the signed and absolute abnormal accruals. DPC refers to “Discrete
Principal Component” derived under Discrete PCA. The numbers represents the respective component numbers.
The aspect of corporate governance covered by the component is included in brackets. Model 1 shows the signed
dependent variable and Model 2 shows the absolute value. *, **, *** denotes two-tailed significance level of
10%, 5% and 1% respectively. P-values are reported in the parentheses.

30
Table 6. Logit Regression Models for Earning Restatements
Model 1 Model 2 Model 3
Variable
Intercept -3.1638*** -6.7760*** -7.5215**
(0.0000) (0.0007) (0.0001)
Principal Components
DPC1 (Board Size) 0.2090 0.2422 0.2705
(0.4880) (0.4744) (0.3762)
DPC2 (Affiliated Directors) 0.0659 0.1071 -0.1505
(0.8317) (0.7412) (0.6712)
DPC3 (Anti-takeover) 0.1670 0.0185 0.0580
(0.6867) (0.9636) (0.8877)
DPC4 (Busy Directors) 0.1330 0.0728 0.1376
(0.6322) (0.8180) (0.6649)
DPC5 (Institutional Blocks) 0.0136 -0.0832 -0.1577
(0.9348) (0.6793) (0.5031)
DPC6 (Insider Directors) -0.2209 -0.2189 -0.1877
(0.4234) (0.4627) (0.5164)
DPC7 (Old Directors) -0.0836 0.0069 0.0090
(0.7818) (0.9827) (0.9790)
Control Variables
Log (Market Cap) 0.4303* 0.4990**
(0.0603) (0.0192)
BM 0.2919 0.4601
(0.6435) (0.3807)
External Financing -4.8520** -4.9956**
(0.0481) (0.0222)
Acquisition -1.9564 -1.7209
(0.7512) (0.7961)
Free Cash Flow -0.0002 -0.0002
(0.3617) (0.3094)
Previously Excluded Governance Variables
Percentage Board Insiders -0.0926
(0.8032)
Percentage Busy Affiliated -0.2827
(0.4053)
Percent Largest Institution 0.1499
(0.5745)
State Incorporated -0.0656
(0.7629)
Debt to Market -0.3325
(0.3769)
CC Chair Affiliated 0.4540**
(0.0166)
 Number of Observations 454 454 454
Pseudo R2 1.12% 7.54% 10.93%
p-value (LR-statistic) 0.9717 0.4544 0.5057
Table 6 shows logistic regression results of the earnings restatements model. Model 1 shows the governance only
specification with no control variables. Model 2 shows the governance and control specification of the regression
models. The controls are book to market ratio BM in the period prior to restatement, the natural logarithm of market
capitalisation prior to the restatement year Log (Market Cap), net external financing External Finance, and net
acquisitions made Acquisitions. All control variables are winsorised to the two extreme percentiles, the 2nd and 98th
percentile. Model 3 shows the governance components, control variables and the previously eliminated governance
terms.

Percent Board Insiders: Percentage of the board who are insiders (employee)
Percent Busy Affiliated: Percentage of affiliated (linked) directors who sit on four or more boards
Percent Largest Institution:Percentage of ordinary shares held by the largest institutional shareholding
State Incorporated: Indicator variable equal to 1 if the firm is incorporated in Pennsylvania, Ohio, Wisconsin
or Massachusetts, and 0 otherwise
Debt to Market: Ratio of book value of debt to the market value of equity
CC Chair Affiliated: Indicator variable equal to 1 where compensation committee chairman is affiliated
(linked), and 0 otherwise

An affiliated director is one who is a former employee; is an employee of or is a service provider, supplier, or
customer; is a recipient of charitable funds; is considered an interlocking or designated director; or is a family
member of a director or executive.
*, **, *** denotes two-tailed significance level of 10%, 5% and 1% respectively. P-values are reported in the
parentheses.

