jaggi et al - 2009 - family control, board independence and earnings management evidence based on hong kong firms

Family control, board independence and earningsmanagement: Evidence based on Hong Kong firms Bikki Jaggia,b,*, Sidney Leungc, Ferdinand Guld,e a Department of Accounting and Information S

Family control, board independence and earnings

management: Evidence based on Hong Kong firms

Bikki Jaggia,b,*, Sidney Leungc, Ferdinand Guld,e

a Department of Accounting and Information Systems, School of Business, Rutgers University, Levin Building,

Piscataway, NJ 08854, United States

b

The Hong Kong Polytechnic University, Hong Kong

c

Department of Accountancy, City University of Hong Kong, Hong Kong

d

School of Accounting and Finance, The Hong Kong Polytechnic University, Hong Kong

e

The Faculty of Business and Accountancy, University of Malaya, Kuala Lumpur, Malaysia

a r t i c l e i n f o

JEL classification:

G32

G34

M41

Keywords:

Corporate governance

Earnings management

Earnings quality

Family ownership concentration

Family board members

a b s t r a c t

In this study, we document that independent corporate boards of Hong Kong firms provide effective monitoring of earnings manage-ment, which suggests that despite differences in institutional envi-ronments, corporate board independence is important to ensure high-quality financial reporting The findings also show that the monitoring effectiveness of corporate boards is moderated in fam-ily-controlled firms, either through ownership concentration or the presence of family members on corporate boards The results based

on firms reporting small earnings increases provide additional sup-port for our finding that the monitoring effectiveness of indepen-dent corporate boards is moderated in family-controlled firms

Ó 2009 Elsevier Inc All rights reserved

1 Introduction

Studies based on data for US and UK firms document that corporations with independent boards tend to have less earnings management (seeDechow and Dichev, 2002;Peasnell et al., 2000) The

earnings quality by reducing earnings management Another strand of research indicates that the institutional arrangements of a country have a significant impact on the magnitude of earnings

man-0278-4254/$ - see front matter Ó 2009 Elsevier Inc All rights reserved.

* Corresponding author Address: Department of Accounting and Information Systems, School of Business, Rutgers University, Levin Building, Piscataway, NJ 08854, United States Tel.: +1 732 445 3539; fax: +1 732 445 32091.

E-mail addresses: jaggi@rbsmail.rutgers.edu , jaggi@business.rutgers.edu (B Jaggi).

Contents lists available atScienceDirect

J Account Public Policy

j o u r n a l h o m e p a g e : w w w e l s e v i e r c o m / l o c a t e / j a c c p u b p o l

agement and earnings quality For example,Leuz et al (2003)document higher earnings management

in countries with low investor protection.Ball et al (2003)argue that institutional factors have a strong influence on the private benefits of control and managerial incentives for financial reporting Recently, some authors have argued that family ownership concentration also influences firm perfor-mance and earnings quality (e.g.,Anderson and Reeb, 2004; Ali et al., 2007)

We extend the existing research by investigating whether independent corporate boards provide effective monitoring of earnings management in firms operating in institutional environments which differ from those of US and UK firms More importantly, we evaluate whether the monitoring effec-tiveness of independent corporate boards is affected by the family ownership control or the appoint-ment of family members on corporate boards We conduct analyses on the Hong Kong firms, which operate in an environment where family ownership control and appointment of family members to corporate boards are well documented Hong Kong has the third highest percentage of family owner-ship of listed companies in the region after Indonesia and Malaysia (SCMP, 2002), and the Hong Kong Society of Accountants (HKSA, 1997) documents that members of controlling families are routinely appointed to corporate boards On the other hand, Hong Kong regulations emphasize corporate board independence (HKSE, 2004)

In this study, we first evaluate whether the negative association between board independence and earnings management that has been documented in the US and UK (seeDechow and Dichev, 2002;

of Hong Kong-based firms, a separate study of this setting is warranted Furthermore, as the leading financial center in the region and one of the largest international financial centers, the Hong Kong financial market attracts local and international investors, which has created demand for high-quality earnings information Investors are interested to know whether board independence, which has re-ceived increased attention in the Hong Kong institutional environment, improves earnings quality

