Is there a difference in relationship
between corporate governance and
earnings management in different
countries? Evidence from comparing
the emerging market of China and the
developed market of U.S.
21 March 2016
Erasmus School of Economics
Master Accounting, Auditing & Control - 2013-2014
Name
Rong Zheng
Student number
366006
Supervisor
Drs. sc. ind. A.H. van der Boom
Co-reader
E.A. de Knecht RA
Date
October 2014
Master
Accounting, Auditing and Control
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Abstract
This empirical thesis aims to investigate whether there is a difference in the
relationship between corporate governance and earnings management based on
comparing the results of China and U.S. With the datasets of China and U.S. during
2007-2011, this thesis adopts the Performance–Matched Discretionary Accruals
Model to calculate and measure earnings management. The specific items - board size,
supervisory board size, executive directors, non-executive directors, independent
directors, CEO dummy, managerial ownership and block-holder ownership - were
employed as proxy for corporate governance mechanism. The OLS regression models
and the fixed effect models were performed and the results confirm there is a
relationship between corporate governance and earnings management both in sample
firms of China and U.S. Especially, these results also stated that there are differences
in the relation between those two items comparing China and U.S.
Keywords: Corporate governance, Earnings management, China, U.S.
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ACKNOWLEDGEMENT
I would like to take the opportunity to acknowledge to all the people who helped me
in my study at Erasmus University of Rotterdam.
My sincere gratitude is directed to my supervisor Drs. sc. ind. A.H. van der Boom at
Erasmus University of Rotterdam. He actively instructed me through the entire thesis,
answered all my questions with great patience, offered useful support at every stage of
the thesis, and shared the valuable knowledge with me. I would also like to thank Mr.
de Knecht for giving me important comments on this research thesis.
I would like to acknowledge the teachers, coordinators, and friends at Erasmus
University of Rotterdam who were kindly helping me during my study.
I owe my loving thanks to my parents, husband and friends. Without their
encouragement it would have been impossible for me to finish this study.
Rong Zheng
Rotterdam, The Netherlands
October, 2014
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Table of Contents
Chapter 1. Introduction .............................................................................................. 6
1.1 Background ..................................................................................................... 6
1.2 Objectives ........................................................................................................ 8
1.3 Research question definition ........................................................................... 9
1.4 Methodology ................................................................................................... 9
1.5 Relevance ...................................................................................................... 10
1.6 Limitation ...................................................................................................... 11
1.7 Structure of the research ................................................................................ 11
Chapter 2. Theoretical Background ......................................................................... 12
2.1 Earnings management ................................................................................... 12
2.1.1
Definitions of earnings management ..................................................... 12
2.1.2
Measurements of earnings management ................................................ 15
2.2 Corporate governance ................................................................................... 21
2.3 Relevant theory ............................................................................................. 24
2.3.1
Agency theory ........................................................................................ 24
2.3.2
Positive accounting theory ..................................................................... 24
2.4 Background of China .................................................................................... 26
2.4.1
Ownership structure ............................................................................... 26
2.4.2
Board structure ....................................................................................... 27
2.5 Summary ....................................................................................................... 28
Chapter 3. Literature Review................................................................................... 29
3.1 Literature evidence on corporate governance ............................................... 29
3.2 Reviewing prior literature on earnings management .................................... 31
3.3 Corporate governance and earnings management ......................................... 32
3.3.1
Board characteristics .............................................................................. 33
3.3.2
Ownership structure ............................................................................... 36
3.4 Summary ....................................................................................................... 38
Chapter 4. Hypotheses Development ...................................................................... 40
Chapter 5. Research Design..................................................................................... 42
5.1 Research model ............................................................................................. 42
5.1.1
Measurement of discretionary accruals ................................................. 42
5.1.2
Measurement of corporate governance .................................................. 43
5.1.3
Research regression model .................................................................... 47
5.2 Sample selection ............................................................................................ 50
5.2.1
Dataset of China ..................................................................................... 50
5.2.2
Dataset of U.S. ....................................................................................... 52
5.3 Statistical tests ............................................................................................... 53
Chapter 6. Results and Analysis .............................................................................. 55
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6.1
Descriptive statistics ...................................................................................... 55
6.2 Correlation matrix (Pearson Correlation test) ............................................... 56
6.3 Multicollinearity test ..................................................................................... 62
6.4 Results and analysis ...................................................................................... 65
6.4.1
OLS Results ........................................................................................... 65
6.4.2
Hausman test of China and U.S. ............................................................ 66
6.4.3
Fixed effect model development ............................................................ 70
6.5 Summary ....................................................................................................... 71
Chapter 7. Conclusions ............................................................................................ 74
7.1 Conclusions ................................................................................................... 74
7.2 Limitations and future recommendations ...................................................... 75
References………...………………………………………………………………….77
Appendix. A Corporate Governance …………………………………………………88
Appendix. B Earnings Management………...………………………………………..89
Appendix. C Corporate governance and earnings management……………………...90
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Chapter 1. Introduction
1.1
Background
Prior empirical evidence shows that managers have incentives to manipulate the
earnings information of the company (Teoh et al. 1998a, 1998b; Xie, 2001). A great
numbers of researchers and analysts attempt to investigate this phenomenon and to
find the solutions to restrict misleading earnings information manipulation. One of the
solutions is effective corporate governance which includes internal control and
external control. In the previous two decades, the relationship between corporate
governance and earnings management attracts increasing attentions from researchers.
Especially in the early 2000s, a number of financial scandals took place in the U.S.,
e.g., Tyco, WorldCom and Enron. The U.S. Congress enacted the Sarbanes-Oxley Act
of 2002 (SOX) to respond to those scandals, for example, adding an independence
auditor, code of ethnic for senior managers and requiring CEO and CFO certifying
financial report. These requirements try to enhance the corporate governance,
strengthen the corporate accountability and reduce the likelihood of misleading
earnings management. Furthermore, a lot of empirical research articles investigated
corporate governance and earnings management and confirmed the relationship
between these two aspects. Klein (2002) indicated in his research paper that both
board independence and audit committee independence have negative relationship
with abnormal accruals by analyzing data of the U.S. Davidson et al. (2005) also
found the similar results by investigating the data from Australian listed firms, which
proves that the board independence and audit committee independence could decrease
the likelihood of earnings management. Park et al. (2004) concluded that the outside
directors did not reduce the abnormal accruals according to the data from Canada.
Audit quality and earnings management were investigated by Piot et al. (2005) based
on the data from France. They confirmed that the Big Five-audited companies in
France did not have a lower level of earnings management. Ching et al. (2006) used
sample firms from Hong Kong and demonstrated that SEO (Seasoned Equity
offerings) firms with large board size have a high likelihood of earnings management.
According to review the prior empirical researches on corporate governance and
earnings management, a tremendous of research results were concluded from
developed market countries or areas such as U.S., UK, Canada, and Hong Kong and
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so on (Klein, 2002; Davidson et al., 2005; Park et al., 2004; Piot et al., 2005).
However, few empirical researches are based on the emerging markets, such as India,
Brazil, Malaysia and China and so on. For instance, Houqe et al. (2007) used a
sample of 648 firm-year observations from 2001 to 2006 in Bangladesh and
demonstrated that corporate governance system has effective monitoring power on
financial reporting. By taking nine Asian emerging markets as test data, Shen and
Chih (2007) found that effective corporate governance mechanism tends to reduce
earnings management activities. The research field linking to this topic is insufficient
in emerging markets, although there have some research results. Furthermore, it is
necessary to investigate the corporate governance and earning management in
emerging markets. Emerging markets are growing faster than developed markets
especially in the economy aspect. These developing regions draw a lot of attentions
from investors around the world since the investors take developing markets as a new
investment opportunity. Nevertheless, there still are some potential risks of
investment in emerging markets. For instance, the information asymmetry problem in
emerging markets is worse than in developed countries (Vives, 2006). On the other
hand, Klapper and Love (2002) argue that inefficient corporate governance and weak
legal infrastructures raise the risks related to emerging markets investments.
One of the specific examples of emerging markets is China because it is the biggest
and fastest growing market from the emerging counties around the world. According
to the government data (National Bureau of Statistics of the People’s Republic of
China), in the end of 2013, China’s GDP (Gross domestic product) scored at 7.7
percentage with 9.31 trillion U.S. dollars. Although the rate of GDP reduced slightly
comparing to prior years, China is still the second largest economy in the world.
However, China is relatively younger than the developed countries in several aspects
and still has some problems and risks as other emerging markets, for instance, high
concentrated ownership, less transparency of financial information, inefficient
regulation and market instability and so on. Furthermore, previous empirical thesis
provided evidence that Chinese listed companies manipulate their earnings
information dramatically. Li et al. (2011) investigated the topic of manipulation
financial data by using data from Industrial Census of China. They found that
earnings management is more common in China than that in developed countries such
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as U.S. Chen et al. (2003) confirmed that local governments take part in earnings
management of listed companies by providing fiscal subsidies in China.
In conclusion, the subject of this research thesis is to investigate whether or not
corporate governance mechanism affects earnings management basing on the specific
emerging market of China. On the other hand, as the world largest economy, The
United States of America plays a vital and influential role in the world. It is often seen
as a remarkable example relating to economy, technology and so on. Moreover, the
researches on the corporate governance and earnings management were booming after
the financial scandals of 2000s in the U.S. Those research findings can provide a
benchmark for investigation of emerging market countries. Therefore, this research
thesis will also collect data from the U.S., and use the same methodology and tests to
provide empirical results for comparing the case of China.
1.2
Objectives
Basing on the previous indication, it is obviously that most of research results are
published from developed countries such as U.S., Canada and so on. A few numbers
of research articles are based on the emerging markets like India, China and so on. In
this research thesis, the first and most important aim is to enrich the empirical
evidence on the emerging markets relating to the issue of corporate governance and
earnings management.
On the other hand, the researches connecting to this issue has different outcomes. For
instance, as mentioned before, both Klein (2002) and Davidson et al. (2005)
highlighted that the board independence and audit committee independence reduce the
likelihood of earnings management. However, Peasnell et al. (2000) found that audit
committee and earning management have no relationship by analyzing the data from
UK. Ching et al. (2006) indicated that there is a positive association between board
size and the level of earnings management. Nevertheless, Xie et al. (2003) found that
negative relationship between board size and earnings management. Therefore, the
second target of this research thesis is to review this issue and analyze the relationship
between corporate governance and earnings management, attempting to provide more
empirical evidence in this research topic.
Finally, basing on the discussion before, China has some problems in corporate
governance and earnings management. Therefore, it is urgent to analyze those issues
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and try to find out the answers. This research will apply a unique step which is to
compare the empirical results between the U.S. and China. The purpose of this
method is to conclude different results and find out the explanation of these
differences. It can provide a guideline for future analysis.
1.3
Research question definition
Based on the aforementioned introduction, the research question has been formulated
as:
“Is there a difference in the relation between corporate governance and earnings
management in the emerging market of China and in the developed market of The
United States of America?”
Before answering such research question, the following sub-questions need to be
answered:
1. What is the definition of the term corporate governance? How do we measure
corporate governance?
2. What is the definition of earnings management? How do we measure earnings
management?
3. What are the underlying economic theories explaining earnings management
and corporate governance?
4. What are the prior research results on the relationship between corporate
governance and earnings management?
5. What are the hypotheses for the empirical research of this thesis?
6. What is the research design for this research thesis?
7. What are the results of this research thesis?
8. What are the analysis and conclusions of this research thesis?
1.4
Methodology
The first step of this research is to locate the relevant empirical studies with the
content of corporate governance and earnings management. These research articles
can provide basic information to explain the term of corporate governance and
earnings management. Meanwhile, the research articles relating to this issue also
provide the process of hypotheses development, research analysis models, and so on.
This information from previous research papers can supply a first clue for this
research work.
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After that, in order to test the relationship between corporate governance and earnings
management, all data will be collected from Erasmus University Database. The data
of China will be selected from CSMAR database. It offers all Chinese listed firms
information relating to corporate governance and financial information. Besides, the
data for analyzing the U.S. will be selected from Compustat North America, GMI
Ratings and Risk Metrics databases. The research period will be draw from 2007 to
2011.
Furthermore, Dimitropoulos and Asteriou (2010) employed Modified Jones Model to
investigate earnings management. Chen (2010) concluded in his paper that the
modified Jones model is the best model to test earnings management comparing to
other models. Although Modified Jones Model is widely used in previous research
articles, in this research thesis, Performance-Matched Discretionary Accruals Model
(Kothari et al., 2005) will be used to calculate the discretionary accruals as proxy for
earnings management. This is because it has advantage in reducing model
misspecification (Dechow et al., 2012). This will be introduced in Chapter two.
Lastly, in the design process of regression model, several corporate governance
variables which include board size, CEO dummy, independent directors, supervisory
board size and non-executives directors and so on will be tested. On the other hand, it
proposes to add some control variables such as firm size, return on equity, Leverage.
Moreover, SPSS and Eviews will be applied to perform the statistical analysis which
is needed to test the hypotheses.
1.5
Relevance
Firstly, the findings of this research thesis could provide useful information for
helping regulators to enhance their insight efficiently. Especially, it can help the
regulators to design more realistic corporate governance policies which link to the
Chinese background.
Secondly, the results of this thesis could provide useful guidance for companies to
carry out appropriate corporate governance policies with a target of reducing earnings
manipulation and facilitating the effectiveness of internal control.
And, last but not lease, the thesis can help the future analysts to understand the real
situation linking to corporate governance and earnings management in China. In the
meantime, some research outcomes can provide a guideline for other emerging
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markets companies to improve corporate governance, effectively restrict on earnings
management, and enhance transparency of accounting information.
1.6
Limitation
This research thesis has some drawbacks. Firstly, whether the Performance-Matched
Discretionary Accruals Model could fully detect earnings management or not is still
in the debates. Secondly, this research thesis will focus on the connection between
corporate governance and earnings management relating to emerging market of China
and U.S. Therefore, this study cannot be used to generalize concerning all emerging
markets countries and all developed countries. Lastly, this thesis may omit some
variables when measures corporate governance.
1.7
Structure of the research
The remaining of the thesis will be structured as follow: Chapter 2 will describe the
definitions of earnings management and corporate governance. In the meanwhile, it
will indicate the measurements of earnings management and the relevant elements of
corporate governance. After that, the underlying theories relating to corporate
governance and earnings management will be introduced. The prior empirical
research outcomes and findings will be presented in Chapter 3. In addition, a
summary will be provided for concluding those research results. Furthermore, Chapter
4 will show the process of hypotheses development. After that, in Chapter 5, the
research design will be demonstrated. Chapter 6 will provide the results of statistical
test and analysis. Chapter 7 will draw conclusions and limitations and provide
suggestions for the future empirical researches.
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Chapter 2. Theoretical Background
This chapter introduces the theoretical background of this research thesis, which
includes the definitions of earnings management, the measurements of earnings
management, the definitions of corporate governance and its relevant elements. Then,
two important theories related to this thesis will be discussed. In the end, the
background of China relating to earnings management and corporate governance will
be illustrated.
2.1
Earnings management
2.1.1 Definitions of earnings management
Earning(s) is also known as “net income”, which is an important item in the financial
reports. It not only reveals the performance of a company relating to profit-generating
activities, but also shows the efficiency of management of this company. The earnings
information presented in financial reports has effect on the company’s value. For
instance, positive earnings information may stimulate the stock price to increase while
negative earnings information may lead to the decrease of stock price. Likewise, the
increase or decrease of stock price will influence the value of the firm. Therefore,
these motivate management to consider how to report the earnings information of
their companies, in other word, how to manage earnings.
Since earnings management is widely research topic in the current society, a large
body of researchers and analysts provided several definitions in their research articles.
Davidson et al. (1987, cited in Schipper 1989) gave a definition of earnings
management as:
“the process of taking deliberate steps within the constraints of generally accepted
accounting principles to bring about a desired level of reported earnings.”
One of the definitions of earnings management demonstrated by Schipper (1989) is:
“…a purposeful intervention in the external financial reporting process with the
intent of obtaining some private gains (as opposed to, say, merely facilitating the
neutral operation of the process).”
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Healy and Wahlen (1999) defined that:
“Earnings management occurs when managers use judgment in financial reporting
and in structuring transactions to alter financial reports to either mislead some
stakeholders about the underlying economic performance of the company, or to
influence contractual outcomes that depend on reported accounting numbers.”
Furthermore, Dechow and Skinner (2000) indicated in their article that earnings
management is:
“The intentional, deliberate, misstatement or omission of material facts, or
accounting data, which is misleading and, when considered with all the information
made available, would cause the reader to change or alter his or her judgment or
decision.”
Basing on the above-mentioned four definitions, earnings management can be
considered as intentional behavior by management in the financial reporting process.
Moreover, there have some self-interested purposes to drive management to distort
the earnings information. This intentional behavior will influence the users’ decisions
and judgments, and sometimes harm their benefits.
Although earnings management is often considered as a negative effect in the
previous literature, not all researchers agree that earnings management is always
negative. Subramanyam (1996) presented that discretionary accruals increase the
information content and help to predict the future of cash flow and earnings of a firm.
Jiraporn et al. (2008) took earnings management as something positive. They adopted
Agency Theory as a research tool and found that there is a positive relationship
between earnings management and firm value. They also argued that earnings
management is beneficial to investors because it provides more information, and the
company has benefits from that.
