Earnings Management
Chi-Yih Yang
Minghsin University of Science and Technology, Taiwan and
Xian Jiaotong-Liverpool University, China.
Email: chiyih.yang@xjtlu.edu.cn
Hung-Neng Lai
National Central University, Taiwan
Introduction
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Managerial Ownership Structure and Earnings Management
Literature Review
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Healy and Wahlen (1999) conclude that earnings management occurs in four
cases, where managers manage earnings to (1) window dress the financial
statement prior to the offering of securities to the public, (2) increase manager
compensation or job security, (3) avoid violating debt covenants, or (4) reduce
regulatory costs and/or increase benefits. Although earnings management has
received considerable attention in the accounting literature, there is little empirical
evidence on the relation between equity incentives and earnings management.
Moreover, the results are mixed and can be grouped into negative relation, no
relation, U-shaped relation, and positive relation as follows.
According to Jensen and Mecklings (1976) agency theory, Warfield et al.
(1995) hypothesize that managers of low managerial ownership have greater
incentives to manage accounting numbers to relieve or relax the behavioral
constraints imposed in accounting-based contracts. Warfield et al. examine US
data from 1988 to 1990 and find a negative relationship between managerial
ownership and the absolute value of discretionary accruals.
Interestingly, in contrast to the results of Warfield et al. (1995), Francis et
al. (1999) analyze US data in 1994 and conclude that there is no systematic
relationship between management ownership and accounting accruals.
Gabrielsen et al. (2002) examine Danish data from 1991 to 1995 and report no
relationship between managerial ownership and absolute abnormal accruals.
Yeo et al. (2002) examine Singapore-listed companies from 1990 to 1992 and
observe a U-shaped relation between director ownership and income-increasing
discretionary accruals. Earnings management decreases with managerial
ownership at low levels (£ 25%) but increases at higher levels of managerial
ownership where the entrenchment effect sets in. That is to say, high ownership
by management implies sufficient voting power to guarantee future employment
and as a consequence, becomes ineffective in aligning managers to take value-
maximizing decisions.
However, as stated by Michael Jensen, Once a firms shares become
overvalued, it is in managers interests to keep them that way, or to encourage
even more overvaluation, in the hope of cashing out before the bubble bursts
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Managerial Ownership Structure and Earnings Management
(The Economist, 2002). That is, managers with high equity incentives could
benefit from earnings management with the objective of keeping stock prices
high and increasing the value of their shares to be sold in the future. According
to this argument, Cheng and Warfield (2005) hypothesize that managers with
high equity incentives are likely to sell shares and such trading behavior
motivates managers to care about short-tem stock prices and to manage
earnings. Unlike Warfield et al. (1995), Cheng and Warfield focus on the relation
between equity incentives and signed abnormal accruals and find that CEO
ownership is positively correlated with abnormal accruals.
All the previous studies regard managerial ownership as a whole without
looking into its composition. Traditional agency theorists treat property rights
as a bundle and neglect the knowledge and competence dimension of
governance (Grandori, 2004). In other words, ownership is considered as a
package of residual rights of control (which include decision rights) and
residual reward rights that can hardly be separated. However, organization
theory helps to overcome this limitation by proposing that decision rights
should be assigned to actors possessing relevant knowledge. Aghion and
Tirole (1997) and Prendergast (2002) suggest that if managers have private
information (i.e. specific knowledge), greater managerial shareholdings may
serve the purpose of inducing them to use this information so as to maximize
firm value. Grandori and Soda (2004) define a governance regime as a
combination of an allocation of property rights and an array of other
organizational mechanisms. They consider two categories of principals: investors
of human capital (highly qualified managers) and investors of financial capital
or their delegates in boards of directors, and suggest that decision rights should
be allocated where the relevant knowledge resides.
According to Nunn et al. (1983), there is a reason to believe that not all
insiders have equal access to non-public information. Sheu and Yang (2005a),
Sheu and Yang (2005b), and Yang and Sheu (2006) decompose insiders (a broad
definition of management) into executives, outside directors, and blockholders
to study the relationship between managerial ownership structure and different
measures of firm performance. They find that increasing executive ownership
beyond a certain percentage will help improve total factor productivity, technical
efficiency, and IPO survivability. Extending the above series of research on
managerial ownership structure, this study continues to contribute to the
corporate governance literature by investigating its influence on the behaviors
of earnings management.
Methodology
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Managerial Ownership Structure and Earnings Management
Empirical Models
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during the early 1990s in order to improve their productivity and administrative
operation (Wu, 2003).
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Results
Descriptive Statistics
Table 1 provides details about the sample distribution by year and by TSEC
industry code. The electronics industry has the largest number of companies,
with more than 51 percent of the total observations in the sample. This is
congruent with the statistics that in 2000 the electronics industry alone
accounted for 40% of the total sales and 72% of the total profits before taxes
generated by all firms listed on the TSEC. The remaining sample companies are
widely distributed across TSEC industry codes.
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Managerial Ownership Structure and Earnings Management
Table 2 provides the descriptive statistics for the sample. The average total
accrual deflated by lagged total assets is 0.0345 and its median is 0.0147. The
mean and median discretionary accruals are 0 and -0.0080. Insiders on average
own 45.49% of the shares of the firms, while executives, board members, and
blockholders hold 9.03%, 23.04%, and 13.42%, respectively. The mean and
median operating cash flows deflated by lagged total assets are 5.14% and
5.24%, respectively. The debt of the average firm equals 42.23% of its total
assets. About 80 percent of the listed firms are audited by a Big 4 auditor.
Notes:
TA it / A it-1 = total accruals deflated by lagged total assets.
DA = outcome of managers opportunistic choices of discretionary accruals.
INS = percentage of outstanding shares owned by insiders, which includes
executives, outside directors, and large shareholders.
EXE = percentage of outstanding shares owned by executives, including
executive directors who are the senior managers and also board
members of a company.
DIR = percentage of outstanding shares owned by outside directors, excluding
executives directors.
BLK = percentage of outstanding shares owned by large shareholders who
own more than 5% shares or are among top ten biggest owners of the
firm.
OCF = cash flows from operations deflated by lagged total assets.
LEV = total liabilities divided by total assets.
SIZE = natural log of total assets.
AUD = dummy variable for Big-4 auditors (coded 1 if the observation is
audited by a Big 4 auditor and 0 otherwise).
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Conclusions
Theories and some previous empirical investigations suggest that the managerial
equity ownership may influence their behavior on earnings management. This
investigation attempts to shed light into the role that managerial ownership
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Managerial Ownership Structure and Earnings Management
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