1
Transparency & Disclosure Scores and their Determinants
in the Istanbul Stock Exchange
Mine Aksu
and
Arman Kosedag
Graduate School of Management, Sabanci University
September, 2005
Preliminary draft. Please do not quote. Comments welcome
Transparency & Disclosure Scores and their Determinants
in the Istanbul Stock Exchange
Mine Aksu
and
Arman Kosedag
Abstract
Recent financial reporting and auditing scandals on both sides of the Atlantic have led to a global realization of the importance of sound corporate governance (CG) practices in alleviating the agency problems in the corporate form of business and for efficient allocation of capital in international markets. Transparency and disclosure (T&D) practices followed by firms are a vital component and a leading indicator of CG quality. Transparent and full-disclosure of information is especially vital for Turkey where the biggest agency problem centers on asymmetric information and expropriation by majority shareholders.
We collaborate with S&P and base our survey on their scoring methodology, a customized version of the 98 desirable T&D attributes they have used to evaluate the T&D practices in several other countries, and their classification of the attributes into three categories: ownership structure and investor relations, financial transparency and information disclosure, and board/management structure and process. We next evaluate the T&D practices of the 52 largest and most liquid firms in the Istanbul Stock Exchange (ISE), based on their English and local language annual reports and websites. Our rankings provide a first time, objective assessment of the corporate disclosure practices of ISE firms.
We also consider a simple model that sequentially links agency costs to CG/T&D mechanisms in place and to firm-level and economy-wide financial performance. Concentrating on the causal side of the model – the determinants of TDS--, we provide out-of-sample evidence that among the commonly used proxies for agency conflicts, firm size, financial performance, growth opportunities, and leverage best explain the variation in the T&D scores in the ISE. While our results provide considerable support for prior findings in developed markets, they also shed light on how specific agency problems faced by ISE firms impact their TD scores.
I. Introduction
The recent corporate governance and financial reporting scandals on both sides of the Atlantic have led to a global realization that sound corporate governance (CG) practices including transparency and full disclosure (T&D) are important for long-term viability of companies and for efficient allocation of capital in the international financial markets. Starting with the Sarbanes-Oxley Act in the US, there has been an unprecedented amount of governmental and institutional intervention and many countries are now in the process of restructuring their current laws, regulations and enforcement capabilities within the framework of best corporate governance practices.[1] Furthermore, academicians, investment and data-base companies are constructing and evaluating ethical, socially responsible, and strong CG indices[2], and companies themselves are paying hefty sums of money to have their CG practices rated by rating agencies such as Standard and Poor’s (S&P) and Institutional Shareholder Services (ISS) to signal their quality in their quest for external capital. Parallel to these developments, there has been a proliferation of country-level (La Porta et al., 1996, 1997; Schleifer and Wolfenzon; 2002; Gugler et al. 2004) and firm level (see for ex., Ashbaugh et al., 2004; Brown and Caylor, 2004) evidence that countries and firms with better CG practices have lower cost of capital, higher firm values and thus easier access to foreign capital.
Full disclosure and transparency (T&D) of financial information are vital components of the CG framework (OECD, 1999) and are regarded as important indicators of CG quality.[3]
Beeks and Brown (2005) find that firms with higher CG quality make more informative disclosures. Sadka (2004) provides theoretical and empirical evidence that the public sharing of financial and analyst reports has enhanced factor productivity and economic growth in 30 countries.
These relationships and the expected benefits of good CG and T&D practices are especially important for emerging markets like Turkey because they are in dire need of external capital as their economies are growing faster than that of more developed nations. As a result, it is important to investigate whether the historical scarcity of external capital flow to Turkey is related to the low quality of transparency and disclosure in Turkey. This paper is a first step in this direction.
Turkey is a French origin civil law country with concentrated family ownership and low float rates.[4] As such, CG &T&D principles and best-practices have not been adequately followed or enforced. It also faces a specific type of agency problem that again creates an impediment to external capital. It has a financial system with many banks owned by business-groups; highly concentrated, pyramidal, family-based ownership structures characterized by substantive inter-corporate shareholdings; and resulting low float rates and dividend payments (see Yurtoglu, 2000 and 2003 for an in-depth description of ownership structures of ISE firms, its drawbacks in terms of firm value). This kind of a structure leads to expropriation of minority shareholders’ rights by the ultimate owners even if they don’t hold a significant amount of the cash-flow rights. A recent (4/12/2005) report of the Institute of International Finance (IIF) discusses the resulting agency problems and states: “Turkish companies are often controlled through the use of founders’ shares that carry multiple voting rights and/or board nominating rights. As a result, the protection of minority shareholder interests rests primarily on full disclosure and accurate financial reporting”. Hence the T&D component of CG is very important in mitigating the expropriation of minority shareholders’ rights, an important and costly agency problem in Turkey.