32
Table 7. Regression Model of Abnormal Returns (Alpha)
Model 1
Variable
Intercept 0.0050***
(0.0000)
Principal Components
DPC1 (Board Size) -0.0002
(0.8995)
DPC2 (Affiliated Directors) 0.0005
(0.6884)
DPC3 (Anti-takeover) -0.0008
(0.5806)
DPC4 (Busy Directors) -0.0003
(0.7549)
DPC5 (Institutional Blocks) -0.0008
(0.3812)
DPC6 (Insider Directors) 0.0006
(0.5760)
DPC7 (Old Directors) -0.0024**
(0.0266)
Number of Observations 644
Adjusted R2 -0.19%
p-value (LR-statistic) 0.5638
Table 7 shows regression results of the abnormal returns model. The governance only specification is used for this
regression and Alpha is estimated using the Carhart (1997). *, **, *** denotes two-tailed significance level of 10%,
5% and 1% respectively. P-values are reported in the parentheses.
Appendix A: Mathematical Background

A.1 The underestimation of correlations between discrete variables adapted from

Appleton, Rugg-Gunn and Hackett (1986) (pp. 1346)

Suppose that two variables, x1 and x2, are bivariately normally distributed with a true population
correlation coefficient ρ. Let the estimated Pearson correlation coefficient from the dichotomised
data be ρ*. Figure 1 graphs the actual and estimated relationships between ρ and ρ*.

Figure 1
Graph of ρ against ρ*
1.0

0.8

0.6
ρ* Underestimation

0.4

0.2

0.0
0.0 0.2 0.4 0.6 0.8 1.0
ρ

ρ: absolute value of the true population correlation coefficient

ρ*: absolute value of the correlation between two dichotomised variables

------ ρ = ρ* Actual relationship between ρ and ρ* if both are estimated accurately

–––– ρ > ρ* Relationship between ρ and ρ* if the correlation between the discrete variables (ρ*) is estimated
using the Pearson correlation coefficient

As seen in Figure 1, if the correlations between the discrete (dichotomised) variables are
estimated accurately, the correlation of the dichotomised variables should be equal to the true
population correlation ρ as denoted by the red broken line. However, if ρ* is estimated using the
Pearson correlation, it tends to be less than the true population correlation as seen in the blue
solid line. The subsequent sections describe alternative methods of estimating correlations which
will be closer to the true population correlations.

34
A.2 Correlations between two binary variables: Tetrachoric correlations adapted from
Guilford (1965) (pp. 326-328) and Beekes, et al. (2008)

Tetrachoric correlations rt can be used to estimate the correlations of two binary variables. The
assumptions underlying the tetrachoric correlation ρt is that the two variables represent normally
distributed and linearly related variables.

Take for example two questions represented by variables X and Y. Let variable X represent the
question: Does the Audit Committee have affiliated directors? Let variable Y represent the
question: Does the Compensation Committee have affiliated directors? The assumption of
continuity and normality can be defended as follows: It is unlikely that companies which
respond “Yes” to either question do so with equal degrees of affirmation (having one affiliated
director on the Audit Committee is different from having the entire committee filled with
affiliated directors). Likewise, it is unlikely for companies which respond “No” to do so with
equal degrees of negation (there may be directors who do not meet the technical definition of
affiliation – which is being linked to the company – but still have a close relationship with the
company, akin to affiliation). The answers to either question are likely to represent a continuum
extending from strong affirmation to strong negation.

Table A.1 shows an example of a contingency table from which the tetrachoric correlations
between a pair of binary variables are derived. The two variables are assumed to follow a
theoretical bivariate normal distribution of cases divided into four categories by dichotomising
distributions on X and Y.

Table A.1
2 x 2 contingency table for two binary variables X and Y
Variable X

No Yes Total Proportion

167 374 541 0.582

Yes
Variable Y

b a b+a (b + a) / N = p

203 186 398 0.418

No
d c d+c (d + c) / N = q

930
370 560
Total a+b+c+d
b+d a+c
=N
0.398 0.602 1.000
Proportion (b + d) / N = (a + c) / N = p + q + p' + q' =
q' p' 1
The equation for the tetrachoric correlation ρt is computed as follows (adapted from Pearson
(1901), Guilford (1965) and Beekes, et al. (2008))

ρt = ad – bc (i)
yy' N2

An alternative expression of the tetrachoric correlation is as follows Guilford (1965) (pp.527):

1 h k
   X i2  2 X 1 X 2  X 22 
 h, k ;    2 1   2 2 
1

 
  

exp
21     dxdy

(ii)

ρ represents the tetrachoric correlation coefficient.