We argue that despite differences in the institutional environments between Hong Kong and the US and the UK, independent corporate boards are likely to provide stricter monitoring of managerial behavior with respect to earnings management, which will lead to better earnings quality Thus, we expect earnings management to be low and earnings quality to be high in the Hong Kong firms with more independent corporate boards

Second, we examine whether family ownership control or family members on corporate boards moderate the monitoring effectiveness of independent boards Two opposing arguments exist as to the effect of family control through ownership or the appointment of family members to corporate boards on the effective monitoring by boards of earnings management On one hand, family control may not result in higher earnings management because founding families will limit the ability of man-agers to manipulate earnings, and there will be less pressure on management to manage earnings to look good in the short term since the controlling family will have a long-term interest in the firm (e.g.,

problem (conflict between managers and shareholders) On the other hand, earnings management is higher in countries where family ownership concentration is higher because of weak investor protec-tion (e.g.,Leuz et al., 2003) and majority shareholder motivation to expropriate minority shareholders’ interests (e.g.,Fan and Wong, 2002; Cheung et al., 2006) This second argument is consistent with firms operating in institutional environments in which the Type II agency problem (conflict between controlling shareholder and minority shareholders) is more common Thus, the overall effect of family control on earnings management depends on whether the Type I or Type II agency problem dominates

In this study, we conjecture that the prevalence of family control in Hong Kong is likely to moder-ate the monitoring effectiveness of independent corpormoder-ate boards The following three arguments are presented in support of this conjecture First, we argue that when insider ownership is high, the mon-itoring role of corporate boards decreases (Jensen and Meckling, 1976) Second, controlling families are more likely to appoint independent directors to seek expertise and advice on strategic direction rather than give them the responsibility of monitoring and controlling managerial activities (Anderson

directors Third, director independence is likely to be compromised when a family controls a firm either through ownership domination or appointing family members to the board, because family

members will have control over the appointment and reappointment of independent directors Inde-pendent directors are less likely to go against the wishes of controlling family members, especially when they sit on corporate boards

We use the proportion of independent non-executive directors (INED) on corporate boards as a proxy for corporate board independence FollowingAnderson and Reeb (2003), we use fractional

equi-ty ownership of the family as a measure of ownership control concentration A cutoff of 20% owner-ship is used to identify firms with family control concentration We also conduct sensitivity analyses

on different cut-off points for family ownership concentration Because of interlocking relationship among firms and insufficient disclosure in annual reports about director ownership via corporate pyr-amids, effective ultimate ownership and the ratio of family voting control over ultimate ownership are not determinable Therefore, we use the appointment of controlling family members on corporate boards as an additional proxy for family control We consider the board as family controlled when two or more members of the controlling family are present on the board on the assumption that two or more family members will exercise a significant influence on the board’s decisions We use two widely adopted proxies for earnings management: the magnitude of discretionary accruals, and the discretionary component of accrual quality (see, for example,Kothari et al., 2005; Francis et al.,

2005) Discretionary accruals are measured on the basis of the performance-adjusted discretionary accruals model (PACDA), suggested byAshbaugh et al (2003) The discretionary component of quality

of accrual (AQ) is measured based on the model suggested byFrancis et al (2005) A lower magnitude

of discretionary accruals and a lower discretionary component of AQ reflect lower earnings manage-ment (or higher earnings quality)

Our study is based on all firms traded on the Hong Kong Stock Exchange (HKSE) during the period 1998–2000 for which financial data are available on the Global Vantage database The final sample for PACDA analysis consists of 770 firm-year observations Because of non-availability of data, the AQ analysis is based on 309 observations.1We conduct 2SLS regression with discretionary accruals (PACDA) and discretionary component of accrual quality (AQ) as dependent variables, and use the predicted value

of ownership in the analyses to control for the potential endogeneity associated with family ownership

