Corporate Governance and the Relationship between Default Risk and the Earning Response Coefficient

Abstract

This study examines the effect of corporate governance on the relationship between default risk and the earnings response coefficient (ERC). Using a sample of 2,004 firm-years comprising 334 firms listed on the Bursa Malaysia over a six year period from 2002 to 2007, this study tests whether corporate governance mitigates the effect of default risk on ERC while controlling for the established determinants of ERC — beta, growth, earnings persistence and size. Using reverse regression, the study confirms that beta is negatively related to ERC and that growth, earnings persistence and size are positively related to ERC. Default risk is found to be negatively related to ERC thus confirming that beta is only a partial measure of risk relevant to ERC. Corporate governance — as indicated by audit quality, audit committee expertise and independence, and board independence and board shareholding — mitigates the negative effect of default risk on ERC. The results of the study hold both for the pooled sample of 2,004 firm-year observations and on a year by year basis for the 334 firms in the sample. The results are also found to be robust to various sensitivity tests including to alternative measures of the variables. The study thus provides systematic and comprehensive additional evidence on the determinants of ERC. Of itself this is an important contribution to the literature but especially so given that the evidence comes from Malaysia — an emerging economy — whereas the existing empirical literature relates mainly to developed countries.