Corporate governance and financial distress prediction in the UK.

Abstract

Prediction of financial distress has been a topic of much interest to companies and all interested stakeholders (Wanke et al. 2015). Investors, debt holders, creditors, employees, governments, auditors and the society in general, are all affected in one way or the other when firms become financially distressed and they eventually fail. Financial distress detection has been an important issue in the academic literature but since the 2007 financial crises, it has become a more relevant issue because of the increasing number of firms becoming financially distressed and bankrupt. From a report in the Guardian newspaper on 17th January 2018, almost half a million UK businesses begun 2018 in significant financial distress and according to the UK Insolvency Service, 17,439 firms in England and Wales went bust in 2018. The expectation is that with Brexit uncertainty, inflation and interest rate may rise which can lead to weaker consumer spending impacting on business financial performance. Early studies (Beaver 1966, 1968; Altman 1968; Ohlson 1980; Taffler 1984) on financial distress used accounting and cash flow empirical-based variables to develop financial distress prediction models. Recent studies (Lee and Yeh 2004; Lajili and Zeghal 2010; Brédart 2014) indicate that the predictive power of these models is improved significantly by including corporate governance mechanisms. However, the role of corporate governance mechanisms in influencing financial distress may be moderated by firms’ contextual factors. Hence, in determining the influence of corporate governance mechanisms on financial distress, firms’ environment, resource, and technology need to be considered. The study, therefore, determines the moderating influence of firms’ environment (complexity, dynamism, and munificence), resource (tangible and intangible), and technology on the relationship between corporate governance mechanisms and financial distress. Also, Daily et al. (2003) have contested that taking a multi-theoretic approach to corporate governance is necessary to observe and understand how each corporate governance mechanism is viewed from each different theoretical perspective. This study uses the agency theory, the resource dependence theory, the stakeholder theory, and the stewardship theory to develop the research hypotheses to test the influence of corporate governance mechanisms on the likelihood of firms’ financial distress because each of these theories may argue and prescribe different functions for each corporate governance mechanism. The study has four main objectives. The first objective is to assess if the composition and structure of corporate boards are associated with the financial distress of UK firms. The second objective is to evaluate whether the different forms of firms’ ownership have any influence on the financial distress of UK firms. The third objective is to determine the extent to which the disclosure and transparency components of corporate governance are related to the financial distress of UK firms. The final objective is to determine whether the environment, resources, and technology moderate the corporate governance and financial distress relationship of UK firms. The data for the study is obtained from the annual reports of 100 financially distressed and 100 financially non-distressed firms listed on the London Stock Exchange for the period 2009 to 2016. The results of the study indicate that from the components of board composition and structure; board activity, board member qualification, audit committee independence, remuneration committee size, and the presence of a firm’s chairperson on the audit committee are all significantly and negatively related to firms’ financial distress. However, the board size, the proportion of independent directors, board member financial expertise, and audit committee size are significantly but positively related to firms’ financial distress. In terms of the ownership structure variables, the directors’ ownership, institutional ownership, as well as the concentrated ownership are all significant and have negative relationships with firms’ financial distress. For disclosure and transparency variables, directors’ remuneration, the presence of senior independent director, and disclosure of notice of annual general meeting in the annual reports are significantly and negatively related to firms’ financial distress, but the disclosure of proxy voting arrangements in the annual reports has no significant relationship with firms’ financial distress. On the control variables, firm size and firm age are all significant and have negative relationships with financial distress. In addition, the industry is ascertained to show significant effects. Regarding the moderating role of environment (complexity, dynamism, and munificence), resources (tangible and intangible), and technology, the results have provided evidence of some moderating influence of these factors on the relationship between the corporate governance mechanism and financial distress. Moreover, the results have shown that models with the interactions of the moderating factors have lower arithmetic values for Akaike’s Information Criteria (AIC) indicating that these models are of best fit than the baseline model without the interactive terms. The results further show that technology has a more moderating influence on corporate governance and financial distress relationship, and this is followed by environmental dynamism, environmental complexity, tangible resources, intangible resources, and environmental munificence. Also, the results indicate that although the board composition and structure model, the ownership structure model, and the disclosure and transparency model have the best fit over the model with only the firm characteristics, the corporate governance model which combines all the corporate governance mechanisms has the best fit to determine firms’ financial distress due to its lower AIC value. This means that corporate governance mechanisms are effective in determining firms’ financial distress when all of them are put together. Based on the results, the study suggests the need for policy makers to ensure that firms comply with the mechanisms of corporate governance, pay attention to their environment and consider their resources and technological capabilities in the institution and implementation of their corporate governance structures to prevent their firms becoming financially distressed.