According to those arguments above, there is still no consensus on the definition of
earnings management in previous academic field. As indicated by Ronen and Yaari
(2008), earnings management can be categorized into three types: white, grey and
black. White earnings management means that managers can choose accounting
treatments flexibly and show their private information related to future cash flows.
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This statement emphasizes that earnings management could improve the transparency
and quality of financial reports. Grey earnings management is defined as that the
chosen accounting treatments maximizes either the managers’ interests or firms’
interests. It emphasizes that earnings management can be opportunistic or
economically efficient. Black earnings management reflects that tricks are used by
management to misrepresent or decrease transparency of financial reports.
In addition, Beneish (2001) described that the information perspective of earnings
management and the presented discretionary management are used by management to
reflect the private expectation to investors. Jiraporn et al. (2008) even indicated that
on the average earnings management is not opportunistic but beneficial to a company.
These statements are similar to the definition of white earnings management. Other
researchers argued that managers discretionarily manipulate the earnings information
so users cannot see the truth of the company due to the biased earnings information
(Dechow and Skinner 2000; Healy and Wahlen 1999; Schipper 1989).
In this research thesis, the relationship between corporate governance and earnings
management is one of the research subjects. It has been argued that corporate
governance could reduce activities of manipulating earnings (Shen and Chih 2007;
Cornett et al. 2009). Therefore, in this study earnings management is viewed as
discretionary behavior by management which may distort financial reporting and
mislead some users.
After introducing definitions and the relevant arguments of the earnings management,
a question which needs to be answered is that what are the motivations of earnings
management by managers? The following are some explanations from Healy (1999):
I.
Capital market motivation
Trueman and Titman (1988) claimed that corporate managers have incentives to
smooth the companies’ income. The purpose of this action is to keep the company
like stable and to avoid the stock price decline. It is well known that financial analysts
use the information of financial reports to perform prospective analysis and determine
the future performance of a company. Analysts usually set standards to some key
figures in the coming years such as future Sales, future Earnings, and etc. If a
company fails to meet the standards provided by analysts, the stock price of that
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company will decrease significantly. Therefore, managers have strong incentives to
achieve those earnings standards by using earnings management. Teoh et al. (1998)
found that managers would adopt income-increasing depreciation policies during the
periods prior to initial public offerings (IPO). This means that managers would
overstate earnings before the company IPO and try to attract the attention of investors.
II.
Contracting motivation
According to Healy and Wahlen (1999), there are two types of contracts. The first one
is management compensation contract. Accounting income is a key figure to evaluate
the performance of a firm. Meanwhile, it is also a key benchmark to assess the
performance of managers. Furthermore, the compensation which includes salary,
bonus and stock options depends on the evaluation of the performance of the
managers. Therefore, managers have incentives to manipulate earnings because poor
performance will affect the compensation and bonus. Even more, managers will lose
the jobs. Matsunaga and Park (2001) found that CEOs’ bonus will be lower when the
earnings information misses the analysts’ forecasts. The second one is lending
contract which relates to debt covenant hypothesis. The basic idea of this hypothesis
is that firm with a lot of debts has motivation to manage earnings. The root of this
motivation is that they do not want to breach the debt covenant. This hypothesis will
discuss deeper in Section 2.3.2 (positive accounting theory).
III.
Regulatory incentives
Political cost hypothesis was stated by Watts and Zimmerman (1986). According to
this hypothesis, managers of big firms have motivations to reduce the earnings
because the high earnings information will draw the attention of the regulators and the
government and the labor unions. Jones (1991) found that the company uses earnings
management to reduce the reported earnings during import relief investigations
performed by the United States International Trade Commission.
2.1.2 Measurements of earnings management
Before introducing the measurements of earnings management, it is necessary to
know two main patterns of earnings management (Gunny, 2010). The first one is real
activities earnings management. According to Roychowdhury (2006), the definition
of real activities manipulation is “departures from normal operational practices,
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motivated by managers’ desire to mislead at least some stakeholders into believing
certain financial reporting goals have been met in the normal course of operations.”
Generally speaking, real activities earnings management means that the operation
actions chosen by management in order to affect the users of financial reporting.
Another pattern of earnings management is discretionary accruals management which
is widely used in previous and current years. Under Generally Accepted Accounting
Principles (GAAP), managers are required to use accruals to reduce timing and
matching problems. However, accruals can be applied to manipulate earnings in order
to meet or just beat the analysts’ forecast or other self-interested incentives (Hsu,
2013). This discretionary behavior by management distorts the true face of the
company. The biased financial information provided by management will influence
the users’ judgment of the company.
In this research thesis, discretionary accruals will be employed to proxy earnings
management. In the prior empirical evidence, lots of literature use discretionary
accruals to proxy earnings management, specifically in China evidence (Liu and Lu,
2007; Gulzar et al., 2011). Moreover, it is more appropriate to compare the research
outcomes based on the same measurement of earnings management.
There are various accrual-based models in research articles, such as the Healy Model,
the DeAngelo Model, the Jones Model and the Modified Jones Model, etc. (Healy,
1985; DeAngelo, 1986; Jones, 1991; Dechow et al., 1995). Before introducing these
models, it is necessary to understand total accruals, which is the starting point of
measuring discretionary accruals.
Earnings management occurs when managers use discretion in accounting
information producing process. According to accrual-based method, total accruals
should be categorized into discretionary accruals and non-discretionary accruals (see
equation 2.1). Discretionary accruals are often adopted as a proxy for earnings
management. However, it is difficult to directly identify which part of total accruals
are non-discretionary accruals and which part are discretionary accruals. Since
management may use discretionary room differently at different time, it is hard to
evaluate the discretionary behavior by managers exactly.
TAt = NDAt + DAt
Where:
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(2.1)
TAt
= Total accruals in year t
NDAt = Non-discretionary accruals
DAt
= Discretionary accruals
In the past years, researchers and analysts attempted to investigate and find out an
effective model to proxy earnings management. Before introducing these models, the
calculation of the total accruals in prior research studies will be shown (Healy, 1985;
DeAngelo 1986; Jones, 1991; Dechow et al., 1995 etc.).
(∆CAt − ∆CLt − ∆CASHt + ∆DEBTt − DEPt )
TA𝑡
=
At−1
At−1
(2.2)
Where:
TAt
= Total accruals in year t
∆CAt
= Change in current assets in year t
∆CLt
= Change in current liabilities in year t
∆CASHt = Change in cash and cash equivalents in year t
∆DEBTt = Change in debt included in current liabilities in year t
DEPt
= Depreciation and amortization in year t
At−1
= Total assets in t-1 year
In this thesis, the same method for determining the total accruals will be used.
2.1.2.1 The Healy Model (1985)
The Healy Model is the starting point of detecting earnings management. Based on
the assumption of on the average no earnings management during the estimation
period, this model adopts the mean of total accruals (by lagged total assets) in the
estimation period as the measurement of non-discretionary accruals in event period.
The difference between non-discretionary accruals and total accruals in the event
period is the discretionary accruals which proxy for earnings management. This
model requires data collected over a long period of time for analyzing, e.g., more than
5 years stated by Ronen and Yaari (2008). The following model was provided:
NDAτ =
∑t TAt
T
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(2.3)
Where
NDAτ = estimated nondiscretionary accruals
TA
= total accruals scaled by lagged total assets
t
= 1,2, … T is a year subscript for years included in the estimation period
τ
= a year subscript indicating a year in the event period
2.1.2.2 The DeAngelo Model (1986)
The DeAngelo Model actually is an adjusted version of the Healy Model. This model
claims that the non-discretionary accruals of current period can be represented by
lagged total accruals, suggesting non-discretionary accruals equal to total accruals of
last year. Therefore, discretionary accruals can be calculated by the difference
between the two successive years. The formula for non-discretionary accruals is
defined as:
NDAt = TAt−1
(2.4)
A common feature of the DeAngelo Model and the Healy Model is that they are all
tested under the same assumption: the non-discretionary accruals are constant over
time and the discretionary accruals have a mean of zero during the estimation period.
However, Kaplan (1985) found that the non-discretionary accruals are not constant
over time and respond on the changes in economic circumstances.
2.1.2.3 The Jones Model (1991)
The Jones Model is one of the most widely used models in measuring accrual- based
earnings management. It is a response to the weakness of the DeAngelo Model and
the Healy model. It does not keep the non-discretionary accruals constant over time
like the previous two models did. The Jones Model tries to control the effect of
changes in economic circumstances on non-discretionary accruals, for instance, by
adding lagged total assets to show the size of the company, REV (changes in revenue)
to reveal the companies’ business activities, PPE (gross property, plant and equipment)
to capture the long-term accruals. This model can be formulated like this:
NDAt
1
ΔREVt
PPEt
= a1 (
) + a2 (
) + a3 (
)
At−1
At−1
At−1
At−1
Where:
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(2.5)
NDAt
= non-discretionary accruals in year t scaled by total assets in t-1 year
ΔREVt
= revenues in year t less revenues in year t-1 scaled by total assets at t-1
PPEt
= gross property plant and equipment in year t scaled by total assets at t-1
At-1
= total assets in t-1 year
a1, a2, a3 = firm-specific parameters
In order to calculate the firm-specific parameters, the equation (2.6) is adopted in the
estimation period, which assumes that on the average earnings management is zero in
the estimation period. The data of changes in revenue, gross property, plant and
equipment and lagged total asset from estimation period are applied in (2.6). In the
meanwhile, total accruals calculated by equation (2.2) are an input of (2.6). The
estimation of firm-specific parameters a1, a2, a3 can be obtained by running an
ordinary least squares regression.
TAt
1
ΔREVt
PPEt
= a1 (
) + a2 (
) + a3 (
) + 𝜀𝑡
At−1
At−1
At−1
At−1
(2.6)
Where:
TA t
= total accruals scales by lagged total assets
a1, a2, a3 = the estimates of a1, a2, a3 that are calculated by OLS regression
Ɛt
= the measurement error in the year t
Then, these parameters a1, a2, a3 estimated from equation (2.6) can be substituted into
equation (2.5) to calculate the non-discretionary accruals in the event period. The
difference between total accruals calculated by equation (2.2) and non-discretionary
accruals obtained from equation (2.5) is discretionary accruals.
DAt
TAt NDAt
=
−
At−1 At−1
At−1
(2.7)
2.1.2.4 The Modified Jones Model (1995)
This model is a modified version of the Jones Model (1991). The difference between
those two models is the changes in net account receivables subtracted from the
changes in revenue. This is because the changes in net account receivables can be
seen as a discretionary item which is easier to manipulate by management than
revenue. This adjustment is applied to decrease the measurement error of
Page 19
discretionary accruals when the discretion is over sales. Dechow (1995) found that the
Modified Jones Model has more test power than previous model like original Jones
Model, the Healy Model and the DeAngelo Model. This model is presented below as:
NDAt
1
ΔREVt − ΔRECt
PPEt
= a1 (
) + a2 (
) + a3 (
)
At−1
At−1
At−1
At−1
(2.8)
Where:
ΔRECt = net receivables in year t less net receivables in year t-1 scaled by total
assets at t-1
As can be seen from equation (2.8), the changes in net account receivable are
removed from the changes in revenue. This demonstrates that Modified Jones Model
assorts all changes in credit sales as earnings manipulation. According to Dechow
(1995), this adjustment is based on the belief that credit sales are easier to manipulate
than sales revenue.
2.1.2.5 The Industry Model
This model relaxes the assumption that the non-discretionary accruals stay constant
just like the Jones Model (1991). The unique feature of this model is a median value
of this relation to derive non-discretionary accruals (Dechow et al., 1995).
NDAt = a1 + a2 medianI ( TAt )
(2.9)
Where
medianI(TAt ) = the median value of total accruals scaled by lagged assets for all nonsample firms in the same 2-digit SIC code
2.1.2.6 The Performance-Matched Discretionary Accruals Model (2005)
The previous empirical studies (McNichols, 2000; Kothari et al., 2005) show
evidences that discretionary accruals which proxy for earnings management is
connected to firm performance. This is obvious that some incentives are associated
with the performance of the company. For instance, managers have motivation to
manipulate earnings when the companies’ performance is poor which is related to
their compensation and bonus. In addition, a company before IPO (initial public
offerings) has high incentive to manage earnings and to make the performance of the
company looking well. Furthermore, in the situation of firm performance extreme, the
Page 20
prior earnings management model miss-specified because they do not consider the
performance of the company.
Kothari et al. (2005), attempts to control this extreme performance situation. Basing
on the Jones Model and the modified Jones Model, he presented a PerformanceMatched Discretionary Accruals Model to measure the accrual-based earnings
management. There have two special features in this model. The first one is ROAt-1 or t
(return on asset) which represents the effect of the performance on discretionary
accruals and is added into the model as control variable. The second one is that a
constant term is added in the regression to reduce heteroskedasticity, which is the first
step in the measurements of earnings management.
Due to the reduced miss-specified effect, this research thesis will employ the
Performance-Matched Discretionary Accruals Model to calculate discretionary
accruals which proxy for earnings management and explain the choice in Chapter 5.
The model is proposed as follow:
NDAt
1
ΔREVt − ΔRECt
PPEt
= 𝑎0 + a1 (
) + a2 (
) + a3 (
) + 𝑎4 (ROAt or t−1 )
At−1
At−1
At−1
A𝑡−1
(2.10)
Where
a0
= a constant term
ROAt or t-1 = the return on assets at period t or t-1.
2.2
Corporate governance
Corporate governance has become increasingly important over the past few years.
One reason for this is that the huge influence of corporate sandals and financial crisis
in the world aroused the concern from those researchers, regulators, academics and
other shareholders. Another reason is that some researchers believe that good
corporate governance related to higher return of investment, low cost of capital and
efficient resources-using (Shleifer and Vishny, 1997). Corporate governance is often
cited in academic articles and economic magazines, however, there is no consensus
regarding to its definition. Lots of researchers attempt to give a systematic conceptual
framework for corporate governance. In 1992, Adrian Cadbury, who is the head of the
Page 21
committee on the Financial Aspect of Corporate Governance in the UK, giving a
definition as:
“Corporate
Governance
is
the
system
by
companies
are
directed
and
controlled.”(Cadbury Committee 1992).
This definition highlights corporate governance as a set of mechanisms which are
operated by the firm. Another definition introduced by Shleifer and Vishny in 1997 is,
“Corporate governance deals with the ways in which suppliers of finance to
corporations assure themselves of getting a return on their investment.”
Moreover, Allen (2005) pointed out a group of comparing definitions of corporate
governance.
“Narrow view: corporate governance is concerned with ensuring the firm is run in
the interests of shareholders.”
“Broad view: Corporate governance is concerned with ensuring that firms are run in
such a way that society’s resources are used efficiently.”
In his paper, the various stakeholders are involved in consideration, not only the
shareholders. It takes the definition as a specific-version because it captures the
accountability of company to the whole of society.
Besides the definition of corporate governance, most researchers take corporate
governance into two categories: internal control and external control. Denis and
McConnell (2003) investigated the topic of corporate governance and present in their
research that corporate governance mechanisms can be classified to internal or
external. Figure 2.1 provides a general framework of corporate governance
mechanism including internal and external control. This figure is adopted in the
article from Gillan (2006), who cited this figure from ‘Corporate Finance’, a financial
book written by Ross, Westerfield and Jaffe.
Page 22
Internal
External
Board of Directors
Debt
Shareholders
Debtholders
Management
Assets
Equity
Fig. 2.1. Corporate governance mechanism from Gillan (2006)
The left side column provides a general framework of internal control. The internal
control concentrates on ensuring successful strategy implementation, appropriate
management of risks and efficient reliable operations. The internal control includes
the interaction between or among firm insiders, specifically, management and board
of directors. Management works for the interests of shareholders, and has right to
operate the company. Jensen and Meckling (1976) introduced that managers (as agent)
act on behalf of the shareholders, who are the owners of the firms. Board of directors
is to act as the shareholders' representative in all matters. It has responsibility to
monitor the actions of management, protect shareholders’ asset and appoint or fire
senior management members. The right side column introduces the external control of
the corporate governance which focuses on the debt-holders’ monitoring function.
However, the society resources which mentioned in Allen (2005) are mentioned in the
description of external control. This is not match the broad view of corporate
governance from Allen (2005). Of course, this still has other elements of external
control. In the paper, Gillan (2006) highlights the other external elements such as law
committee, markets (capital markets, labor market and so on) and culture. Denis and
McConnell (2003) also focused on external control and introduced the takeover force
and the legal system. The takeover force plays a vital role in the capital reallocation
of the world. The underlying thought of this takeover is that the outsider parties are
seeking to take over or control the target firm. If the target firm has been taken over,
the management would be replaced. This threat of takeover can stimulate
Page 23
management to work hard for shareholders’ interests. Consequently, the firm value
will be increased and the information bias will decline. Denis and McConnell (2003)
also presented that legal system does not attract the attention from the researchers
who concentrated on corporate governance analyzing firstly. Then, they highlighted
the research outcomes from LaPorta, Lopez-de-Silanes, Shleifer, and Vishny (1998)
that the legal system is important for corporate governance mechanism.