This study is the first attempt to create a summary T&D index for the largest and most liquid firms trading on the Istanbul Stock Exchange (ISE). We undertook the project in collaboration with Standard & Poor’s (S&P), a well-known, global rating and financial services company that has been carrying out large scale research since 2001 to score the Transparency and Disclosure (T&D) practices of a number of large and liquid firms they follow in the US, Latin America, Europe, Japan, Russia and some emerging Asian markets. We first customized the 98 attributes used in these prior surveys and came up with a final set of 106 attributes which not only reflects the expertise of S&P analysts and researchers, but also fits the regulatory, institutional, cultural, and economic environment in Turkey. We grouped the 106 attributes into three sub-categories, again using S&P’s classification scheme: (i) Disclosure of ownership structure and investor relations (OwnStr); (ii) Financial transparency and disclosure in the financial statements (FinDisc); and (iii) Disclosure of the board and management structure and processes (Board&Mgmt). Next, the annual reports and the websites (both English and local language versions) of the 52 largest and most liquid firms listed in the Istanbul Stock Exchange (ISE) were searched for the inclusion of these information attributes. Each firm was then graded and ranked in the above-mentioned three categories as well as their overall T&D quality.[5]
We find that the transparency and disclosure scores of ISE companies are not impressive, especially in terms of the board and management structure and processes. Nevertheless, considerably high scores (7/10) are obtained in the category of financial transparency and information disclosure and the average T&D score (TDS) of Turkish companies is 5/10, a score comparable to many countries in continental Europe.
In this paper, we also envision and model CG and T&D as mechanisms as a system of checks and balances that have evolved to mitigate the agency problems often encountered in the corporate form. In line with the agent-principal theory, our expectation is that if companies have effective mechanisms in place, these agency problems -- such as extraction of private benefits by majority shareholders, consumption of perquisites by entrenched management, under or overinvestment --and their associated costs will be mitigated. This simple model of incentives for good CG/T&D practices has been studied extensively. (see for ex., Watts and Zimmerman, 1986; Healy and Palepu. 2000; Core, 2001; Rahman. 2002). We draw on this body of research for the second objective of the study: exploring the crossectional differences in quality of disclosure in ISE firms. We find that larger and more profitable firms, firms with more information asymmetry and with higher leverage have higher TDS while free cash flow available to management and the family-firm dummy variable does not have explanatory power over TDS.
The study has several contributions and is expected to be of interest to regulators, researchers, managers, and market participants. The rankings provide a first time, objective, quantitative and verifiable assessment of corporate disclosure practices of listed companies in the ISE and will be a benchmark for future studies. Hence, this is also the first study that investigates the relationship between T&D and the firm specific agency conflict proxies in the ISE firms. The results provide out-of-sample evidence that some firm-specific agency conflict proxies do a good job in explaining the variation in TDS.[6] Third, since the same attributes and methodology used in previous S&P studies are used, the findings allow comparisons with the scores previously obtained in other emerging and developed countries. The rankings based on a universal benchmark are expected to help investors and other stakeholders in their decision making through a more objective assessment of differences in the level of reporting quality and hence investment risks across firms, markets, and sectors. Finally, the T&D rankings will provide a meaningful, objective monitoring and enforcement tool for local and international regulators.
The remaining part of the paper is organized as follows: Section two discusses prior research and motivates the study. In section three, we discuss our simple model of the causes and the consequences of the CG/T&D framework. We also develop our hypothesis in this section. The sample, data requirements and methods of analysis are described in section four. The results are presented in section five while section six concludes and presents some ideas for future research.
II. Prior Research and Motivation
In this section we review some other surveys that have attempted to rate the T&D practices in different countries and the important prior research that examines the country and firm-level determinants of transparency and disclosure. We also summarize the historical legal, political, economic, regulatory impediments to T&D quality in Turkey that motivate this research.
II. 1. Prior research
This paper is closely related to several surveys that scored the CG and T&D quality in several countries, carried out by rating firms, academicians and firms collecting and selling financial data-bases. Most of these studies have also examined the consequences of good CG practices. For example, Brown and Caylor (2004) relate the Gov-Score, a composite measure of 52 factors encompassing eight governance categories, to five measures of performance using Compustat and Crisp data. They find that better governed firms are more profitable, more valuable, less risky, less volatile, and pay out more cash to the shareholders. Bai et al. (2004), among others, have shown that the findings are not confined to developed countries. They observe a positive relation between good CG proxies and market valuation in China. Although similar to this study in many respects, these studies are related to the quality of CG practices rather than the extent to which the CG practices and financial data are made public.