We also conduct OLS regression analyses as a sensitivity analysis

The 2SLS regression results, which control for the endogeneity problem, show a negative associa-tion between earnings management and board independence, suggesting that a higher proporassocia-tion of INEDs on corporate boards results in more effective monitoring of earnings management that in-creases earnings quality The results based on family-controlled and non-family-controlled firms show that the negative association between board independence and earnings management is moderated

by family ownership and control We test the robustness of our findings by examining whether family ownership and family board control have an impact on the effectiveness of independent boards to control earnings management when firms report small earnings increases The results of this test indi-cate that more independent boards are associated with a reduced likelihood of reporting small earn-ings increases The results on the impact of family control show that the negative association between earnings management and board independence is weak for family-controlled firms Sensitivity tests performed on different cut-off points for family ownership concentration for identifying family-con-trolled firms do not change the result Overall, our findings indicate that independent boards tend

to be effective in controlling earnings management only in non-family-controlled firms Board inde-pendence does not appear to improve earnings quality in family-controlled firms An alternative explanation for the results could be that independent directors and family control are substitutes for controlling earnings management.2

The findings of this study make the following contributions First, the results indicate that, on aver-age, INEDs provide effective monitoring of earnings management in Hong Kong firms This finding suggests that strengthening the independence of boards by appointing more INEDs is a positive step toward improving earnings quality Second, the monitoring effectiveness of independent directors is moderated in family-controlled firms Third, given similarities in the business and institutional

1 The number of AQ observations is much smaller than that of PACDA observations because of non-availability of observations for running the time-series regression model to obtain the residuals that are used as a proxy of AQ.

2

B Jaggi et al / J Account Public Policy 28 (2009) 281–300

arrangements of Hong Kong and countries in East and Southeast Asia (e.g., Taiwan), the findings based

on this study provide useful information for regulators in these countries Fourth, the results suggest the policy makers in Hong Kong and other Southeast Asian countries should be careful in borrowing rules/regulations from the US/UK because they may not work as effectively in a different institutional setting Finally, the findings also provide useful information to investors in evaluating the impact of board independence on earnings quality, especially in family-controlled firms

The remainder of the paper is organized as follows: Section2introduces the background of the study Section3contains discussion on the development of hypotheses, and Section4presents search design, including the sample selection procedures and research methodology Discussion of re-sults is provided in Section5, and Section6presents the summary and conclusions

2 Background of the study

2.1 Institutional environments of Hong Kong firms

different countries Though Hong Kong’s legal framework is influenced by English common law, sig-nificant differences exist between the business environment of Hong Kong and the business environ-ments of western industrialized countries, especially with regard to corporate governance, ownership and control The corporate governance structure of Hong Kong firms is characterized by a personal networking system (guanxi), which revolves around informal relationships rather than formal written contracts As a result, family ownership concentration in firms and the appointment of family mem-bers to corporate boards are common (e.g.,Claessens et al., 2000; Mok et al., 1992) The 10 most prom-inent business families control 32.1% of all the corporate assets in Hong Kong (Tsui and Stott, 2004) Additionally, according to the 1994 statistics, family ownership of Hong Kong firms was worth about US$155 billion, representing 60% of total market capitalization (for example, seeWeidenbaum and

As a result of family ownership concentration, market control mechanisms are weak in Hong Kong: hostile takeovers and mergers and acquisitions are almost non-existent Moreover, because of family ownership concentration, institutional shareholdings is not very common (Tsui and Stott, 2004) Hong Kong firms also differ from US firms with regard to corporate borrowings: private borrowing through banks rather than issuing public debt is more common in Hong Kong