2.3
Relevant theory
2.3.1 Agency theory
One of famous economic theories is Agency Theory. Jensen and Meckling (1976)
stated in their article that “We define an agency relationship as a contract under which
one or more persons (the principal(s)) engage another person (the agent) to perform
some service on their behalf which involves delegating some decision making
authority to the agent.” Based on this statement, shareholders can be seen as the
principles and managers can be seen as agents. Furthermore, both sides have their
own interests’ target. This leads to diverge in the relationship between the two parties
(Berle and Means, 1932). Moreover, due to the separation of this ownership and
control, managers know more information regarding to the company than
shareholders. Thus, managers could be inclined to act for self-interested motivation
rather than shareholders’ interest. Meanwhile, managers could also use the unique
information which is unavailable to shareholders engaging in earnings management.
This behavior will mislead shareholder, and harm the best interest of shareholders. To
solve this problem, monitoring can be applied to reduce the conflict of interests
between managers and shareholders. “Monitoring” means the shareholders measure
the performance of the managers (Fama and Jensen, 1983). The cost, which is
generated by the shareholders monitoring the actions of management, is called
“monitoring cost”.
2.3.2 Positive accounting theory
Before introducing positive accounting theory, it is necessary to know two main
streams of accounting theories: Normative and Positive. Normative means that the
objective is to tell managers what ought or should do. Positive means that the
objective is to predict and to understand what is or will be (Vorster, 2007). The
Positive Accounting Theory (PAT) is one of the most important accounting theories
Page 24
in the prior decades. It is based on the assumptions that managers work for selfinterest and exhibit opportunistic behavior. It seeks to predict and explain why
managers choose to use specific accounting methods (Watts and Zimmerman 1986).
According to Scott (2009) PAT is “concerned with predicting such actions as the
choices of accounting policies by firm managers and how managers will respond to
proposed new accounting standards.”
An important background theory that could explain why managers choose to use
particular accounting methods is Agency Theory. Because of the separation of
ownership and control, controllers know more information than owners, which leads
to an information asymmetry problem. In this situation, management may select
specific accounting methods to benefit themselves. With this statement, it can be said
that Agency Theory is a theoretical cornerstone of PAT.
The Positive Accounting Theory has three hypotheses: the bonus plan hypothesis, the
debt/equity hypothesis and the political cost hypothesis. These hypotheses will be
shortly explained below.
The bonus plan hypothesis: as described before, managers work for the maximum selfinterest. Therefore, managers who have bonus plan are more likely to use accounting
policies to increase current period reported income. It predicts that if managers’ payments
depend on the bonus which is related to the income on the financial report, they may
attempts to increase the bonus by increasing the reported income (Watts and Zimmerman,
1986).
The debt/equity hypothesis: this hypothesis demonstrates that if a company has higher
debt/equity ratio, managers are more likely to adopt accounting methods to shift the
reported income from future periods to the current period. It presents that if a company
has covenant to have certain level of ratio, managers may use accounting policies to raise
income as much as possible in fear of violation of covenant. Dichev & Skinner (2002) in
their research article drew a similar conclusion that managers choose accounting policies
to maintain covenant ratios and work harder to avoid covenant violation.
The political cost hypothesis: it indicates that if a firm has a higher political cost,
manager is more likely to reduce the current earnings. Just as presented in the
previous section, high profit of a company may attract attention of both government
and regulators. Management of the company may choose accounting policies to defer
the current earnings to future (Watts and Zimmerman, 1986).
Page 25
In this thesis, Agency Theory and Positive Accounting Theory (PAT) are applied as
theoretical supporting for empirical researching. PAT may be helpful to evaluate and
explain the motivations of observed activities of accounting activities. In the
meanwhile, PAT can be adopted to forecast the unobserved accounting activities.
Agency Theory may provide a foundation for understanding the issue of corporate
governance in greater depth. Specially, the corporate governance mechanism can be
discussed by Agency Theory in relation to reduce agency cost, protect shareholders’
interest and align the agent-principal relationship (Davis et al., 1997).
2.4
Background of China
In this research thesis, China will be taken as an example of the emerging markets for
analysis of the relationship between corporate governance and earnings management.
In this section, some background information about China will be introduced and two
special features of China will be highlighted.
2.4.1 Ownership structure
Although China’s Economy has dramatically growing in the two decades, corporate
governance framework is still developing. The first unique feature of China’s
ownership structure is highly concentrated ownership. In UK, European countries,
U.S., and other developed markets, firms normally belong to private people, families
or organizations. However, the situation in China is different. Most of firms of China
are state-owned enterprises (SOEs). The term “state-owned enterprises” refers to
companies or business entities established by central and local governments, or
governments have control power of the company. Moreover, according to a report
from Gao Xu, an economist from The World Bank1, there were 154,000 SOEs in the
end of 2008. Meanwhile, the average assets of SOEs equal to 13.4 times of non-SOEs.
In addition, The CFA institution (2007) shows that the state holds the majority of
shares of listed firms in China. It is estimated that 60% shareholding held by state in
the end of 2001.
According to OECD (Organization for Economic Co-operation and Development)
working group (2009), in the end of 2004, the total number of listed firms is 1342
which consists of 400 Non-SOE listed firms (around 30% of total number of listed
1
Source from: The World Bank: http://blogs.worldbank.org/eastasiapacific/state-owned-enterprises-in-china-howbig-are-they (2010)
Page 26
firms) and 942 SOE listed firms (around 70% of total number of listed firms). Table
2.1 introduces the size of Non-SOE listed firms and SOE listed firms from 1998 to
2004 in China. As described in the table, Non-SOE listed firms account for small size
of total listed firms constantly. However, SOE listed firms keep account for large size
for the total size of listed firms.
Table 2.1. Number of listed companies of China from1998 to2004
1998 1999 2000 2001 2002 2003 2004
Non-SOE listed firm
120
149
187
205
247
313
400
SOE listed firms
701
769
867
931
945
942
942
Total listed firms
821
918
1054 1136 1192 1255 1342
Source from: (OECD, 2009).
2.4.2
Board structure
Comparing to the board structure of U.S. and other leading European countries, the
board governance structure of China listed firm adopts two-tier structure similar to the
Netherlands and Germany. The two-tier board consists of the board of directors and
supervisory board. In 1993, China’s Company Law requires all public firms in China
to establish supervisory board which includes at least three members. At least one
should be selected from employees of the firm and at least one should represent the
interests of the shareholders. The board directors, top executives and financial
managers cannot be appointed into supervisory board. Moreover, the supervisory
board should be independent of the board of directors (Firth et al., 2007). In the
meanwhile, Company Law (1993) also requires all listed firms to keep the mechanism
as board of directors, board of supervisors and an annual meeting with shareholders
(Xiao et al., 2004). It also presents that supervisory board is designed to monitor the
day-to-day work of management, control and oversee the actions of board directors
and monitor the financial affairs of the company. Figure 2.2 presents the relationship
between shareholders, management, board of directors and board of supervisors
(Chang et al., 2013). In 2006, the revision version of Company Law highlights the
supervisory board should protect the interest of the firm besides the old vision of the
Company Law of 1993 (OECD, 2011). In 2002, the code of corporate governance of
China was published by China Securities Regulatory Commission (CSRC). One of
Page 27
statements of this Code is that the members of supervisory board should have
professional knowledge and work experience in accounting and law (CSRC, 2002).
Although the two-tier board structure of China is similar to that of the Netherlands
and Germany, there still have some differences from the two Counties. For instance,
in the Netherlands, the supervisory board has rights to appoint or fire the member of
the board directors, whereas the supervisory board of China does not have such rights.
Furthermore, the members of supervisory board can be generally nominated by the
supervisory board itself 2 . This is also different from the election process of
supervisory board in China.
Board of Supervisors
Monitoring
Board of Directors
Management
Monitoring
Shareholder Meeting
Fig. 2.2. China two-tier board framework (Chang et al., 2013)
2.5
Summary
This chapter provides several definitions of earnings management and corporate
governance. In the meanwhile, it introduces the previous literature evidence on how to
detect earnings management. Moreover, two important theories (Agency Theory and
Positive Accounting Theory) are illustrated to help explain the earnings management
behaviors by management. Finally, it introduces the background of China and
highlights two special features related to corporate governance (ownership structure
and two-tier board).
2
Source from: http://www.eurofound.europa.eu/emire/NETHERLANDS/SUPERVISORYBOARD-NL.htm(2009)
Page 28
Chapter 3. Literature Review
In order to answer the sub-research question “What are the prior research results on
the relationship between corporate governance and earnings management?” the prior
literature related to this question will be introduced in this chapter. Section 3.1
provides an overview of prior empirical researches on corporate governance. In
Section 3.2, the empirical literature evidence linked to earnings management will be
introduced. Section 3.3 will present the literature associating to corporate governance
and earnings management, especially the explanations of the correlation between
specific proxies for corporate governance and earnings management. The last section
will give a summary of this chapter.
3.1
Literature evidence on corporate governance
Besides the definitions and categories of corporate governance which have been
introduced in Chapter 2, the other fields of corporate governance have been also
investigated by researchers and analysts. Gregory and Simms (1999) documented that
effective corporate governance is critical because it improves the resource use
efficiency of the company. In the meanwhile, effective corporate governance helps
the company and economies to attract investment capital through the improved
confidence of investors from domestic and foreign areas. They also presented that
effective corporate governance assists firms to meet the social expectations and
enhance the long-term performance of firms. In short, companies’ performance is
reflected on whether corporate governance mechanism of firms is effective or not.
Furthermore, researchers and analysts attempt to analyze corporate governance more
specific. For instance, Patel et al. (2002), Utama (2003) and Basel Committee (2005)
all stated that the disclosure is an important part of corporate governance. The
information asymmetry problem is reduced because of higher level disclosure. Chung
et al. (2010) investigated the relationship between corporate governance and stock
market liquidity based on the data collected from Institutional Shareholder Services
(ISS) and indicated that effective corporate governance mechanism can improve stock
market liquidity. Based on the data of Thailand listed firms from 2006 to 2009,
Prommin et al. (2014, see Appendix A.4) also came to conclusions similar to Chung
et al. (2010) - there is a significant association between corporate governance and
Page 29
equity liquidity. Especially, they demonstrated that liquidity is improved significantly
as governance quality increases. Moreover, this effect still exists even after
controlling lots of relevant factors such as firm size, leverage, and firm age.
According to the survey data of Indian firms in 2006, Balasubramanian et al. (2010,
see Appendix A.1) established a broad Indian Corporate Governance Index (ICGI) to
investigate the association between ICGI and firm value. Although the causal effect
could not be verified due to its one year cross-sectional data, they still concluded that
there is a positive relationship between ICGI and firm value. This relationship is more
significant in large profitable companies in India. They also claimed that corporate
governance mechanism is not “one fits all”. This might imply that different industries,
cultures, areas, firm size etc. need to be considered into the corporate governance
structure.
The studies related to corporate governance in China are developing in the decades
(Liu 2005). Allen et al. (2005) indicated that standard corporate governance
mechanisms are ineffective for public listed firms in China. However, other
governance mechanisms based on reputations and relationships have been effective in
the private sector. Based on the data from China Stock Market and Accounting
Research (CSMAR) database and the China Corporate Governance Research (CCGR)
database, Li et al. (2007, see Appendix A.3) analyzed the connection of CEO
compensation and corporate governance structure, and found less evidence of Chinese
CEOs taking advantage of weaker governance structures to boost their compensation.
Hass et al. (2014, see Appendix A.2) investigated the association between corporate
governance and information environment based on the data from China Stock Market
during 2003-2011. They used analyst following, analyst forecast accuracy, and
analyst forecast dispersion and price timeliness as proxies for information
environment and constructed a parsimonious firm-level score of corporate governance
which captures seven characteristics. The research outcome reveals that wellgoverned companies are connected to the larger analyst followings and more
information forecasts.
The previous paragraphs described some relevant research fields connected to
corporate governance. There is a large body of research literature based on the
relationship between corporate governance and earnings management besides those
presented above. It will be introduced in Section 3.3.
Page 30
3.2
Reviewing prior literature on earnings management
Earnings management is an important research topic in the current society. The
incentives of managers carrying out earnings management attract a lot of attentions
from the prior literature. Based on the data of companies listed on Taiwan’s Over the
Counter (OTC) market and Taiwan Stock Exchange from 2005 to 2007, Chen and
Tsai (2010, see Appendix B.2) investigated the motivations of earnings management.
They demonstrated that there are three broad categories of motivation which lead to
earnings management. These are “altruistic motivation, speculative motivation and
pressure from affiliated parties.” Burgstahler and Dichev (1997) found out that the
reason of companies attempting to manipulate earnings is to avoid the losses and
decreases of earnings. In addition, they also found out that two components of
earnings (cash flow from operating and changes in working capital) are easily adopted
to manipulate earnings. Based on a sample of 312 Chief Financial Officers (CFOs) of
listed firms, Graham et al. (2005) pointed out that 86.3% of CFOs strongly agree that
beating the earnings standards assists to get credibility with capital market. Kedia
(2003, see Appendix B.3) focused on the investigation of pay for performance
incentives on earnings management using the data of 224 listed firms from January
1997 to June 2002. Kedia’s paper controls several other incentives such as debt
covenants and analyst forecasts to relax the endogeneity problem. It concludes a
positive relationship between pay for performance incentives (based on stock and
options) and earnings manipulation, implying that management is more likely to
maximize their pay by manipulating earnings.
The prior literature presented that reducing taxation burdens drives management to
manipulate earnings. By using the data of China A-share listed companies from 2004
to 2006, Wang et al. (2012, see Appendix B.4) found out that there is a significantly
positive relationship between earnings management and tax avoidance. Specifically,
long-term business performance weakens this positive relationship. Furthermore, the
business performance of state-owned enterprises has less influence on earnings
manipulation. Similarly, Marques et al. (2011) investigated the correlation between
tax policy and manipulation of earnings based on private Portuguese companies. They
found that companies with higher average income tax rates were more likely to
manage their earnings than other companies with lower income tax rates. Moreover,
Beneish et al. (2005, see Appendix B.1) provided another explanation of earnings
Page 31
management incentives, which is insider trading. By analyzing of 462 firms who had
financial problems during the years from 1983 to 1997, they pointed out that insider
selling incentives are related to earnings management. In the meanwhile, they also
highlighted that both debt contract incentive and insider selling incentives expand the
likelihood of income increasing earnings management.
Prior empirical literature also provides numerous evidences on the accrual-based
earnings management and real activities earnings management. It is argued that most
of prior research articles have tried to detect earnings management by accrual-based
approach (Dechow et al., 1995). The primary objective of accruals is to show the true
performance of the company. Management can record the revenue and expenses
rather than present the cash in or outflows. However, accruals can be also used to
manipulate earnings. For instance, the bad debt reserves and the inventory writedowns can be manipulated to increase or decrease the income. Therefore, these
discretionary behaviors are employed to investigate earnings management. Robb
(1998), using a sample of banks, indicated that bank managers are likely to
manipulate earnings to beat the market expectation. His research outcome stated that
the bank managers use loan loss provision to manage earnings in a discretionary
manner. Daniel et al. (2008) indicated that before the passage of the Sarbanes-Oxley
act in 2002, accrual-based earnings management was adopted extensively. On the
other hand, real-activities earnings management also attracts a lot of attentions.
Graham et al. (2005) conducted a survey of 401 executives and demonstrated that
managers prefer real activities earnings management to accrual-based earnings
management. Gunny (2010) also draw a similar conclusion as Graham did and
presented that managers like to use real activities earnings management with better
operating performance.
3.3
Corporate governance and earnings management
In the last three decades, lots of researchers and analysts have devoted themselves to
investigate corporate governance aspects and attempt to explain the existence and
determinants of earnings management. However, as presented in Chapter One, most
of literature is based on the developed market such as U.S. and Western Countries.
The key argument is whether corporate governance could constrain the activities of
earnings management effectively? The empirical literature shows a lot of answers to
this question. Shen and Chih (2007, see Appendix C.8) investigated the effect of
Page 32
corporate governance on earnings management by using 495 companies of 25 Asian
emerging countries. They found a negative relationship between corporate governance
and earnings management, and pointed out that companies with large size and higher
growth have more earnings management activities. Good corporate governance
mechanism can assist to reduce the level of earnings management. The similar
conclusion was drawn by Cornett et al. (2009). They took large U.S. banks as samples
and found out that some corporate governance elements can help to reduce the
earnings management. Moreover, Houqe et al., (2007) found a positive relationship
between corporate governance mechanism and the quality of earnings based on India
evidence. Specifically, this article used return on equity (ROE) as control variable.
Wang et al. (2011) studied the association of the Sarbanes-Oxley Act of 2002 and
earnings management. Sarbanes-Oxley Act (the SOX Act) is designed for innovating
corporate governance structure. The research outcome indicated that the
implementation of SOX Act reduced the earnings management significantly. However,
not all research results presented a significant relationship between corporate
governance and earnings management. Abed et al. (2012, see Appendix C.2) took
listed firms of Amman Stock Exchange (Jordan) from 2006 to 2009 as a research
sample, and analyzed the relationship between corporate governance and earnings
management. The outcome is surprising – no significant relationship between
corporate governance factors and earnings management. The authors explained that
this is because Jordanian public listed firms are owned by family or identifiable group.
Therefore, agency problem is not pronounced and the role of corporate governance
mechanism is less necessary in this situation. In the next sub-sections, researches
related to specific items of corporate governance and earnings management will be
introduced.
3.3.1 Board characteristics
Plenty of researchers took board characteristics as an important element of corporate
governance research. Board size, independent directors, supervisor board size and
CEO duality are often adopted in those empirical literatures.

Board size
There is no clear consensus on whether the board size affects earnings management.