X1 and X2 represent the two dichotomous variables.
h and k are the thresholds that discretize the latent variable.

A.3 Correlations between two count variables: Polychoric correlations (adapted from
Pearson (1901), Pearson and Pearson (1922), Olsson (1979) and Beekes, et al. (2008))

The polychoric correlation is used to measure the correlation between two count variables such
as the number of directors on the board and the number of institutions holding shares in the
company. It is derived as follows: X1 and X2 represent the two count variables with the
underlying latent continuous, normally distributed variables X 1* , X 2* can be estimated using the
maximum likelihood method and the following function:

N K1 K2 N
  xi ,1 , xi , 2 ;  ,  
I  xi ,1  j , xi , 2  q 
L      j, q;  ,   (iii)
i 1 j 1 q 1 i 1

where  represents the categorizing thresholds given by:

   1, 0   1,1  ...   1, K1 1   1,K1   for X 1 and
    2 ,0   2,1  ...   2, K 2 1   2 ,K 2   for X 2
such that x1  1,K1 when 1,K1 1  x1*  1,K1 and x 2   2, K 2 when  2,K2 1  x2*   2,K2

Given this, the log-likelihood function is as follows:

N
Ln L    Ln  xi ,1 , xi , 2 ;  ,   (iv)
i 1

36
A.4 Correlations between one discrete and one continuous variable: Polyserial correlations
adapted from Beekes, et al. (2008)
Polyserial correlations measure the correlation between a pair of variables with one being
discrete and one being continuous in nature. The coefficients are derived as follows:

 
L ,  ; x1  1,K , x 2   Pr 1, K 1  x1*  1, K |x2   x 2 
(v)
  1,K  x 2    1,K 1  x 2   x 2 

X 1 is a discrete variable with the underlying normally distributed variable X 1* discretized

according to the thresholds    1,0  1,1  ...  1,K1 1  1,K1  
X 2 is a continuous variable.
Appendix B: Criteria for including corporate governance variables in Discrete PCA

We adopt the criteria set out in Hair, et al. (1998) as follows:

B.1 Anti-image correlation matrix

The anti-image correlation matrix contains the negatives of the partial correlation coefficients.
Diagonal correlations in the matrix are a measure of sampling adequacy and quantify the degree
of inter-correlations among the variables and the appropriateness of applying PCA. In a good
factor model, the diagonal correlations must all be above 0.5 while off-diagonal elements should
be smaller. Variables which do not meet this criterion are omitted.

B.2 Kaiser-Meyer-Olkin (KMO) and Bartlett test of sphericity

The KMO value is a measure of sampling adequacy, and tests if the partial correlations among
the variables are small. The KMO value should be greater than 0.5 for sampling adequacy to
hold. “The Bartlett test of sphericity is a statistical test for the presence of correlations among
variables” Hair, et al. (1998). It ensures that the correlation matrix is an identity matrix.

B.3 Communality (h2)

The Communality (h2) values are the squared multiple correlations for the variable as dependent
using the factors as predictors. This measure shows the percentage of variance in a given
variable explained by all the factors jointly and is indicative of which variables the PCA is
working well on. As a general rule, the h2 value should be above 0.5. A communality below this
value could mean that the factor model is not working well for that variable and it may need to
be removed.

B.4 Loadings and cross-loadings

To ensure practical significance of each component, corporate governance variables which have
loadings larger than 0.4 are considered important. Such variables are retained as constituents of
the corresponding components on which they load. Variables with loadings of 0.4 or greater on
multiple principal components are deleted from the analysis. However, Hair, et al. (1998) also
note a challenge faced by researchers since “a variable with several significant loadings must be
considered in interpreting (labeling) all the factors on which it has significant loading”.