2.2 Agency problems in the Hong Kong ownership structure

Family-controlled firms are likely to face agency problems different from those of non-family-con-trolled firms The phenomenon of family ownership concentration results in two distinct groups of shareholders, i.e., majority and minority shareholders As a result of these two groups of shareholders, family-controlled firms are more likely to suffer from the Type II agency problem (conflict between majority and minority shareholders) than the Type I agency problem (conflict between managers and shareholders) (seeAnderson and Reeb, 2004; Ali et al., 2007) Controlling shareholders have an opportunity to maximize their private benefits by expropriating minority shareholders (e.g., Fan

may not be in the best interest of outside (minority) shareholders

2.3 Regulations on the presence of INEDs on corporate boards

The Hong Kong Stock Exchange’s (HKSE) guidelines at the time of this study required that firms ap-point at least two independent non-executive directors on corporate boards To strengthen corporate board independence, the HKSE appointed a committee to improve the Stock Exchange’s operations and strengthen the listing requirements so that corporate boards would assume greater responsibility and accountability in ensuring reliability of reported information The HKSE Committee (2004)

recom-mended that the number of independent directors on Hong Kong corporate boards be raised from two

to three members effective for accounting periods starting on or after January 1, 2005

3 Research questions and hypotheses

3.1 Corporate board independence and earnings management

The first research question addressed in this study is whether a higher degree of corporate board independence of Hong Kong firms, proxied by the proportion of INEDs on corporate boards, is associ-ated with lower earnings management

The impact of corporate board independence on monitoring effectiveness has been examined in prior studies Most of these studies emphasize the importance of independent corporate boards, prox-ied by a higher proportion of independent non-executive directors, to monitor managerial activities.3

monitoring of managerial activities and initiatives.Williamson (1981)argues that the independence of corporate boards is needed to protect investor interests.Roe (1991)supports the monitoring role of cor-porate boards on the ground that managerial activities could not be targeted by legislative actions, and argued that effective monitoring by corporate boards prevent the abuse of powers by managers Some studies have examined empirically the impact of board independence on earnings manage-ment; these studies have primarily been based on data from the US and UK firms.Dechow et al (1996) evaluate the causes and consequences of earnings manipulation based on firms subject to enforce-ment actions by the Securities and Exchange Commission (SEC) Their findings indicate that ‘‘the like-lihood of earnings manipulation is systematically related to weaknesses in the oversight of management” (p 3), and they argue that firms with greater earnings manipulation are more likely

to have a board dominated by insiders In another study,Beasley (1996)concludes that inclusion of

a larger proportion of outside directors on boards reduces the likelihood of financial statement fraud

In a recent study based on a small sample of US firms,Xie et al (2003)find a negative association be-tween corporate board independence and discretionary accruals.Peasnell et al (2000)find a similar result using a sample of UK firms for pre- and post-Cadbury periods Their findings show that in the post-Cadbury period, there is less income-increasing accrual management to avoid earnings losses

or declines when the proportion of non-executive directors is high

We extend the existing empirical research by evaluating whether the negative association between corporate board independence and earnings management is also valid for Hong Kong firms, which operate in a different institutional environment than US or UK Based on the conceptual arguments presented in the literature, we postulate that independent corporate boards provide effective monitor-ing of managerial behavior in Hong Kong Furthermore, in the absence of audit committees durmonitor-ing the study period, responsibility for ensuring high-quality earnings information falls on the boards We test the following hypothesis, stated in the alternative form:

H1: Higher independence of Hong Kong corporate boards, proxied by the percentage of INEDs on corporate boards, is associated with lower earnings management

3.2 Impact of family control on the association between board independence and earnings management Our second research question examines whether family control has a moderating effect on the monitoring effectiveness of independent boards There are two opposing theoretical viewpoints on the impact of family control on earnings management On one hand, earnings management is ex-pected to be lower in family-controlled firms The results of studies based on US firms show that fam-ily firms are significantly less likely to manage earnings (Jiraporn and DaDalt, 2007; Ali et al., 2007;

3

Among others, these studies include those of Brickley et al (1994), CALPERS (1998), Cadbury (1992), Fama (1980), Dahya and

B Jaggi et al / J Account Public Policy 28 (2009) 281–300

are expected to monitor managerial behavior and actions effectively, which will reduce managerial opportunities to engage in earnings management Second, in accordance with the stewardship theory, earnings are less likely to be manipulated because controlling families would identify their interests more closely with the firms’ wealth (e.g.,Tosi and Gomez-Mejia, 1989) Third, there will be less pres-sure on management to meet short-term earnings expectations because controlling families focus more on the long term