Using 281 listed firms as a sample, Xie et al. (2003, see Appendix C.10) indicated
Page 33
that large board size can help to reduce earnings management because independent
directors with law or accounting knowledge are more likely to be included in large
board. Similar results were provided by other researchers such as Chtourou et al.
(2001). They concluded that the corporate board size has a negative relationship with
earnings management. This means the larger the corporate board is, the less activities
of earnings management exist. However, lots of researchers argued that large board
size is not effective for the company. Lipton et al. (1992) presented that the number of
members of corporate board should not be more than ten people. It is hard to
exchange ideas efficiently due to large body of board members. By using a sample of
97 listed firms from Malaysia in the period of 2002-2003, Abdul Rahman et al. (2006,
see Appendix C.1) studied the association between board characteristics, audit
committee, culture and earnings management. The empirical results indicated that
there is a significantly positive relationship between board size and earnings
management, implying large board size with more activities of earnings management.
Moreover, this research article took leverage (a ratio of total debt to total assets) and
firm size (nature logarithm of total assets) as the control variables. The results
indicated that there is a negative relationship between firm size and earnings
management. However, there was no significant relationship between leverage and
earnings management. Referring to supervisory board size, Firth et al. (2007) found a
significant and negative effect of supervisory board size on earnings management.

Independent directors
Fama and Jensen (1983) demonstrated that independent directors make the corporate
board more effective. It is obvious that insiders (directors) have more information
about the company than the outsiders (directors). This situation may lead to selfinterest of insiders at the expense of the shareholders. Therefore, independent
directors are included in the corporate board to monitor the whole board activities.
This improves company performance, decreases the agency conflicts and makes the
corporate board more effective in working as Fama and Jensen signaled. Klein (2002,
see Appendix C.6) also gave the similar conclusions. He analyzed the association
between earnings management and board directors by using 692 listed firms of U.S.
The research results showed that there is a significantly negative relationship between
abnormal accruals and independent directors, suggesting more independent directors
with less level of abnormal accruals. Furthermore, this study also adopted leverage
Page 34
and firm size as the control variables. The results presented a positive relationship
between leverage and earnings management, meanwhile a negative relationship
between firm size and earnings management. In China, Lo et al. (2010) suggested that
the more independent directors results in less level of transfer pricing manipulation.
However, the empirical research results on the association between earnings
management and board independence are conflicting. By using a sample of 539 firmobservations of Canada in the period of 1991-1997, Park et al. (2004, see Appendix
C.7) found that the independent directors do not have a statistically significant
correlation with earnings management, suggesting that the proportion of independent
directors does not assist the company to decrease activities of earnings management.
In addition, Abdul Rahman et al. (2006) used discretionary accrual as a proxy for
earnings management and found no significant relationship between independent
directors and earnings management for Malaysian samples.

CEO duality
Plenty of studies argue the role of Chief Executive Officer (CEO) who is also the
Chairman of the company. The Cadbury Committee published the Code of Best
Practice in 1992, suggesting separating the responsibilities of CEO and Chairman
(Dedman, 2002). Jensen (1993) also stated that separating the role of CEO from that
of Chairman improves the efficiency of the work. Actually, the duties of Chairman
are to run a board meeting, communicate with independent directors, and even
monitor the CEO. The combination of the roles of CEO and Chairman might weaken
the duty of Chairman. Based on a group of sample of 173 firms with CEO as
Chairman and 112 firms with non-CEO as Chairman, Davidson et al. (2004, see
Appendix C.4) pointed out that combining the two roles in the same person may
engage more in earnings management. This is because the CEO who is also acting as
the Chairman wants to show the confidence of facilitating the performance of the
company duo to the duality. Klein (2002) also obtained a similar result, which is that
discretionary accruals are positively connected to the CEO who holds the position of
Chairman. His findings reveal that the CEO who is also the Chairman with too much
control power over board responsibilities can manipulate earnings easily.
So far the prior empirical research outcomes suggest the separation of CEO duality to
reduce earnings management. However, Brickley et al. (1997, see Appendix C.3)
Page 35
showed that 80% of American companies have the situation of the same person
holding both positions of CEO and Chairman. They also highlighted that the
combination of CEO and Chairman has certain benefits. The cost of splitting those
positions is larger than agency cost of duality. They also found out that the CEOs
perform well after they hold the position of Chairman. As Lipton and Lorsch (1992)
mentioned, the true leader of a company is the CEO as Chairman, who is intelligent,
competent and experienced enough to hold this position. Abdul Rahman et al. (2006)
pointed out that CEO duality has no relationship with earnings management.
3.3.2 Ownership structure

Managerial ownership
In the previous literature evidence, the association between managerial ownership and
earnings management is still subject to debate. Jensen and Meckling (1976) argued
that the separation of ownership and control leads to the conflicts of interest between
managers and shareholders. When managers do not hold shares but lead a company,
their behaviors might be influenced by self-interested incentive. Some studies argued
that the insiders holding the shares would contribute to align the interests of
shareholders and management and would reduce the activities of earnings
management. Basing on the data of U.S. from 1988 to 1990, Warfield et al. (1995, see
Appendix C.9) investigated the association among informativeness of earnings, the
level of discretionary accruals and managerial ownership. Their research outcomes
indicated that when managerial ownership is low, the magnitude of discretionary
accruals is significantly high. This reveals a negative relationship between earnings
management and managerial ownership. Ali et al. (2008) also drew a similar
conclusion based on the samples from Malaysian listed companies. They analyzed the
correlation between discretionary accruals which is used as a proxy for earnings
management and managerial ownership, and found a significant and negative
relationship between those two items. However, this effect is less in large-sized firms
because these firms normally have good corporate governance mechanism in
Malaysia.
On the other hand, another opinion exists on this issue, which is maintaining high
level of managerial ownership encourages more earnings management. The higher
ownership may give management more power, who can engage in the self-interested
Page 36
activities. This may lead to the occurrence of earnings management. The empirical
study investigating managerial ownership and earnings management by Yang et al.
(2008, see Appendix C.11) stated that insiders with high level of shares holding could
gain from earnings management. This is because insiders with the purpose of
increasing the value of shares they hold and keeping the high stock price may engage
in more activities of manipulating earnings. Morck et al. (1988) argued that greater
ownership results in more entrenchment and provides more incentives to pursue
opportunistic behaviors. Moreover, Isenmila and Elijah (2012) examined the
relationship between ownership structure and earnings management based on the
samples of Nigeria. Their finding is consistent with Morck’s finding, and indicated
that there is a significantly positive relationship between insider ownership and
earnings management.

Block-holders ownership
Block-holders are the shareholders who have a large proportion of the firms’ shares
than other shareholders. Holderness (2009) presented that 96% of U.S. companies
have at least one block-holder who owns at least 5% or greater of total shares. He
also indicated that these block-holders totally own 39% of the companies. Since the
block-holders have large amount of shares, they may have more power to influence
the operation of the company. Shleifer and Vishny (1986) indicated that large blockholders have strong motivations to monitor and influence the company management.
Thus, block-holders ownership can be seen as an important role in monitoring
earnings management, suggesting a negative relationship between block-holders
ownership and earnings management. Klein (2002) found a significant and negative
relationship between 5% blocker-holder setting in audit committee and earnings
management. A study by Iturriaga and Hoffmann (2005, see Appendix C.5) attempted
to determine the influence of internal corporate governance on earnings management
by choosing a sample of Chilean firm-observations from 1991 to 2001. Their finding
showed that large shareholder ownership can reduce the discretionary behaviors by
management.
However, other empirical evidences have opposite opinions indicating that high level
of block-holder ownership may engage in more activities of earnings management.
Yang et al. (2008) used a sample of 1306 Taiwan-listed firm in Taiwan Economic
Page 37
Journal database (TEJ) to investigate the association between discretionary accruals
which is a proxy for earnings management and ownership structure. The outcomes
show that there is a positive relationship between block-holders ownership and
earnings management, suggesting higher magnitude of block-holder ownership
related to more earnings manipulations. This is because large shareholders have more
powers and rights to create private interests. Meanwhile, by using this powers and
rights, large shareholders may intervene in the affairs of the company, and may
encourage management to pursue earnings management to self–interest (Jaggi et al.,
2007).
3.4
Summary
In summary, this chapter provided a large number of literature evidence including
corporate governance research fields, earnings management researches and the
investigations on the relationship between corporate governance and earnings
management. This literature evidence provides a theoretical basis for this research
thesis. Based on those literatures, several crucial evidences related to corporate
governance and earnings management will be employed to help the further processes
of this thesis. For instance, as mentioned before, Shen and Chih (2007) and Cornett et
al. (2009) demonstrated that good corporate governance can reduce the level of
earnings management, implying a relationship between these two items. In contrast,
Abed et al. (2012) indicated that corporate governance has a weak power in affecting
earnings management. Those evidences can assist in developing first hypothesis on
whether a relationship between corporate governance and earnings management exists
or not. Moreover, this chapter also introduces several prior literatures which
investigate the important specific items of corporate governance such as board size,
CEO-duality, independent directors, managerial ownership and block-holders
ownership. Those literatures present different research outcomes between specific
items and earnings management. For instance, Xie et al. (2003) illustrated a negative
relationship between board size and earnings management while Abdul Rahman et al.
(2006) indicated an opposite conclusion. Warfield et al. (1995) and Ali et al. (2008)
also drew a similar conclusion that there is a negative correlation between managerial
ownership and earnings management. In contrast, Yang et al. (2008) presented that
the level of earnings management activities increases when managerial ownership is
high. All of the various conclusions provide a strong theoretical support for
Page 38
hypotheses development and research design. Finally, Klein (2002) and Rahman et al.
(2006) employ leverage and firm size (nature logarithm total asset) as control
variables into their studies because firm size and leverage have significant
relationship with earnings management. Houqe et al. (2007) adopted return on equity
(ROE) as one of control variables to investigate the association between corporate
governance and earnings quality. They found a positive relationship between ROE
and earnings management. These methods which consider leverage, firm size and
ROE as control variables contribute for the regression model design in the further
chapters.
Page 39
Chapter 4. Hypotheses Development
In this chapter, several hypotheses related to this research thesis will be developed.
Firstly, the sub-question: “What are the hypotheses for the empirical research of this
thesis?” will be answered. Then, the hypotheses connected to the main research
question will be formulated.
The main research question of this thesis was formulated as: “Is there a difference in
the relation between corporate governance and earnings management in the
emerging market of China and in the developed market of The United States of
America?” Based on the empirical literature evidence related to corporate governance
and earnings management presented in the previous chapter, the answer to this
research question will be found according to hypotheses development.
Most of researchers demonstrated a negative correlation between corporate
governance and earnings management, implying that good corporate governance
mechanism could reduce the activities of earnings management. The empirical study
provided by Hutchinson et al. (2008) indicated that corporate governance mechanism
is important for reducing earnings management. Similarly, Gulzar et al. (2011), using
a sample of 1009 listed firms from China Center for Economic Research (CCER)
during 2002-2006, analyzed the association between corporate governance and
earnings management. Their research results confirmed the relationship between those
two items and highlighted the vital role of corporate governance in mitigating
earnings management. However, Abed et al. (2012) stated that there is a weak
relationship between corporate governance and earnings management, suggesting
corporate governance may not limit the activities of earnings management effectively.
Although some articles indicated an insignificant relationship between corporate
governance and earnings management, a large number of other evidence confirm the
relationship between them. Therefore, the first hypothesis is formulated as:
H1 :
There is an association between corporate governance and earnings
management in China.
H2 :
There is an association between corporate governance and earnings
management in U.S.
Page 40
This thesis will adopt U.S. data to compare with that of China related to corporate
governance and earnings management. As mentioned before, China and other
emerging markets are weak related to researches of corporate governance and
earnings management. Pagano et al. (1998) demonstrated that companies are less
developed in term of corporate governance than those in developed countries based on
the Italian dataset. Claessens and Yurtoglu (2013) indicated that corporate governance
issues in emerging markets are different from that in developed markets. In addition,
U.S., as the largest economy in the world, is a benchmark related to the researches of
corporate governance and earnings management after financial scandal of 2000s.
Therefore, to answer the main research question, it is expected that:
H3: There is a difference in the association between corporate governance and
earnings management in U.S. and China.
Page 41
Chapter 5. Research Design
The theoretical background and literature reviews of the relevant research studies on
the relationship between corporate governance and earnings management have been
presented in previous chapters. Based on the theories and empirical evidence, the
hypotheses of this thesis have been formulated in Chapter 4. This chapter will
concentrate on developing the research design of this thesis. Firstly, the main research
model for the statistical analysis such as dependent variable, independent variables
and control variables will be introduced. After that, the process of data selection will
be presented. In the end, the statistical tests adopted in this thesis will be discussed.
5.1
Research model
5.1.1 Measurement of discretionary accruals
This thesis applies the Performance-Matched Discretionary Accruals Model to
calculate discretionary accruals, which is proxy for earnings management. Firstly,
Dechow et al. (1995) assessed prior accrual-based models in detecting earnings
management by comparing the specification and the power of test
3
across
discretionary accruals estimated by those models. Their outcomes indicated that all
models face a problem: the probability of making a type I error is high when those
models applied to sample firms with extreme firm performance. Kothari et al. (2005)
added lagged return on asset as a tool to control this extreme performance situation,
which reduces the misspecification problem. Dechow et al. (2012) stated that the
Performance-Matched Discretionary Accruals Model eliminates misspecification
effect to some extent. Ronen and Yaari (2008) demonstrated that this model is
superior to the Jones model in showing strong results. Secondly, Dechow et al. (2012)
introduced a new method to investigate earnings management. This new approach
assumed that the occurrence of accruals-based earnings management activities in one
period will reverse in another period. By adopting a dummy variable (equal to 1 if
earnings management reverses certainly in another period and 0 otherwise) to
measure earnings management, Dechow et al. (2012) found that this approach
3
Power of test: The probability that a test will reject a null hypothesis that is false. Source from: Park, Hun
Myoung. 2008. Hypothesis Testing and Statistical Power of a Test. Working Paper. The University Information
Technology Services (UITS) Center for Statistical and Mathematical Computing, Indiana University.”
http://www.indiana.edu/~statmath/stat/all/power/index.html
Page 42
improves power of test when the researchers know the specific periods. However, this
method does not clearly point out how to identify the periods when accrual-based
earnings management happen and reverse. Based on the aforementioned discussions,
the Performance-Matched Discretionary Accruals Model is employed for this study.
In order to obtain discretionary accruals, the total accruals need to be calculated first.
The numerous empirical research based method presented in section 2.1.2 of Chapter
2 is used here to estimate total accruals.
TA𝑡 (∆CAt − ∆CLt − ∆CASHt + ∆DEBTt − DEPt )
=
At−1
At−1
(5.1)
After obtaining the value of total accruals, then the specific parameters a1, a2, a3, and
a4 in equation (5.2) can be estimated by running OLS regression.
TAt
1
ΔREVt − ΔRECt
PPEt
= 𝑎0 + a1 (
) + a2 (
) + a3 (
) + a4 (ROAt or t−1) + 𝜀𝑡
At−1
At−1
At−1
At−1
(5.2)
With the obtained a1-a4, the value of non-discretionary accruals can be calculated as
follow.
NDAt
At−1
= 𝑎0 + a1 (
1
At−1
) + a2 (
ΔREVt − ΔRECt
At−1
) + a3 (
PPEt
At−1
) + 𝑎4 (ROAt or t−1 )
(5.3)
By substituting the values of total accruals and non-discretionary accruals into
equation (5.4), discretionary accruals can be obtained.
DAt
TAt NDAt
=
−
At−1 At−1
At−1
(5.4)
5.1.2 Measurement of corporate governance
After estimating the discretionary accruals which proxy for earnings management,
corporate governance measured by several specific items will be introduced. These
specific items are the board characteristics and ownership structure which were
discussed in Chapter 3. Fama and Jensen (1983) indicated that board of directors play
an important role in corporate governance mechanism. Claessens and Yurtoglu (2013)
also emphasized that board characteristics are crucial to governance system.
Furthermore, ownership structure is another vital part of corporate governance system
and is often discussed in tremendous numbers of empirical studies. Bebczuk (2005)
mentioned that the link between corporate governance and ownership structure has
Page 43
been studied and developed since 1970s. Kaur and Suveera (2008) demonstrated that
investigating corporate governance issues especially related to ownership structure
could yield important insights into this topic. Therefore, this thesis will concentrate on
investigating the relationship between board features and ownership structure which
proxy for corporate governance and earnings management.
(Supervisory) Board size
Jensen (1993) indicated that the board size should be small in order to enhance the
performance of the company. An appropriate number of the board members should
not be more than eight people. Similarly, Yermack (1996) also stated that the firm
performance will be better when the board is smaller in size. However, Dalton et al.,
(1999) indicated an opposite statement that there is positive relation between board
size and firm performance. Referring to supervisory board, Habbash et al. (2014)
demonstrated that supervisory board could not reduce the activities of earnings
management based on the Chinese listed firms from 2005 to 2010. This argument is
different from that of Firth et al. (2007) who found a negative relationship between
supervisory board size and earnings management.
Although the prior studies did not reach a general consensus on the relationship
between (supervisory) board size and earnings management, the expectation in this
thesis is a negative relationship between (supervisory) board size and earnings
management. The total number of (supervisory) board directors is used to measure
board size (𝐵𝑆𝑖,𝑡 and 𝑆𝐵𝑆𝑖,𝑡 ).