38
 Appendix C: Principal Components Derived under Standard PCA

Principal Components
SPC1 SPC2 SPC3 SPC4 SPC5 SPC6 SPC7 SPC8
Aspect of Corporate Affiliated Institutional Anti- Old Insider Affiliated Busy
Board Size
Governance Directors I Blocks takeover Directors Directors Directors II Directors
Panel A: Total Variance
Variance Retained (%) 15.45 11.51 8.82 7.45 7.3 6.65 6.22 6.03
Cumulative Variance
15.45 26.97 35.80 43.25 50.56 57.21 63.44 69.47
(%)
Panel B: Factor Loadings
Variables
CC Size 0.862
AC Size 0.842
Board Size 0.761
Percent AC Affiliated -0.758
Percent CC Affiliated 0.791
AC Chair Affiliated -0.861
CC Chair Affiliated 0.866
Staggered Board 0.769
Poison Pill 0.791
Supermajority
Percent Busy Insiders 0.788
Percent Busy Outsiders 0.742
Percent Block Own 0.974
Number of Blocks 0.974
Insider Chairman 0.797
Percent Old Insiders 0.658
Percent Old Affiliated 0.792
Percent Old Outsiders 0.664
Table 3 presents the principal components derived using Discrete PCA. Panel A represents the total variance, showing the percentage of the
variance represented by each component and then the cumulative variance. Panel B shows the factor loadings for each component. The description
of each factor is as follows.

CC Size: Number of members on the compensation committee

AC Size:
Board Size:
Percent Board Insiders:
Percent Busy Outsiders:
Percent Busy Affiliated:
Percent Busy Insiders:
Percent of Old Outsiders:
Percent of Old Affiliated:
Percent of Old Insiders:
Percent AC Affiliated:
Percent CC Affiliated:
Percent Block Owned:
Number of Blocks:
Percent Largest Institution:
Debt to Market:
Preferred to Market:
AC Chair Affiliated:
CC Chair Affiliated:
Insider Chairman:
otherwise
Staggered Board:
Supermajority:
State Incorporated:
and 0 otherwise
Unequal voting:
Poison Pill:
Number of members on the audit committee
Number of members on the Board of Directors
Percentage of the board who are insiders (employee)
Percentage of independent (outside) directors who sit on four or more boards
Percentage of affiliated (linked) directors who sit on four or more boards
Percentage of insider (employee) directors who sit on two or more boards
Percentage of independent (employee) directors who are older than 70
Percentage of affiliated (linked) directors who are older than 70
Percentage of insider (employee) directors who are older than 70
Percentage of audit committee members who are affiliated (linked)
Percentage of compensation committee members who are affiliated (linked)
Percentage of company’s ordinary shares owned by institutional block holders
Number of institutional block holders
Percentage of ordinary shares held by the largest institutional shareholding
Ratio of book value of debt to the market value of equity
Ratio of book value of preferred equity to the market value of equity
Indicator variable equal to 1 where audit committee chairman is affiliated (linked), and 0 otherwise
Indicator variable equal to 1 where compensation committee chairman is affiliated (linked), and 0 otherwise
Indicator variable equal to 1 if an executive holds the position of the role of chairman of the board, and 0
Indicator variable equal to 1 if the firm has a staggered board, and 0 otherwise
Indicator variable equal to 1 if the firm has a supermajority provision for takeovers, and 0 otherwise
Indicator variable equal to 1 if the firm is incorporated in Pennsylvania, Ohio, Wisconsin or Massachusetts,
Indicator variable equal to 1 if there are unequal voting rights across common shareholders, and 0 otherwise
Indicator variable equal to 1 if the firm has adopted a poison pill, and 0 otherwise

An affiliated director is one who is a former employee; is an employee of or is a service provider, supplier, or customer; is a recipient of charitable
funds; is considered an interlocking or designated director; or is a family member of a director or executive.