On the other hand, family control of a firm is likely to result in the Type II agency problems, i.e., a conflict of interests between majority and minority shareholders (e.g.,Anderson and Reeb, 2004) In this case, the majority controlling shareholders may use earnings management to camouflage the re-ported earnings and hide expropriation from minority shareholders Some studies find that the own-ers of family-controlled firms extract private benefits at the cost of minority shareholdown-ers (e.g.,Morck

countries, where controlling family ownership is widespread, legal protection of minority sharehold-ers is weaker, and financial reporting is less transparent (Fan and Wong, 2002; Ball et al., 2003) Empir-ical studies also document higher earnings management in countries with lower investor protection (e.g.,Faccio et al., 2001; Leuz et al., 2003) These studies suggest that earnings management may be used to maximize the private benefits of majority shareholders.4

In view of the different expectations regarding the effect of family control on earnings manage-ment, it is an empirical question whether family control moderates the monitoring effectiveness of independent boards We conjecture that family control through family ownership concentration or appointment of family members to the board is likely to moderate the monitoring effectiveness of IN-EDs for the following reasons First, controlling families will appoint ININ-EDs to seek their advice rather than giving them the responsibility to monitor managerial activities (Anderson and Reeb, 2004) Sec-ond, consistent with the Type II agency problem, controlling families will have a motivation to expro-priate minority shareholders’ interest, and thus they will have an incentive to limit monitoring by INEDs they appoint Third, INEDs’ independence may also be compromised because of their closeness and loyalty to the controlling family that appoints or reappoints them to corporate boards We develop the following hypothesis to test this expectation:

H2: The negative association between corporate board independence and earnings management is moderated in firms with family ownership control or corporate board control through family board members

4 Sample selection and research methodology

4.1 Sample selection and data collection procedures

We started the sample selection process by searching the Global Vantage database (CD dated December 2002) for Hong Kong firms for the three-year period from 1998 to 2000 The number of Hong Kong firms that have financial data in Global Vantage by year is as follows: 391 firms in 1998,

394 firms in 1999 and 399 firms in 2000 In the second step, we examined the Global Vantage database for financial data to estimate current discretionary accrual (PACDA) and total discretionary accruals (TDA) Because of the requirement of at least 10 observations in a two-digit SIC code per year, we could measure discretionary accruals for 943 of firm-years

In the third step, we manually collected data on corporate governance and family control variables from the annual reports of sample firms for each study year As a result of missing reports or missing values in the available statements, the sample size was reduced to 876 firm-year observations As a result of some missing values for the control variables, the final sample consists of 770 firm-year observations The data for measuring the quality of accruals based on the model of Francis et al

4

The controlling shareholders may also use other means to expropriate minority shareholders, such as selling assets, goods, or services to other companies under their control (e.g., Cheung et al., 2006 ) However, the Type II agency problem can come at a price

to the controlling owners and their firms because investors can discount the share prices in response to the agency conflict

(2005)were obtained from the PACAP databases.5Because of the strict data requirement of the AQ esti-mation that is based on theFama and French (1997)portfolio approach, which requires residual values for five years, the number of data observations was reduced to 309 for this variable

The number of firm-year observations by SIC code and year is provided inTable 1

The sample distribution indicates that there is no significant difference in the number of observa-tions across the sample years The sample distribution by industry classification shows a higher num-ber of observations for SIC code 36 (electronic and other electric equipment), SIC code 50 (wholesale trade – durable goods), and SIC code 51 (wholesale trade – nondurable goods) There is relatively a small number of observations for SIC codes 22 (textile mill products) and 47 (transport services) Dis-tribution of our sample is similar to the industry disDis-tribution of Hong Kong firms in the database 4.2 Family board members and family ownership