Executive directors and non-executive directors
Generally, U.S. listed companies adopt one-tier board structure which is composed of
executive directors and non-executive directors. Executive directors are the directors
who really manage and run the whole corporation as executives. Non-executive
directors are people who do not form part of the executive management team but
monitor the day to day work of management (Shakir, 2008). By comparing the board
structures of the U.S. and Germany, Tüngler (2000) indicated that the non-executive
directors are similar to supervisory board, especially in the function of monitoring the
activities of executive directors and management. Bergstresser et al. (2006) showed
that executive directors are more likely to engage in earnings management to enhance
incomes and stock price, which increases their compensation eventually. Chtourou et
al. (2001) investigated the effect of non-execuive directors on earnings management.
Page 44
A negative relationship between these two items has been found out, meaning that
larger size of non-exective directors is accosicated with lower level of earnings
management activities.
According to the above arguments, a negative (positive) correlation between nonexecutive directors (executive directors) and earnings management is expected. Nonexecutive directors (𝑁𝐸𝐷𝑆𝑖,𝑡 ) and executive directors (𝐸𝐷𝑆𝑖,𝑡 ) are measured by total
numbers of non-executive directors and executive directors in sample firms,
respectively.
Independent directors
Independent directors play an important role in monitoring the actions of management
and protecting the interests of shareholders. Some researchers argued that higher
proportion of independent directors tends to have lower level of earnings
manipulations (Peasnell et al., 2006; Ebrahim 2007). On the other hand, some
researchers gave an opposite argument - independent directors might not have a
significant and effective impact on reducing earnings management activities (Park et
al., 2004). Apparently, prior research conclusions of the relationships between
independent directors and earnings management are conflicting. Therefore, it is
difficult to draw a certain statement related to independent directors and earnings
management. But, it expects a negative relationship between those two items which
follows the studies of Peasnell et al. (2006) and Ebrahim (2007). Independent
directors (𝐵𝐼𝑖,𝑡 ) is measured by the ratio of independent directors to total board size.
CEO duality
Although few research studies argued that the combined roles of CEO and Chairman
might benefit the company, a great number of other empirical studies disagree with
this statement. Chen et al. (2006) stated that one person holding the positions of CEO
and Chairman is more likely to manage earnings because this will decrease the
monitoring function of the board. This leads to higher level of manipulation behaviors.
The Malaysian Code on Corporate Governance (MCCG) 2000 recommends
separating the roles of CEO and Chairman to reduce the likelihood of concentration of
power in one person (Hashim, 2008). In this thesis, it predicts the relationship
between earnings management and CEO duality as positive, implying CEO as
Chairman will do more earnings management activities. A dummy variable is adopted
Page 45
to measure CEO-duality (CEO-dummyi,t), which is equal to 1 when the position of
CEO and Chairman is combined and equal to 0 if otherwise.
Managerial ownership
In Chapter 3, it has been argued that there is no general consensus with respect to the
impacts of managerial ownership on earnings management. Alves (2012) found a
negative relationship between earnings management and managerial ownership based
on the Portugal-listed firms. A U-shaped relation between managerial ownership and
earnings management was found by Yeo et al. (2002) based on investigating
Singapore-listed companies. Their research results showed that earnings management
is reduced when the magnitude of managerial ownership is low, and vice versa.
However, Al-Fayoumi et al. (2010) found a significantly positive relationship
between earnings management and managerial ownership, meaning that a company
with higher level of managerial ownership engages in more activities of earnings
management. It is difficult to conclude a certain statement on the association between
managerial ownership and earnings management because of the contradictory
findings mentioned before. However, in this thesis the correlation between these two
items is expected positive which follows Al-Fayoumi et al. (2010). Management
ownership (Insideri,t) is estimated by the percentages of outstanding shares held by
management.
Block-holders ownership
The academic evidence is various related to the association between block-holders
ownership and earnings management. Iqbal et al. (2010) indicated a significantly
negative relationship between block-holding and earnings management by using the
data of UK, suggesting that a large block-holders ownership forms a low level of
earnings management. Similarly, Klein (2002), Iturriaga and Hoffmann (2005) and
Shleifer and Vishny (1986) also presented the same conclusions. Obviously, these
studies took block-holding as an effective mechanism to monitor management and to
reduce the likelihood of discretionary behaviors. However, few studies stated an
opposite views. For instance, Zhong (2007) demonstrated a significantly positive
relationship between block-holders ownership and discretionary accruals and stated
that block-holders are ineffective in monitoring discretionary behaviors. Although the
above arguments are contradictory, it is expected that the relationship between blockholding and earnings management is negative. On the other hand, the method of
Page 46
measuring block-holders ownership (𝐵𝑙𝑜𝑐𝑘 − ℎ𝑜𝑙𝑑𝑒𝑟𝑖,𝑡 ) is followed by Yang et al.
(2008) who use percentages of outstanding shares held by any 5% or greater
shareholders to estimate block-holders ownership. The summary of all independent
variables will be presented in Table 5.1.
5.1.3 Research regression model
The first multivariate regression model is adopted to investigate corporate governance
and earnings management based on China dataset. The model presents as follow:
𝐷𝐴𝑖,𝑡 = 𝛽0 + 𝛽1 × 𝐵𝑆𝑖,𝑡 + 𝛽2 × 𝐵𝐼𝑖,𝑡 + 𝛽3 × 𝐶𝐸𝑂 − 𝑑𝑢𝑚𝑚𝑦𝑖,𝑡 + 𝛽4 × 𝑆𝐵𝑆𝑖,𝑡 + 𝛽5
× 𝐼𝑛𝑠𝑖𝑑𝑒𝑟𝑖,𝑡 + 𝛽6 × 𝐵𝑙𝑜𝑐𝑘 − ℎ𝑜𝑙𝑑𝑒𝑟𝑖,𝑡 + 𝛽7 × 𝐹𝑆𝑖,𝑡 + 𝛽8 × 𝑅𝑂𝐸𝑖,𝑡
(5.5)
+ 𝛽9 × 𝐿𝑒𝑣𝑒𝑟𝑎𝑔𝑒𝑖,𝑡 + 𝜀𝑡
Where:
𝐷𝐴𝑖,𝑡
=
the absolute value of discretionary accruals scaled by lagged total assets
𝐵𝑆𝑖,𝑡
=
the number of board members (supervisory board member is excluded)
𝐵𝐼𝑖,𝑡
=
proportion of independent directors to total board size
𝐶𝐸𝑂 − 𝑑𝑢𝑚𝑚𝑦𝑖,𝑡
=
equal to 1 if CEO is Chairman, equal to 0 if otherwise.
𝑆𝐵𝑆𝑖,𝑡
=
the number of supervisory board members
𝐼𝑛𝑠𝑖𝑑𝑒𝑟𝑖,𝑡
=
percentages of shares hold by management
𝐵𝑙𝑜𝑐𝑘 − ℎ𝑜𝑙𝑑𝑒𝑟𝑖,𝑡
=
percentages of shares hold by block-holders
𝐹𝑆𝑖,𝑡
=
nature logarithm of total assets as proxy for firm size
𝑅𝑂𝐸𝑖,𝑡
=
nature logarithm of return on equity
𝐿𝑒𝑣𝑒𝑟𝑎𝑔𝑒𝑖,𝑡
=
nature logarithm of leverage
𝜀𝑡
=
error term
As mentioned before, this thesis will compare the results of U.S. listed companies and
China-listed companies by using the same methodology. Although the US-listed
companies have no supervisory board because of one-tier board structure, Tüngler
(2000) indicated that the non-executive directors are similar to supervisory board,
especially in monitoring function. Therefore, in this research design the board based
on the U.S. listed companies is split to two parts: non-executive directors and
executive directors. This method is to balance the regression model which is similar to
Page 47
that base on China dataset. Meanwhile, this design will answer the hypotheses in
Chapter 4.
The second regression model based on U.S. dataset is formulated as:
𝐷𝐴𝑖,𝑡 = 𝛽0 + 𝛽1 × 𝐸𝐷𝑆𝑖,𝑡 + 𝛽2 × 𝐵𝐼𝑖,𝑡 + 𝛽3 × 𝐶𝐸𝑂 − 𝑑𝑢𝑚𝑚𝑦𝑖,𝑡 + 𝛽4 × 𝑁𝐸𝐷𝑆𝑖,𝑡
+ 𝛽5 × 𝐼𝑛𝑠𝑖𝑑𝑒𝑟𝑖,𝑡 + 𝛽6 × 𝐵𝑙𝑜𝑐𝑘 − ℎ𝑜𝑙𝑑𝑒𝑟𝑖,𝑡 + 𝛽7 × 𝐹𝑆𝑖,𝑡 + 𝛽8
(5.6)
× 𝑅𝑂𝐸𝑖,𝑡 + 𝛽9 × 𝐿𝑒𝑣𝑒𝑟𝑎𝑔𝑒𝑖,𝑡 + 𝜀𝑡
Where:
𝐸𝐷𝑆𝑖,𝑡
𝑁𝐸𝐷𝑆𝑖,𝑡
= the number of executive directors
= the number of non-executive directors
Control Variables
As observed in both of regression models, firm size (𝐹𝑆𝑖,𝑡 ), return on equity (𝑅𝑂𝐸𝑖,𝑡 )
and leverage (𝐿𝑒𝑣𝑒𝑟𝑎𝑔𝑒𝑖,𝑡 ) are included as control variables, which are included into
multivariate regression models as explanatory variables for statistical analysis. The
reason of controlling these variables is because they may potentially correlate to both
independent variables and dependent variable. Without including control variables, it
would result in correlated omitted variables bias4.
Firm size is a critical control variable in the research of corporate governance and
earnings management. Given the large-sized firms potentially are associated to lower
information asymmetry and effective external monitoring, the level of earnings
management activities may be lower in these companies (Meek et al., 2007). In
contrast, Kim et al. (2003) indicated that large-sized firms are more aggressive in
earnings management than small-sized firms since the large-sized firms desire to
avoid reporting decreased income which may not meet or beat the analysts’
predictions. Because of the conflicting literature evidence, no expectations are made
for the firm size coefficient. In this thesis, firm size is defined as the nature logarithm
of total assets.
Return on Equity (ROE) is another important variable which needs to be controlled.
In 1996, a guideline issued by China Securities Regulatory Commission (CSRC)
4
Correlated omitted variables bias: the bias occurs when the regression model does not control for factors Z which
may relate to both X and Y. If the correlated variables are omitted, the regression coefficients are biased and the
causality is unclear. Source from: Barreto, H., Howland, F. (2006). Introductory Econometrics: Using Monte Carlo
Simulation with Microsoft Excel, Cambridge University Press.
Page 48
required that the listed firms must achieve a minimum ROE of 10 percentage of each
the first three years before rights offering. This may provide management with
motivations to manipulate earnings to meet the requirement of ROE (Chen et al.,
2004). In addition, Haw et al. (2005) indicated that rights issuing companies manage
reported incomes to meet ROE benchmarks. Therefore, it expects a positive
relationship between return on equity and earnings management.
The last control variable is the leverage which is a ratio of total debt to total assets.
Klein (2002) demonstrated that leverage may encourage management to engage in
earnings management because high level leverage is related to debt covenants
violation. Therefore, a positive relation is expected in this thesis between leverage and
earnings management.
Table 5.1. Summary of dependent variable, independent variables and control
variables
Variable title
Dependent
Control
variables
Prediction
DAi,t
Absolute value of discretionary accruals
BSi,t
Total number of board directors
BIi,t
Ratio of number of independent directors to total number of board directors
CEOdummyi,t
Dummy variable equal to 1, if CEO and
Chairman is the same individual, otherwise +
equal to 0
SBSi,t
Total number of supervisory board directors
Insideri,t
Percentages of outstanding shares hold by
+
management.
Blockholderi,t
Percentages of outstanding shares hold by any
5% or greater shareholders
NEDSi,t
Total number of non-executive directors
-
EDSi,t
Total number of executive directors
+
FSi,t
Nature logarithm of total assets
N/A
ROEi,t
Nature logarithm of net income divide total
+
equity
Leveragei,t
Nature logarithm of the ratio total debt divide
+
total assets
variable
Independent
variables
Measurement
-
-
In order to show a clear research picture of this thesis, a predictive validity framework
which is also known as Libby Boxes is provided below. This is a very helpful tool to
Page 49
illustrate the process and design of research thesis (Libby, 1981). In this framework,
the theoretical concepts, measurements of the concepts, process and design of this
research thesis will be indicated.
Fig. 5.1. Predictive validity framework5
5.2
Sample selection
5.2.1 Dataset of China
The dataset of China is collected from China Stock Market & Accounting Research
Database (CSMAR), which is a comprehensive databank for Chinese business
research. CSMAR database covers data on the Chinese stock market, financial
statements, fund market data and listed firms corporate governance information and
so on. The research period is draw from 2007 to 2011. The reason of choosing these
years as a research period is because new Chinese accounting standards are issued by
the Ministry of Finance of the People’s Republic of China in 2006 (Wang and
Campbell, 2012). This new accounting standards are substantially in line with
International Financial Reporting Standards (IFRSs) and mandatory for all listed
Chinese enterprises from 1 January 2007. In addition, the observations of 2006 are
included in the dataset because the calculation of several variables requires data from
the previous year.
The initial data consist of 2396 A-Shares listed companies which are listed in
Shanghai Stock Exchange and Shenzhen Stock Exchange. In China, there are
generally four types of shares: A, B, H and N shares. Class A-shares are only issued
to Chinese citizens and using the Chinese Yuan (RMB) for trading. B-shares are
5
Note: Link #1 theoretical support for the effect IV on DV. Link #2 and #3 show the operationalization of IV and
DV. Link #4 reflects the empirical test on the relation IV and DV. Link #5 captures the effects of control variables
on DV.
Page 50
issued to Chinese people and foreigners, for which the Hong Kong dollar or U.S.
dollar are used for trading. H-shares companies are incorporated in China, but listed
in Hong Kong Stock Exchange and using Hong Kong dollar as transaction currency.
N-shares firms are listed in New York Stock Exchange and using U.S. dollar as
trading currency (source: CSRC). This thesis selects A-shares listed firms as samples
due to the limitation of data on B-, H- and N-shares listed firms. For instance, in the
CSMAR database, the number of all B-shares listed firms is 114, which is not
sufficient for an empirical research.
Table 5.2. Summary of shares classifications in China
Type
A-shares
B-shares
Listing in
Shanghai
or Shenzhen
Shanghai
or Shenzhen
Transaction
currency
Investors
Chinese citizen (excluding Hong
Chinese Yuan (RMB)
Kong)
Chinese
investors
citizen
and
foreign Hong Kong dollar or
U.S. dollar
H-shares
Hong Kong
Chinese
investors
citizen
and
foreign
N-shares
New York
Chinese
investors
citizen
and
foreign
Hong Kong dollar
U.S. dollar
Source: China Securities Regulatory Commission (CSRC).
According to previous literature evidence, several collection criteria need to be
considered. Firstly, Becker et al. (1998) indicated that financial institutions (Standard
Industrial Classifications (SICs) between 6000 and 6999) and public utility firms
(SICs between 4000 and 4999) have to be removed when calculating discretionary
accruals. This is because these industries have specific regulations which affect
discretionary accruals. Moreover, China Securities Regulatory Commission (CSRC)
provides the guideline of industry code of Chinese listed firms. There are nineteen (AS) industries classifications in the CSRC guideline such as agriculture (A), mining
industry (B), manufacturing (C), education (P) and so on. All listed firms on industry
category G (public utilities) and J (financial industries)6 will be removed from the
sample set based on Becker et al. (1998). Furthermore, the IPO firms in the period of
2005-2011 are eliminated as they may manipulate earnings due to the incentives of
6
CSRC industry code class J: financial industries (insurance, monetary and financial services, capital market
services and so on); class G: transportation and public utilities (road transport, railway transportation industry and
so on).
Page 51
going to public. In addition, in the collection process, some listed firms with missing
data during the research period will be removed. In the end, 1105 listed firms of
China have been selected for this empirical research. Table 5.3 provides a summary of
the data selection process of Chinese listed firms.
Table 5.3. Summary of data selection process of Chinese listed firms
Chinese A-shares listed firms
Number of Firms
Initial data set
2396
Less: listed firms which are financial industries and public utilities.
-437
Less: IPO firms from 2005 to 2011
-809
Less: missing data of financial statements
-11
Less: missing data of corporate governance
-34
Final number of listed firms
1105
5.2.2 Dataset of U.S.
The research data for analyzing the relationship between corporate governance and
earnings management of U.S. are selected from Compustat North America, GMI
Ratings and Risk Metrics database. Compustat North America is a database covering
the market information and financial reportings of U.S. and Canada. The data for
calculating discretionary accruals are collected from this database. GMI Ratings and
Risk Metrics database provide the data related to corporate governance such as board,
shareholder, voting, director information and ownership and so on. To match the data
set of China, the research period of U.S. is also from 2007 to 2011.
For selection, it needs to first obtain the stock tickers of listed firms. The tickers are
collected from website of NASDAQ Company List7, which includes firms listed on
NASDAQ, NYSE, and AMEX. Following the introduction of website, 4614 tickers of
U.S. listed firm are downloaded. Then, the 610 new IPO firms during the research
period of 2005 to 2011 are excluded from the data set since these companies have
high likelihood of motivations on manipulating earnings. Similarly to the data set of
China, the financial institutions and public utilities listed firms are eliminated.