Most studies on T&D quality have been carried out by S&P. They have and are still conducting similar surveys in many other regions of the world, often with collaborating academicians, as was the case in Turkey. In 2002, Standard & Poor’s Governance Services published its first T&D study, which included companies in the following Standard & Poor’s indices: S&P/IFC Asia; S&P/IFC Latin America; S&P Asia Pacific 100; S&P/TOPIX 150 (Japan). Then they conducted a similar survey in Russia in 2002, 2003, and, as a result of continued interest among investors, in 2004. Furthermore, in 2003, S&P released its study of the S&P Europe 350 companies.[7] The T&D survey results are summarized in Table 3 below.
This research is also related to a large body of accounting and finance literature that investigates the causes and consequences of voluntary disclosure. We explore the former for ISE firms in this study. On the consequences side, and motivated by the theoretical work on discretionary disclosure (Verrecchia, 1983, Darrough and Stoughton, 1990, and Feltham and Xie,1994), accounting researchers have focused on the effect of corporate disclosure quality on cost of capital, performance and other firm specific variables. The theory of discretionary disclosure predicts that firms will withhold private information when disclosure is costly. Recently, Shin (2003)shows that a sanitization policy, in which only good news is disseminated, can be supported in equilibrium. This theory suggests that the reported firm value is upward-biased, with the extent of the bias negatively related to disclosure quality. As a result, investors will penalize a lower disclosure quality by charging a higher discount rate to the firms’ cash flows.
There are a few studies that explore the determinants of CG and disclosure practices. Many studies have found that there is a strong country effect in what companies disclose (see for ex. Berglof and Pajuste, 2005). The former authors also report that information is more available to public in larger firms, firms with lower leverage, higher financial performance, higher market-to-book ratios and more concentrated ownership. Black et al. (2005) investigate the cross-sectional differences in Korean firms’ CG practices and find that firm size, risk, and long-term profitability and equity finance need are positively related to better CG practices. Voronina et al. (2005) study is similar to the present study in that they measure both the transparency practices of 102 listed Russian firms using a checklist of 441 items from IAS in 2001 and also investigates cross-sectional differences in transparency. They find that use of a Big-5 auditor, foreign listing, firm size, government shareholdings and independence of CEO and Board Chair are positively associated with transparency. We draw on the agency research and the above-mentioned empirical studies in our choice of relevant agency conflict proxies described below in Section III.
II.2.The poor regulatory framework and culture of CG and T&D in Turkey
Turkey has historically had a poor culture of CG and T&D. It has always been a civil law country and has had a very late start in the liberalization of its economy, the establishment of its stock market (1986), and the setting of its financial reporting standards based on generally accepted accounting principles and the concept of full and fair disclosure (1994).
The first legislation concerning commercial law was enacted for the first time in Ottoman Empire in 1850 and was based on the French Code of Commerce of 1807. Under the legal reforms of 1926, this was replaced by a system based on Swiss Civil Code and Code of Obligations, the Italian Penal Code, and the German Code of Penal Procedure. Neither these, nor the present Turkish Code of Commerce dated back to 1957 were based on the generally accepted principles of accounting and auditing and hence did not regulate financial reporting. They highlight the strength of the civil law tradition, weak enforcement of the rules and the lack of a disclosure philosophy in the Turkish business culture.
This legal and cultural infrastructure seems to be an important factor in the historic difficulty with which Turkish firms have attracted external capital. Table 1 reconstructed from tables 2 and 8 in La Porta et al. (1997) places Turkey in the French origin legal systems which has enjoyed the lowest access to external capital or debt markets and the weakest rule of law and investor rights protection indices among the 3 other civil law and the common law traditions. The table also depicts that even though GDP growth is stronger in Turkey than in the other legal origins, access to external capital and measures of investor rights are even lower than the average of the French origin countries. Hence, while the fast growth rate in the Turkish economy underscores the need to access external debt and equity capital, the table highlights the difficulty of accessing external capital when enforcement of the rule of law and protection of investors rights are weak. The solution to this dilemma through observance of good CG and T&D practices has been a major motivation for this study.
(Place Table 1 about here)
Recent studies have observed that the weak CG and disclosure tradition in Turkey have continued until very recently. Ararat and Ugur (2003) describe Turkey’s civil law tradition and its inefficient and inconsistent regulatory framework and the ensuing paucity of the rule of law and its enforcement; the concentrated and pyramidal ownership structure dominated by families; the inconsistent and opaque accounting and tax regulations and the investor misinformation caused by the absenceof inflation and consolidation accounting. As a result of this infrastructure, corporate governance problems are concentrated around weak minority shareholders’ and creditors’ rights, inconsistent and opaque disclosure policies and lack of voluntary disclosure, and convergence (inseparability) of ownership and management. These create an environment that fosters corruption, share dilution, asset stripping, tunneling, insider trading, and market manipulation.