7
NASDAQ Company List: http://www.nasdaq.com/screening/company-list.aspx.
Page 52
Therefore, the listed firms with SIC code from 4000 to 4999 and SIC code from 6000
to 6999 are excluded. Some listed firms without industry information are also
eliminated from the dataset. In the end, the total numbers of tickers of U.S. listed
firms are 2026. Although 2026 tickers are found, the Compustat North America
database merely provides the data of 1091 listed firms. This might be because some
tickers are invalid. Subsequently, the listed firms which miss the data of financial
reportings and corporate governance have to be removed. Therefore, the total
numbers of listed firms of U.S. applying to this thesis are 752. Table 5.4 summarizes
the data collection process of U.S.
Table 5.4. Summary of data selection process of U.S.
Number of Firms
5.3
Initial tickers from NASDAQ
4614
Less: listed firms which are financial industries and public utilities.
-1125
Less: IPO firms from 2005 to 2011
-610
Less: listed firms of no industry information
-853
Final tickers
2026
Initial data collection
1091
Less: missing data of financial statements
-130
Less: missing data of corporate governance
-209
Final number of listed firms
752
Statistical tests
Once all the variables are obtained, by using SPSS, the descriptive statistics test is
implemented firstly in order to obtain a general overview of all variables. This test
provides the mean, maximum and minimum values and the standard deviation of
dependent, independent and control variables. After that, Normality test will be
performed to verify the distribution of dependent variable. Then, Pearson correlation
test will be carried out to test whether dependent variable and independent variables
are influenced by each other. Furthermore, to reduce the probability of
multicollinearity between independent variables, the collinearity diagnostics test will
Page 53
be performed. In the end, ordinary least squares (OLS) regression which estimates the
association between earnings management and other independent and control
variables will be performed by using the statistical software Eviews.
Panel data (also called longitudinal or cross-sectional time-series data) is a dataset in
which the behaviors of entities are observed across time (Hsiao, 2003). Since this
empirical research adopts panel data analysis for investigating the relationship
between earnings management and corporate governance, fixed effect approach or
random effect approach needs to be considered into the statistical test. The fixed
effect model also known as least squares dummy variable (LSDV) model, has
constant slopes but different intercepts. It assumes that each entity has special or
individual characteristics, which may affect the explanatory variables. The random
effect model is estimated according to Generalized Least Squares (GLS) model,
which treats time and individuals specific as random (Greene, 2002). Correlated
random effects-Hausman test will be conducted by software Eviews to determine
which effect–fixed or random can better explain the panel regression model. This test
is under the null hypothesis that the individual effects are not associated with the other
predictors in the model (Hausman, 1978). If the null hypothesis is rejected, the fixed
effect model is preferred than random effect model.
Page 54
Chapter 6. Results and Analysis
In this chapter, the results of tests and analyses will be presented. At first, the
descriptive statistics of all variables’ mean, standard deviation, etc. will be introduced.
Then, it will provide correlation matrix analysis in order to show the correlation of all
variables. After that, the ordinary leased squared (OLS) regression, Hausman test with
random effect model, two-way fixed effect model will be implemented step by step.
6.1
Descriptive statistics
The descriptive statistics of dependent variable, independent variables and control
variables are provided in Table 6.1. The total numbers of firm-observations of China
and U.S. are 5525 and 3760, respectively. As observed in the table, the dependent
variable (DAi,t) in the sample firms of China has a mean of 2.36 with a standard
deviation of 1.32. The minimum and maximum values of DAi,t in the sample firms of
China are 0.0018 and 9.528, respectively. In contrast, in the sample firms of U.S., the
mean of DAi,t is 0.04 with a standard deviation of 0.05, and the range of DAi,t is from
0.00 to 0.85. Moreover, the average level of CEO as the Chairman (see independent
variable CEO-dummyi,t) in the sample firms of China is 15%, while it is 69% in the
samples of U.S. This indicates that the magnitude of combining CEO and Chairman
in U.S. listed firms is higher than that in China. In addition, the ratio of independent
directors to total directors (BIi,t) of China has a mean value of 0.36 and with a
minimum of 0.09 and a maximum of 0.71. In contrast, the mean value of BIi,t of U.S.
is 0.74, which implies the U.S. listed firms have more independent directors on the
board than China listed firms. The maximum and minimum numbers of supervisory
board (see independent variable SBSi,t) in China are 9 and 0, respectively. The average
number of supervisory board is around 4. In U.S. listed firms, the average number of
non-executives directors (NEDSi,t) is 7 with a minimum value of 0 and a maximum
value of 16. Moreover, the percentage of shares held by management (see
independent variable Insideri,t) of China has an average value of 3%, which is lower
than that in U.S. (13.2%). This suggests that managers in China hold fewer shares
than that in U.S.
8
This value is quite higher than the maximum value of DAi,t in U.S. sample firms. The occurrence of this extreme
value may be because the calculation currency of China and U.S. is different (Chinese Yuan and U.S dollar).
Page 55
In order to verify the distributions of discretionary accruals in the samples, normality
test has been applied with the aid of SPSS. Table 6.2 and 6.3 show the distributions of
discretionary accruals which as proxies of earnings management of China and U.S.
Both of them are normal distributions.
6.2
Correlation matrix (Pearson correlation test)
In order to investigate whether the dependent variable (DAi,t) and other variables are
associated to each other, a Pearson correlation test has been implemented. The results
of Pearson correlation test based on the sample firms of China and U.S. are given in
Table 6.4 and 6.5, respectively. The determination criterion is based on the value of
Pearson correlation coefficient. This coefficient is a statistical measure of the strength
of a linear correlation between variables, and its value varies between -1 and +1.
When the observed value of that coefficient is drawn from 0 to -1, it indicates a
negative relationship between tested variables. In contrast, it suggests a positive
relationship between variables when the observed value of that coefficient falls into
the range of 0 to +1 (Bryman and Cramer, 2005). They also suggested that the value
of that coefficient should not be greater than 0.8. Otherwise the risk of
multicollinearity will be very high. Since the values given in Table 6.4 and 6.5 are not
exceeding 0.8, the regression is considered to be valid.
Page 56
Table 6.1. Descriptive Statistics of China and U.S.
China
Dependent variable
Independent
variables
Control variables
U.S.
Number
Min.
Max.
Mean
Std.
deviation
Number
Min.
Max.
Mean
Std.
deviation
DAi,t
5525
0.0018
9.52
2.36
1.32
DAi,t
3760
.00
.85
.04
.048
BSi,t
5525
3
18
9.09
.025
EDSi,t
3760
0
7
1.47
.766
BIi,t
5525
.09
.71
.36
.0006
BIi,t
3760
.0
1.0
.74
.138
CEO-dummyi,t
5525
0
1
.15
.005
CEO-dummyi,t
3760
0
1
.69
.461
SBSi,t
5525
0
9
3.95
.017
NEDSi,t
3760
0
16
7.41
2.322
Insideri,t
5525
.00
4.22
.03
.002
Insideri,t
3760
.0000
1.00
.132
.198
Block-holderi,t
5525
.008
.894
.343
.203
Block-holderi,t
3760
.0000
.979
.242
.160
FSi,t (log)
5525
10.84
27.75
21.60
.018
FSi,t (log)
3760
1.286
5.519
3.246
.704
ROEi,t (log)
5525
-8.47
6.56
-2.63
.016
ROEi,t (log)
3760
-8.978
4.954
-1.975
1.01
Leveragei,t
(log)
5525
-11.69
3.24
-1.79
.016
Leveragei,t
(log)
3760
.0000
2.615
.2153
.228
This table summarizes the descriptive statistics of China and U.S. DAi,t = the absolute value of discretionary accruals. BSi,t = the number of board members. BIi,t = ratio of
independent directors to total board size. CEO-dummyi,t = 1 if CEO is Chairman, equal to 0 if otherwise. SBSi,t = the number of supervisory board size. Insideri,t = percentages
of shares hold by management. Block-holderi,t = percentages of shares hold by block-holders. EDSi,t = the number of executive directors. NEDSi,t = the number of nonexecutive directors. FSi,t(log) = nature logarithm of total assets as proxy for firm size. ROEi,t(log) = nature logarithm of return on equity. Leveragei,t(log)= nature logarithm of
leverage. Note: the calculation currency of China is Chinese Yuan (RMB), while the currency of U.S. is US Dollar.
Page 57
Table 6.2. Discretionary Accruals of China
DA Stem-and-Leaf Plot
Frequency Stem & Leaf
117.00 Extremes (=<-5.5)
10.00
-5 . 44
27.00
-5 . 222233
41.00
-5 . 0000011111
39.00
-4 . 8888999999
48.00
-4 . 666666777777
59.00
-4 . 444444455555555
69.00
-4 . 22222222233333333
100.00
-4 . 0000000000000111111111111
131.00
-3 . 88888888888888899999999999999999
136.00
-3 . 6666666666666666666677777777777777
174.00
-3 . 4444444444444444444444455555555555555555555
193.00
-3 . 222222222222222222222222223333333333333333333333
235.00
-3 . 00000000000000000000000000011111111111111111111111111111111
275.00
-2 . 888888888888888888888888888888888889999999999999999999999999999999999
280.00
-2 . 6666666666666666666666666666666666666677777777777777777777777777777777
346.00
-2 . 444444444444444444444444444444444444444455555555555555555555555555555555555555555555555
392.00
-2 . 22222222222222222222222222222222222222222222222222223333333333333333333333333333333333333333333333
364.00
-2 . 0000000000000000000000000000000000000000000011111111111111111111111111111111111111111111111
374.00
-1 . 888888888888888888888888888888888888888888889999999999999999999999999999999999999999999999999
363.00
-1 . 666666666666666666666666666666666666666667777777777777777777777777777777777777777777777777
298.00
-1 . 444444444444444444444444444444444444445555555555555555555555555555555555555
258.00
-1 . 22222222222222222222222222222223333333333333333333333333333333333
193.00
-1 . 000000000000000000000111111111111111111111111111
157.00
-0 . 888888888888888888899999999999999999999
149.00
-0 . 6666666666666666666777777777777777777
166.00
-0 . 444444444444444444445555555555555555555555
110.00
-0 . 2222222222222223333333333333
132.00
-0 . 000000000000000011111111111111111
73.00
0 . 000000000111111111
66.00
0 . 2222222223333333
52.00
0 . 4444444555555
24.00
0 . 666677
19.00
0 . 88899
10.00
1 . 00&
45.00 Extremes (>=1.2)
Page 58
Table 6.3. Discretionary Accruals of U.S.
DA Stem-and-Leaf Plot
Frequency Stem & Leaf
121.00 Extremes (=<-.110)
20.00
-10 . 06&&&
40.00
-9 . 0124578&
33.00
-8 . 013679&&
60.00
-7 . 0112234456789
99.00
-6 . 01112233445566677899
146.00
-5 . 000111122233344555667778899
143.00
-4 . 00001112223333445556677888999
200.00
-3 . 000011111222233333444444555566667778888999
269.00
-2 . 000000111112222333333444455555666666677777888889999999
326.00
-1 . 000000001111111222222233333333444455555666666777777778888889999999
365.00
-0 . 00000000111111111222222222233333333444444555555566666667777777788888999999
404.00
0 . 00000000111111111122222333333334444444444555555666666666777777778888888899999999
362.00
1 . 00000001111111122222222333333344444445555566666677777778888888889999999
297.00
2 . 00000011111112222222233333444444555555666666777777888899999
240.00
3 . 000001111222222333333444455556666677777788889999
165.00
4 . 0001111122222334455566677788889999
111.00
5 . 0001111223566667788999&
77.00
6 . 001234566677889
58.00
7 . 0123445678&
54.00
8 . 01122334578&
29.00
9 . 012346&
28.00
10 . 0135&&
113.00 Extremes (>=.110)
Stem width: .0100
Each leaf:
5 case(s)
Page 59
Table 6.4. Pearson Correlation Matrix of China
Correlation
DAi,t
BSi,t
BIi,t
CEO-dummyi,t
SBSi,t
Insideri,t
Block-holderi,t
FSi,t (log)
DAi,t
1
BSi,t
-.037**
1
BIi,t
.025
-.312**
1
CEO-dummyi,t
.007
-.124**
.031*
1
-.039**
.343**
-.078**
-.094**
1
Insideri,t
-.005
-.054**
.017
.109**
-.105**
1
Block-holderi,t
-.002
.025
.006
-.113**
.057**
-.116**
1
FSi,t (log)
-.011
.320**
-.021
-.140**
.214**
-.034*
.276**
1
.112**
.007
-.037*
.014
.004
.033*
.038**
.062**
-.008
.059**
-.011
-.009
.078**
-.033*
.000
.079**
SBSi,t
ROEi,t (log)
Leveragei,t (log)
*. Correlation is significant at the 0.05 level (2-tailed).
**. Correlation is significant at the 0.01 level (2-tailed).
Page 60
ROEi,t (log)
Leveragei,t (log)
1
.076**
1
Table 6.5. Pearson Correlation Matrix of U.S.
Correlation
DAi,t
EDSi,t
BIi,t
CEO-dummyi,t
NEDSi,t
Insideri,t
Block-holderi.t
FSi,t (log)
ROEi,t (log)
DAi,t
1
EDSi,t
-.013
1
BIi,t
-.030
-.501**
1
CEO-dummyi,t
-.067**
-.012
.019
1
NEDSi,t
-.130**
-.138**
.242**
.014
1
Insideri,t
.049**
.347**
-.443**
.034*
-.246**
1
Block-holderi,t
.038*
-.132**
.071**
-.121**
-.089**
-.288**
1
FSi,t (log)
-.178**
.010
.144**
.142**
.525**
-.237**
-.265**
1
ROEi,t (log)
.089**
-.027
.063**
.027
.109**
-.036*
-.087**
.070**
1
-.029
.048**
-.069**
-.019
.095**
.061**
.068**
.156**
.185**
Leveragei,t (log)
*. Correlation is significant at the 0.05 level (2-tailed).
**. Correlation is significant at the 0.01 level (2-tailed).
Page 61
Leveragei,t (log)
1
6.3
Multicollinearity test
Multicollinearity problem exists when one variable is perfectly or highly associated with
another variable in the regression model (Rashwan et al., 2011). Biased results will be
generated if the multicollinearity problem exists in the regression research. Therefore, a
key step before performing a regression model is to detect whether a multicollinearity
problem exists or not.
In order to reduce the likelihood of multicollinearity issue between independent variables
and control variables, the collinearity diagnostics test is performed by SPSS to detect
whether this problem exists or not. One of independent variables is chosen into the
dependent variable list while other independent variables and control variables are
imported into independent variable list. Then, a collinearity diagnostics test is
implemented by SPSS. Every independent variable and control variable follow this
method to test the multicollinearity. Table 6.6 and 6.7 show the results of this test for
China and U.S. sample firms. It is necessary to check variance inflation factors (VIF)
since it measures how much the variance of the estimated regression coefficients is
inflated due to the multicollinearity (O’Brien, 2007). When the multicollinearity issue
exists, VIF of the variables in the test will be quite large. According to Berman (2006), if
the value of VIF is from 1.0 to 2.0, the multicollinearity problem does not exist. For
instance, in the first column of Table 6.6, board size (BSi,t) was inputted into dependent
variable list and other variables were inputted into independent variables list. Then, the
collinearity diagnostics test was run by software SPSS. As observed in the second column,
the values of VIF are all falling into the range of 1.0 to 2.0, which means no
multicollinearity problem. It can be found out that other independent variables and
control variables in Table 6.6 and 6.7 have not a VIF more than 2, which indicates the
multicollinearity does not exist in this research datasets.
Page 62
Table 6.6. Collinearity Diagnostics of China
BS
BI
VIF
1.009
CEOdummy
SBS
Insider
FS (log)
1.066
1.032
1.136
dummy
SBS
Insider
1.030
1.171
1.032
holder
FS (log)
1.015
(log)
1.196
(log)
dummy
BS
BI
SBS
Insider
VIF
1.321
1.103
holder
FS (log)
1.014
(log)
1.170
1.029
(log)
BS
BI
VIF
1.208
1.103
dummy
Insider
1.205
holder
FS (log)
1.029
1.024
(log)
1.195
(log)
1.327
BI
1.103
dummy
SBS
1.027
1.162
holder
FS (log)
1.016
(log)
1.088
1.208
(log)
holder
BS
BI
ROE
VIF
dummy
SBS
Insider
FS (log)
1.014
(log)
1.316
1.103
Page 63
(log)
VIF
BS
BI
1.249
1.094
CEO1.025
1.171
1.019
VIF
dummy
SBS
Insider
1.128
holder
BS
BI
1.335
1.102
1.030
1.157
1.031
dummy
SBS
Insider
Leverage
(log)
BS
BI
VIF
1.336
1.106
CEO-
CEO-
Block-
1.034
1.171
1.030
dummy
SBS
Insider
1.034
1.169
1.031
Block-
Block1.026
holder
1.103
1.011
FS (log)
1.220
holder
1.102
ROE
1.015
(log)
FS (log)
1.220
ROE
Leverage
1.014
FS (log)
(log)
ROE
Leverage
1.014
Block-
CEO-
ROE
Leverage
1.014
BS
VIF
Block1.101
ROE
1.015
Insider
CEO-
Block1.096
Leverage
1.015
SBS
CEO-
ROE
Leverage
1.014
CEO-
Block1.101
ROE
Leverage
(log)
1.214
Block1.092
ROE
(log)
BS
VIF
CEO1.026
Blockholder
BI
Leverage
1.014
Leverage
1.014
(log)
1.016
(log)
(log)
1.014
Table 6.7. Collinearity Diagnostics of U.S.
EDS
BI
VIF
1.283
CEOdummy
NEDS
Insider
FS (log)
1.521
1.516
1.697
dummy
NEDS
Insider
1.022
1.518
1.454
holder
FS (log)
1.057
(log)
1.742
(log)
dummy
EDS
BI
NEDS
Insider
VIF
1.390
1.516
holder
FS (log)
1.056
(log)
1.528
1.569
(log)
EDS
BI
VIF
1.383
1.503
dummy
Insider
1.727
holder
FS (log)
1.020
1.567
(log)
1.333
(log)
BI
1.343
1.403
dummy
NEDS
holder
FS (log)
1.052
(log)
1.021
1.526
1.122
1.613
(log)
holder
EDS
BI
VIF
VIF
dummy
NEDS
Insider
FS (log)
1.055
(log)
1.392
1.516
Page 64
(log)
BS
VIF
BI
1.020
BI
1.531
1.387
SBS
(log)
(log)
holder
1.517
Insider
1.561
Block-
1.274
holder
1.262
FS (log)
1.053
1.700
ROE
Leverage
(log)
1.023
SBS
FS (log)
1.064
dummy
1.584
1.056
Leverage
1.070
1.025
Block-
ROE
1.046
CEO-
Insider
1.143
1.546
1.512
1.464
holder
BI
SBS
Block1.567
dummy
1.174
Insider
1.405
1.545
CEO1.014
VIF
BS
1.406
1.545
dummy
Leverage
(log)
BS
1.375
CEO-
Leverage
1.074
ROE
FS (log)
(log)
ROE
Leverage
1.091
Block-
CEO-
ROE
Leverage
1.090
EDS
VIF
Block1.270
ROE
1.056
Insider
CEO-
Block1.268
Leverage
1.093
NEDS
CEO-
ROE
Leverage
1.092
CEO-
Block1.270
ROE
Leverage
(log)
1.178
Block1.271
ROE
(log)
EDS
VIF
CEO1.021
Blockholder
BI
1.741
(log)
1.021
6.4
Results and analysis
In this section, the results of ordinary least squares (OLS) regression, Hausman test, and
two-way fixed effect model will be presented.
6.4.1 OLS Results
The results of OLS regression based on China and U.S. sample firms are presented at first.
As observed in Table 6.8, the values of F-statistics (p-value) of China and U.S. are
8.00(0.000***) and 16.817(0.000***), respectively. This means both OLS models of
China and U.S. are significant, and indicates that there is a relationship between corporate
governance and earnings management based on the sample firms of China and U.S.,
which confirms the first and the second alternative hypotheses. Moreover, board size
(BSi,t) has a negative relationship with earnings management at 5% significance level in
China (t=-2.062, p-value=0.039), suggesting that the listed firms with larger board size in
China have a lower level of earnings management activities. This result is consistent with
Xie et al. (2003) and Chtourou et al. (2001). In U.S. sample firms, the evidence indicates
that the executive directors have a negative relationship with earnings management at 10%
significance level, which is similar to Bowen et al. (2008). Furthermore, the supervisory
board size has a negative and significant (t=-2.055, p-value=0.04) relationship with
earnings management in China, which means that more members in supervisory board
could reduce earnings management activities more effectively. Firth et al. (2007) and
Quttainah et al. (2011) also drew the similar outcomes. A negative relationship between
non-executive directors and earnings management is also observed in the U.S. sample
firms. This result is significant at 1% significance level, which is indicated by the slope
coefficient of -0.002 and the p-value of 0.000. It is consistent with the research outcomes
of Chtourou et al. (2001). In addition, there is a negative relatioship between CEOdummy and earnings management in U.S. sample firms, whereas no significant
association between those two items has been observed in China sample firms. No
significant relationship between earnings management and both management ownership
and block-holders ownership has been found in China and U.S. sample firms. On the
other hand, a positive relationship is presented between firm size (log of total assets) and
earnings management at 1% significance level in China sample firms, meaning more
Page 65
earnings management activities in large-size listed firms of China. However, a negative
relationship between firm size and earnings management is obeserved in the sample firms
of U.S. In both China and U.S. sample firms, a positive relationship between ROE and
earnings management is found at 1% significance level, which comfirms the expectation
of this thesis.
Despite some significate variables were detected, as observed in Table 6.8. the values of
the adjusted R-squared9 in both regression models are very low, which is 0.014 for China
and 0.046 for U.S., respectively. This results might imply that the independent variables
are weak predictors, or some important variables related to earnings management are not
included in the regression model. In the next section, it will attempt to solve this problem
by establishing fixed effect model or random effect model which is based on the results
of the Hausman test.
6.4.2 Hausman test of China and U.S.
Firstly, a regression model with random effect for both China and U.S. is performed by
using Eviews. As observed in the first column of Table 6.9, the random effect model of
China indicates similar results as OLS regression model. Then, the correlated random
effects-Hausman test is performed to see whether this random effect model is appropriate
or not. As indicated in the second column of Table 6.9, the Hausman test shows a
significant result (p-value=0.000***) to reject the null hypothesis, suggesting that the
fixed effect model is better in investigating this research dataset. Similarly, the random
effect model of U.S. sample firms and Hausman test are performed by Eviews (see Table
6.10). The Hausman test indicates a statistical and significant result (p-value=0.0009***),
which rejects the null hypothesis and reveals that the fixed effect model is also
appropriate for U.S. dataset. In conclusion, this test illustrates that the fixed effect model
is better than the random effect model for both China and U.S. sample firms.
9
R2 measures the variation in the dependent variable that can be explained by the independent variables and shows the
predictive power of the model. Source from: Wooldridge, J. M. (2002). Introductory Econometrics: A Modern
Approach, South-Western.
Page 66
Table 6.8. Ordinary least squares regression (OLS) of China and U.S.
China
U.S.
Variable
Coefficient
Std. Error
t-Statistic
Constant
3.790
0.439
8.627
BSi,t
-0.027
0.013
-2.062
BIi,t
0.492
0.450
1.094
CEO-dummyi,t
0.006
0.064
0.088
SBSi,t
-0.037
0.018
-2.055
Insideri,t
-0.093
0.145
-0.642
Block-holderi,t
-0.002
0.001
-1.266
FSi,t (log)
0.100
0.020
5.077
ROEi,t (log)
0.111
0.020
5.694
Leveragei,t (log)
0.008
0.019
0.396
Prob.
Variable
Coefficient
Std. Error
t-Statistic
Constant
0.086
0.008
10.430
0.039**
EDSi,t
-0.002
0.001
-1.713
0.274
BIi,t
0.006
0.007
0.834
0.930
CEO-dummyi,t
-0.005
0.002
-3.104
0.040**
NEDSi,t
-0.002
0.000
-4.074
0.521
Insideri,t
0.008
0.005
1.479
0.206
Block-holderi,t
0.003
0.006
0.460
0.000***
FSi,t (log)
-0.007
0.002
-4.616
0.000***
ROEi,t (log)
0.005
0.001
6.120
0.692
Leveragei,t (log)
-0.006
0.004
-1.569
0.000***
R-squared
0.016
0.050
Adjusted R -squared
0.014
0.046
F-Statistic(p-value )
8.00(.000***)
Prob.
0.000***
0.087*
0.404
0.002***
0.000***
0.139
0.645
0.000***
0.000***
0.117
16.817(.000***)
*. Correlation is significant at the 0.1, **. Correlation is significant at the 0.05, ***.Correlation is significant at the 0.01
This table summarizes the results of OLS regression based on the sample of China and U.S. BSi,t = the number of board members. BIi,t = ratio of independent directors to total
board size. CEO-dummyi,t = 1 if CEO is Chairman, equal to 0 if otherwise. SBSi,t = the number of supervisory board size. Insideri,t = percentages of shares hold by
management. Block-holderi,t = percentages of shares hold by block-holders. EDSi,t = the number of executive directors. NEDSi,t = the number of non-executive directors. FSi,t
(log) = nature logarithm of total assets as proxy for firm size. ROEi,t (log) = nature logarithm of return on equity. Leveragei,t (log) = nature logarithm of leverage.
Page 67
Table 6.9. Hausman test of China with random effect model
Random effect model
Hausman test
Variable
Coefficient
Std. Error
t-Statistic
Prob.
Constant
3.847775
0.434185
8.862070
0.0000***
BSi,t
-0.028206
0.013140
-2.146577
0.0319**
BIi,t
0.483591
0.442997
1.091633
0.2751
CEO-dummyi,t
0.006451
0.063425
0.101711
0.9190
SBSi,t
-0.038193
0.018052
-2.115706
0.0344**
Insideri,t
-0.091003
0.143215
-0.635429
0.5252
Block-holderi,t
-0.001950
0.001465
-1.330779
0.1833
FSi,t (log)
0.103327
0.019464
5.308530
0.0000***
ROEi,t (log)
0.111357
0.019177
5.806678
0.0000***
Leveragei,t
(log)
0.006481
0.019040
0.340368
0.7336
Correlated Random Effects - Hausman Test for China
Equation: Untitled
Test cross-section random effect
Test Summary
Chi-Sq. Statistic
Cross-section random
R-squared
0.016329
Adjusted R -squared
0.014304
233.162112
Chi-Sq. d.f
Prob.
9
0.000***
*. Correlation is significant at the 0.1, **. Correlation is significant at the 0.05 , ***.Correlation is significant at the 0.01
This table summarizes the results of random effect model and Hausman test based on the sample firms of China. BSi,t = the number of board members. BIi,t = ratio of
independent directors to total board size. CEO-dummyi,t = 1 if CEO is Chairman, equal to 0 if otherwise. SBSi,t = the number of supervisory board size. Insideri,t =
percentages of shares hold by management. Block-holderi,t = percentages of shares hold by block-holders. FSi,t (log) = nature logarithm of total assets as proxy for firm size.
ROEi,t (log) = nature logarithm of return on equity. Leveragei,t (log) = nature logarithm of leverage.
Page 68
Table 6.10. Hausman test of U.S with random effect model
Hausman test
Random effect model
Variable
Constant
EDSi,t
BIi,t
CEO-dummyi,t
NEDSi,t
Insideri,t
Block-holderi,t
FSi,t (log)
ROEi,t (log)
Leveragei,t (log)
Coefficient
Std. Error
t-Statistic
Prob.
0.092333
0.009837
9.386733
0.0000***
-0.001673
0.001400
-1.194438
0.2324
0.000591
0.008191
0.072114
0.9425
-0.005293
0.002077
-2.547965
0.0109**
Equation: Untitled
-0.001964
0.000474
-4.142019
0.0000***
Test cross-section random effect
0.003557
0.006501
0.547156
0.5843
-0.005636
0.006410
-0.879234
0.3793
-0.006765
0.001944
-3.479412
0.0005***
0.004074
0.000843
4.835554
0.0000***
-0.007685
0.005081
-1.512512
0.1305
R-squared
0.029816
Adjusted R –squared
0.026869
Correlated Random Effects - Hausman Test for U.S
Test Summary
Chi-Sq. Statistic
Chi-Sq. d.f
Cross-section random
26.763974
9
Prob.
0.0009***
*. Correlation is significant at the 0.1, **. Correlation is significant at the 0.05 , ***.Correlation is significant at the 0.01
This table summarizes the results random effect model and Hausman test based on the sample firms of U.S. CEO-dummyi,t = 1 if CEO is Chairman, equal to 0 if
otherwise. Insideri,t = percentages of shares hold by management. Block-holderi,t = percentages of shares hold by block-holders. EDSi,t = the number of executive
directors. NEDSi,t = the number of non-executive directors. FSi,t (log) = nature logarithm of total assets as proxy for firm size. ROEi,t (log) = nature logarithm of return on
equity. Leveragei,t (log) = nature logarithm of leverage.
Page 69
6.4.3 Fixed effect model development
Since the fixed effect model is preferred for investigating the relationship between
corporate governance and earnings management based on the previous discussions. In
this section, based on OLS models, two-way fixed effect models are constructed to
present the research results.
The two-way fixed model examines the fixed effects including both cross-section specific
effect and time specific effect. Generally, this model includes cross-section dummies and
time dummies (e.g., firms, years) to control the entity and time effects (Baltagi, 2005). By
adding the cross-section dummies, this model examines the entity (e.g., firm, country)
differences in the intercepts and controls the differences across entities in any observable
or unobservable predictors. Moreover, the time dummies are included for measuring how
the time affects the intercept.
The results of two-way fixed effect model of China and U.S. are given in Table 6.11.
Firstly, in the left column of Table 6.11, a negative relationship is observed between
board size (BSi,t) and earnings management in China at 10% significance level, implying
that larger board size could reduce the earnings management activities. However, under
the U.S. sample firms, the size of executive directors (EDSi,t) does not show a statistical
significant correlation with earnings management. Firm size and ROE have a positive
relationship with earnings management at the 1% significance level in China samples,
which is similar to that based on OLS regression model. Especially, a negative
relationship was detected between leverage and earnings management at 5% significance
level. This means when the ratio of leverage is high in a listed company of China, the
likelihood of earnings management activities is low. This result is consistent with
Alsharairi et al. (2011) and Dechow et al. (2000), but is not the expectation of this thesis.
More specific, the adjusted R-squared reaches to 29%, which indicates that the
explanatory power of this model increases after incorporating two-way fixed effect.
Secondly, in the right column of Table 6.11, the number of non-executive directors
(NEDSi,t) has a negative relationship with earnings management in the U.S. sample firms
(t=-3.532, p-value=0.0004). However, supervisory board size (SBSi,t) in China listed
firms does not show a significant correlation with earnings management. Moreover, a
Page 70
negative correlation between block-holders ownership and earnings management is
detected at 5% significance level, which is not found under the OLS regression and the
sample firms of China. This result demonstrates that the U.S. listed firms have less
earnings manipulations when more shares are held by block-holders, which is consistent
with the findings of Shleifer and Vishny (1986), Klein (2002) and Iturriaga and
Hoffmann (2005). Firm size and ROE present a positive relationship with earnings
management and 1% significance level. Leverage has a negative relationship with
earnings management at 10% significance level. The adjusted R-squared is improved
under this two-way fixed effect and reaches to 33% compared to that in OLS regression
(4.6%).
6.5
Summary
This chapter illustrated the empirical findings of this research thesis. At first, by using
SPSS, the descriptive statistics shows the details of dependent variable, independent
variables and control variables. Pearson correlation test was performed to test the
association among dependent, independent and control variables. The collinearity
diagnostics test is employed to verify whether multicollinearity issue is exist or not. All
of the tests show that the datasets of China and U.S. are valid.
Secondly, the ordinary least squares (OLS) regression model was provided to indicate the
relationship between corporate governance and earnings management in China and U.S.
Both board size (BSi,t) of China and the size of executive directors (EDSi,t) of U.S. have a
negative relationship with earnings management. Similarly, supervisory board size
(SBSi,t) of China and the size of non-executive directors (NEDSi,t) of U.S. have a negative
relationship with earnings management. Especially, CEO as chairman (CEO-dummyi,t) of
U.S. listed firms has a negative association with earnings management, while China
sample firms does not show this relation. For control variables, an opposite result of the
relationship between firm size and earnings management comparing China and U.S was
found. Firm size has a positive correlation with earnings management under China
samples, while a negative relationship was detected under U.S. sample firms.
Page 71
Thirdly, Hausman test was adopted to identify which effect-fixed or random is
appropriate for these panel datasets. The results of this test indicated that fixed effect
model is more suitable than random effect model for both China and U.S. datasets.
Finally, two-way fixed effect model was established for both China and U.S. samples.
Board size (BSi,t) of China has a negative relationship between earnings management,
while the size of executive directors (EDSi,t) in U.S. sample firms does not show a
statistical correlation with earnings management. The size of non-executive directors
(NEDSi,t) shows a significant and negative relationship with earnings management in U.S.
listed firms. However, no statistical association was detected between supervisory board
size (SBSi,t) and earnings management in China samples. Moreover, a negative
relationship between block-holders ownership and earnings management was observed in
U.S. samples, which is not detected in China sample firms. Based on these discussions,
the third alternative hypothesis is accepted that there is a difference in relationship
between corporate governance and earnings management comparing China and U.S. On
the other hand, it is important to notice that numerous research studies of earnings
management and corporate governance often suffer from endogeneity problem
(Karamanou and Vafeas, 2005). To some extent, the fixed effect model can mitigate
unobserved effects, for instance, omitted variables which rise endogeneity and may
reduce the level of this problem.
Page 72
Table 6.11. Two-way fixed effect model of China and U.S.
China
U.S.
Variable
Coefficient
Std. Error
t-Statistic
Prob.
Variable
Coefficient
Std. Error
t-Statistic
Constant
5.29045
1.437079
3.830196
0.0001***
Constant
-0.048285
0.030890
-1.563121
0.1182
BSi,t
-0.051018
0.027256
-1.871813
0.0613*
EDSi,t
-0.000447
0.001955
-0.228636
0.8192
BIi,t
-0.934015
0.680686
-1.372160
0.1701
BIi,t
-6.39E-05
0.011430
-0.005594
0.9955
CEO-dummyi,t
-0.012125
0.099485
-0.121874
0.9030
CEO-dummyi,t
-0.002241
0.003130
-0.716062
0.4740
SBSi,t
-0.036922
0.051204
-0.721071
0.4709
NEDSi,t
-0.002373
0.000672
-3.532043
0.0004***
Insideri,t
-0.000743
0.280010
-0.002654
0.9979
Insideri,t
-0.017290
0.014973
-1.154690
0.2483
Block-holderi,t
-0.000777
0.003860
-0.201206
0.8405
Block-holderi,t
-0.019506
0.008644
-2.256577
0.0241**
FSi,t (log)
0.565588
0.026232
9.180655
0.0000***
FSi,t (log)
0.037806
0.008590
4.401234
0.0000***
ROEi,t (log)
0.125365
0.061606
4.779010
0.0000***
ROEi,t (log)
0.004269
0.001112
3.837788
0.0001***
Leveragei,t (log)
-0.079488
0.036214
-2.194957
0.0282**
Leveragei,t (log)
-0.018209
0.010098
-1.803173
0.0715*
R-squared
Adjusted
R
squared
F-Statistic(p-value )
-
0.467573
0.500108
0.293805
0.336085
2.69(.000***)
Prob.
3.049(.000***)
*. Correlation is significant at the 0.1, **. Correlation is significant at the 0.05, ***.Correlation is significant at the 0.01
This table summarizes the results of two-way fixed effect regression based on the samples of China and U.S. BSi,t = the number of board members. BIi,t = ratio of independent
directors to total board size. CEO-dummyi,t = 1 if CEO is Chairman, equal to 0 if otherwise. SBSi,t = the number of supervisory board size. Insideri,t = percentages of shares
hold by management. Block-holderi,t = percentages of shares hold by block-holders. EDSi,t = the number of executive directors. NEDSi,t = the number of non-executive
directors. FSi,t (log) = nature logarithm of total assets as proxy for firm size. ROEi,t (log) =nature logarithm of return on equity. Leveragei,t (log) =nature logarithm of leverage.
Page 73
Chapter 7. Conclusions
In this chapter, a brief summary including the research subject, hypotheses and empirical
results will be introduced. Moreover, it will discuss several limitations of this research
thesis. In the end, for the future researches, some recommendations relating to the
research of corporate governance and earnings management will be presented.
7.1
Conclusions
This research thesis empirically investigated whether there is a relationship between
corporate governance and earnings management in both China and U.S., specifically
attempting to compare the differences in relationship between those two items in China
and U.S. Firstly, it introduces the definitions of earnings management and corporate
governance and the measurements of earnings management. Then, the positive
accounting theory and the agency theory were presented as the theoretical basis for this
research. After reviewing the previous literature evidence, three main hypotheses were
developed for investigating the research questions of this thesis.
This research thesis adopted the listed firms in China and U.S. during 2007-2011 as
datasets. By using SPSS, the descriptive statistics test, the normality test, the Pearson
correlation test and the collinearity diagnostics test were performed. Those test show that
both the datasets of China and U.S. are valid and appropriate for the regression test in the
next step. In addition, the ordinary least squares (OLS) regression model, the random
effect model, the Hausman test, and the two-way fixed effect model were applied to
analyze the panel datasets by using Eviews, which provides the empirical results of those
models and tests the hypotheses.
The results of this research provide evidence that corporate governance have a
relationship with earnings management in China and U.S., which confirms the first and
second alternative hypotheses. Under the OLS model, board size and supervisory board
size have a negative relationship with earnings management at 5% significance level.
This means that including more members in the board and supervisory board eliminates
the likelihood of earnings management in China. In the meanwhile, a negative
Page 74
relationship is detected between non-executive directors and earnings management in U.S.
listed firms, suggesting larger non-executive director’s size reduces earnings management
activities in U.S. Moreover, this study found some different results between China and
U.S. For instance, the CEO as Chairman has a negative relationship with earnings
management in U.S. listed firms. However, this relationship is not confirmed in the
sample firms of China. The control variable firm size has a positive relationship with
earnings management in China, but negative in U.S. listed firms.
Since this thesis adopts panel data for the investigation, fixed effect and random effect
models are taken into account in the process of the study. The Hausman test is employed
to identify which effect model is appropriate for this empirical study. The results of the
Hausman test reject the null hypothesis and indicate that the fixed effect model is more
suitable than the random effect model both in the sample firms of China and U.S. After
that, in the sample firms of China, a two-way fixed effect model has been established by
Eviews automatically adding the cross-section dummies and the time dummies. Under
this effect, in the main independent variables group, only board size has a negative
relationship with earnings management at 10% significance level. In the sample firms of
U.S., by using the same method as China to construct two-way fixed effect model, a
significantly negative relationship was found between non-executive directors and
earnings management, suggesting that more numbers of non-executive directors in a
listed firm could reduce earnings management activities in the sample firms of U.S.
Meanwhile, the block-holders ownership has a negative relationship with earnings
management at 5% significance level, implying that large shareholders could eliminate
earnings management behaviors in U.S. However, this relationship was not shown in the
sample firms of China. Since some different outcomes are detected in the tests, it could
confirm the third hypothesis that there is a difference in relationship between corporate
governance and earnings management in China and U.S.
7.2
Limitation and future recommendations
This research thesis has several limitations. Firstly, the Performance-Matched
Discretionary Accruals Model was used to measure earnings management in this study.
Although this model could mitigate misspecification problem, it also reduces the test
Page 75
power (Dechow, 2012). Meanwhile, several researchers in the previous literature were
doubted whether this model can capture the full level of discretionary accruals. However,
this model is a crucial improvement to the prior models in terms of detecting earnings
management. Therefore, the performance–matched discretionary accruals model is still
an appropriate one to capture earnings management in this empirical study.
Secondly, this study is based on the emerging market of China and the developed market
of U.S. The results cannot be used to generalize the concerns of all emerging markets and
all developed countries. However, the outcomes of this thesis might contribute to the
future studies on the correlation between corporate governance and earnings management.
Thirdly, as described in Chapter 2, the corporate governance mechanism includes internal
governance and external governance. This thesis only concentrated on the board
characteristics and ownership structure, and may omit some specific items which could
measure corporate governance. This is considered as one of limitations of this research
thesis.
In addition, to future studies, it may be interesting for future researchers to examine the
changes in the relationship between corporate governance and earnings management
before and after the implement of the new accounting standards in China. The new
accounting standards are substantially in line with the International Financial Reporting
standards (IFRS) and are mandatory to all Chinese listed firms since 1st January, 2007. It
might bring significant differences compared with the old accounting system, and might
impact the correlation between corporate governance and earnings management.
Last but not the least, it might be interesting to investigate the differences in the
association between corporate governance and earnings management in the state-owned
enterprises and the private firms in China since the state-owned enterprises (SOEs)
account for a large percentage in China listed firms.
Page 76
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Appendix.A Corporate Governance
Title
Author(s)
Object of this study
Sample
1. The relation between
firm-level corporate
governance and market
value: A study of India
(2010)
Balasubramanian, N.B.
Black, Bernard S.
Khanna, Vikramaditya.
S.
Examine corporate
governance and market
value in India.
370 listed firms of
India in 2006.
Built a broad Indian Corporate
Governance Index (ICGI) for
survey.
Significant association between
ICGI and firm market value in
India, especially, in big
profitable firms.
2. Corporate
governance and the
information
environment: Evidence
from Chinese stock
markets (2014)
Hass, Lars Helge.
Vergauwe, Skrålan.
Zhang, Qiyu.
Investigate the
correlation between
corporate governance
and information
environment.
2152 firms for analyst
following model,
2176 firms for forecast
accuracy model,
1995 firms for forecast
dispersion model,
2134 firms for price
timeliness model
during 2003 to 2011.
Build four models for
regression; used pooled ordinary
least squares (OLS) method and
fixed-effects (FE) regressions.
Firms with good corporate
governance attract larger analyst
followings and more
information forecasts. Better
governed firms tend to improve
on the timeliness of bad news
relative to good news.
Constructed three models to
examine CEO compensation and
corporate governance, including
control variables, industry
dummy and time dummy;
provided OLS regression and
reweighted least-squares
regression.
Built a corporate governance
index; employed Amihud
estimate (ILLIQ), turnover, and
liquidity ratio to measure
liquidity.
3. Corporate
governance or
globalization: What
determines CEO
compensation in China?
(2007)
Li, Donghui.
Moshirian, Fariborz.
Nguyen, Pascal.
Tan, L.
Investigate the
correlation between
corporate governance
structure and CEO
compensation based on
China perspective.
206 firms listed on the
Shanghai Stock
Exchange (SHSE) and
the Shenzhen Stock
Exchange (SZSE)
during 2000-2001.
4. The effect of
corporate governance
on stock liquidity: The
case of Thailand (2014)
Prommin, Panu
Jumreornvong, Seksak
Jiraporn, Pornsit
Investigate the effect of
corporate governance
on equity liquidity in
Thailand.
100 listed firms on the
Stock Exchange of
Thailand during 20062009.
Page 88
Research Methodology
Results
Control variables: firm size,
leverage and so on.
A little evidence on the
relationship between CEO
compensation and corporate
governance.
Control variables: CEO age,
firm size, and tenure and growth
rate.
Positive relationship between
corporate governance and
liquidity, even controlling
endogeneity.
control variables: firm size,
leverage
Appendix.B Earnings Management
Title
Author(s)
Object of this study
Sample
Research Methodology
Results
1. Does the Threat of
Litigation Explain
Insider Selling and
Earnings Management
in Distressed Firms
(2005)
Beneish, Messod, D.
Press, Eric, G.
Vargus, Mark E.
Investigate whether
threat of litigation has
an effect on
management
accounting choice and
trading choice.
462 firms with financial
problem during 19831997, 102 firms from
NYSE, 122 firms from
American Stock
Exchange, and 238
firms from NASDAQ.
OLS regressions, two-stage
estimation of models for
controlling endogeneity.
Insider trading has a relationship
to upward earnings
management. Managers are
more likely to do income
increasing earnings
management.
Control variables: firm size and
market-to-book ratio.
2. Earnings
Management Types and
Motivation: A Study in
Taiwan (2010)
Chen, Ming-Chia,
Tsai, Yuan-Cheng.
Examine the types of
earnings management
behaviors and
investigate the
relationship between
motivations and
earnings management.
902 listed companies
from Taiwan’s Over the
Counter (OTC) market
and Taiwan Stock
Exchange during 20052007.
Made a questionnaire survey to
financial managers and auditors
of listed firms.
3. Do Executive Stock
Options Generate
Incentives for Earnings
Management? Evidence
from Accounting
Restatements (2003)
Kedia, Simi.
Explore the effect of
pay for performance
motivation on earnings
management.
224 listed firms
restating their financial
reports during 19972000. This data
collected from Execu
Comp database.
Constructed econometric model
for regression analysis; used
standard two-stage estimation of
models to control endogeneity.
Two types of earnings
management
(production/distribution
manipulation and discretionary
accruals manipulation).
Three motivations: altruistic
motivation, speculative
motivation and pressure from
affiliated parties.
A positive effect on pay for
performance incentives and
earnings management.
Control variables: firm age, firm
sales and growth rate.
4. The Motivation for
Tax Avoidance in
Earnings
Management (2012)
Wang, Shiwei,
Chen, Siyu.
Analyze the correlation
between earnings
management and tax
avoidance on listed
firms of China.
Data of Chinese A
share non-financial
listed companies from
annual reports during
2004-2006.
Ordinary least squares (OLS)
method and added industry
dummies.
Page 89
Positive relation between
earnings management and tax
avoidance.
For SOE listed firms, the firm
performance has little effect on
earnings management.
Control variables: firm size,
leverage, industry dummy and
year dummy.
Appendix.C Corporate governance and earnings management
Title
Author(s)
Object of this study
Sample
Research Methodology
Results
Positive relationship between
board size and earnings
management.
Ethnicity (race) has no effect on
earnings management.
Negative relationship between
firms size and earnings
management.
No significant relationship
between leverage and earnings
management.
Board size is the only variable
that has a significant relation
with earnings management.
Control variables: company size
and leverage
1. Board, audit
committee, culture and
earnings management:
Malaysian evidence
(2006)
Abdul Rahman,
Rashidah.
Mohamed Ali,
Fairuzana Haneem
Examine whether the
board items, audit
committee and
concentrated ownership
reduce activities of
earnings management.
97 listed firms on the
Main Board of Bursa
Malaysia during 20022003.
Ordinary least square regression;
Modified Jones Model and
abnormal working capital
accruals are used as proxies of
earnings management.
2. Corporate
Governance and
Earnings Management:
Jordanian Evidence
(2012)
Abed, Suzan.
Al-Attar, Ali,
Suwaidan, Mishiel.
Explore earnings
management and
specific items of
corporate governance.
Econometric model and OLS
regression. Firm size, leverage
and industry are included as
control variable.
3. Leadership structure:
Separating the CEO
and chairman of the
board (1997)
Brickley, J. A.
Coles, J. L.
Jarrell, Gregg.
Investigate whether
CEO, a same person of
Chairman, benefits to
the company.
4. Earnings
Management
following DualityCreating Successions:
Ethnostatistics,
Impression
Management, and
Agency Theory (2004)
Davidson, W. N.
Jiraporn, P.
Nemec, C.
Kim, Young. S.
Find the relationship
between earnings
management and CEO
as Chairman
329 firm-observations
for the companies listed
on the Amman Stock
Exchange (ASE)
during
2006-2009.
264 listed firmobservations in U.S.
during 1984-1991
including 102 listed
firms which CEO and
Chairman are separated
and 162 listed firms
which CEO and
Chairman are the same
person.
A sample of 173 firms
which CEO is
Chairman and 112
firms which CEO and
chairman is separated
during 1982-1992.
Page 90
Empirical analysis, survey,
statistical test, and event study.
About 80% listed firms in U.S.
combine CEO and Chairman.
There are certain costs of
separating CEO and Chairman.
CEOs perform well after they
are awarded as the Chairman.
Using Modified Jones Model to
measure earnings management.
Ordinary Least Square
Regression for statistical
analysis.
CEO duality related to greater
income-increasing earnings
management.
Poor firm performance gives
CEO a big pressure. This is a
motivation for earnings
management.
5. Earnings
management and
internal mechanisms of
corporate governance:
Empirical evidence
from Chilean firms
(2005)
6. Audit committee,
board of director’s
characteristics and
earnings management
(2002)
Iturriaga, Félix J.
López.
Hoffmann, Paolo
Saona.
Analyze the ownership
structure as a control
tool to managers and
firms in order to reduce
the accounting
discretionary behaviors.
A sample of 185
Chilean non-financial
firms during 19912001.
The Jones’ model for detecting
earnings management.
Fixed effect regression.
High level of block holder
ownership can reduce earnings
management.
Klein, April
Examine whether board
items and audit
committee affect
earnings management.
692 listed firms
selected from SEC filed
proxy statement during
1992-1993.
Cross-section of the Modified
Jones Model analysis.
Negative relationship between
abnormal accruals and
independent directors.
Control variables: firm size and
debt.
7. Board composition
and earnings
management in Canada
(2004)
Park, Yun. W.
Shin, Hyun-Han.
539 listed firmobservations of Canada
from Global Vantage
Database during 1991
to 1997.
Econometric model and OLS
regression.
8. Earnings
Management and
Corporate Governance
in Asia’s Emerging
Markets (2007)
9. Managerial
ownership, accounting
choices, and
informativeness of
earnings (1995)
Shen, Chung-Hua.
Chih, Hsiang-Lin.
Investigate the
relationship between
board composition and
earnings management
based on Canadian
companies.
Study the effects of
corporate governance
on earnings
management.
495 companies in 25
emerging countries
during April 2001February 2002.
Econometric model and OLS
regression.
Warfield, Terry D.
Wild, John J.
Wild, Kenneth L.
Analyze the impacts of
managerial ownership
on the informativeness
of earnings and the
level of discretionary
accrual accounting.
Around 1600 firms and
nearly 5000 annual
reports during 19881990.
Ordinary Least Squares
Regression for statistical
analysis.
Managers are more likely to
manipulate income-increasing
earnings.
No relationship between
independent directors and
earnings management.
Companies with good corporate
governance have lower activities
of earnings management.
Large firms are more likely to
manipulate earnings.
Negative relationship between
earnings management and
managerial ownership.
Positive relationship between
returns and managerial
ownership.
10. Earnings
management and
corporate governance :
the role of the board
and the audit committee
(2003)
Xie, Biao,
Davidson, Wallace N,
DaDalt, Peter J
Investigate whether
board characteristic,
audit committee and
executive committee
affect earnings
management.
281 listed firms
collected from S&P
500 index in 1992,
1994 and 1996.
OLS regression; cross-sectional
of the Modified-Jones Model.
11. Managerial
Ownership Structure
and Earnings
Management (2008)
Yang, Chi-Yih.
Lai, Hung-Neng.
Tan, Boon. Leing.
Study the relationship
between managerial
ownership and earnings
management.
A sample of 1306 listed
firms collected from
Taiwan Economic
Journal (TEJ) database
during 1997-2004.
Econometric model
longitudinal mixed model
Restricted Maximum Likelihood
(REML).
Page 91
Audit committee and
independent boards with
corporate experience decrease
the likelihood of earnings
management.
Meeting times are connected to
reduce the level of earnings
management.
U-shaped relationship between
inside ownership.
Positive relationship between
earnings management and
director ownership, block holder
ownership.
Page 92