The ‘directors and management profile’ in the annual reports of Hong Kong firms provides a profile

of each director According to the listing rules of the Hong Kong Companies Ordinance and Stock Ex-change, companies are required to disclose the profile of all directors and senior management and their relationships, if any The annual reports also contain the shareholding information for each direc-tor, and disclosure of this information is done at three levels, namely personal interest, family interest and corporate and other interest Information contained in the annual reports enabled us to identify re-lated family members on corporate boards Based on this information, we could identify the following relationships: father/mother and son/daughter, husband and wife, father/mother-in-law, son/daugh-ter-in-law, brothers and sisters, nieces and nephews The board is defined as family controlled when two or more members of the controlling family are appointed as directors Consistent with the liter-ature (e.g.Ho and Wong, 2001), we find that controlling family members are routinely appointed as chairman or as executive director to control board decisions (Ho and Wong, 2001)

5

We use the PACAP database for AQ estimation because it covers Hong Kong firms more extensively than does the Global Vantage database The PACAP databases are compiled by the Pacific-Basin Capital Markets Research Center at the University of Rhode Island College of Business, and provide historical research data for Hong Kong, Indonesia, Japan, Korea, Malaysia, Singapore,

Table 1

Sample by industry and year.

Our analyses are based on data for 1999 Among 269 firms in 1999, 141 (52.4%) have family mem-bers representing family interest on the board, and 72 (51.1%) out of the 141 family-controlled firms have two family members serving as directors The number of firms with three family members on the board is 36 (25.5%), and the number with four or more members is 33 (23.4%) Additionally, we find that in 132 (93.6%) of the family-controlled firms, family members hold the position of Board Chair-man, and an overwhelming majority of family board members (86.7% of firms) hold one of the key positions (i.e., chairman, CEO, or executive directors) Also, the family-controlled firms with three or more family members on the board occasionally appoint a family member as a non-executive director Additional analyses indicates that in half of the family-controlled firms (N = 70), a ‘father/mother and son/daughter’ relationship exists among family board members, which shows that family firms have a tendency to keep the business within the family over generations In 26.2% of the 141 family firms, husband and wife jointly represent the family interest on the board Descriptive statistics also indicate that controlling shareholders tend to have family members holding key managerial positions Information contained in annual reports also indicates families’ ultimate share ownership.6We use

a 20% cut-off point for family ultimate ownership control to identify the family-controlled firm.7

4.3 Corporate board independence

The corporate board independence is measured by the proportion of INED on corporate boards Directors are considered to be INEDs if they do not hold any executive position in the firm, have no relationship to the firm, and have no related-party transactions with the firm Thus, grey directors are excluded from the INED category

4.4 Calculation of discretionary accruals and accrual quality

Our first proxy for earnings management is the magnitude of discretionary accruals We calculate both total and current discretionary accruals Total discretionary accruals (TDA) are calculated using the cross-sectional discretionary accruals model suggested byJones (1991)and modified byDechow

sus-ceptible to earnings manipulation (e.g.,Ashbaugh et al., 2003), and others have argued that firm per-formance should also be considered in calculating discretionary accruals (Kothari et al., 2005) Our main results are based on the performance-adjusted current discretionary accruals (PACDA) model, which takes both of these factors into consideration, and TDA is used in a sensitivity test Details for estimation of PACDA and TDA are provided inAppendix A.8

As a second proxy, we use the quality of accruals, as suggested byFrancis et al (2005) Because of estimation errors9in calculating discretionary accruals, the quality of accruals has recently been sug-gested as an alternative proxy for earnings management (Francis et al., 2005) Dechow and Dichev

in the preceding, current and subsequent periods The model ofFrancis et al (2005)extends theDechow

and property, plant and equipment (PPE), both of which are scaled by the average total assets.McNichols

6

Family ownership is calculated as the fractional ordinary shares held by family directors as the sum of beneficial interests at the personal, family and corporate levels It represents the ultimate voting control of the family in the firm Because the majority of footnotes associated with corporate interest of directors are unclear about the effective ownership of family members, we cannot measure the disparity between family voting control and ownership rights.

7

A similar ownership cutoff point for concentrated ownership has been used by Morck et al (1988) and by Hermalin and Weisbach (1991) Our results, however, are not sensitive to this cut-off.

8

Because the results for PACDA and TDA are qualitatively similar, the results on the magnitude of discretionary accruals are tabulated for PACDA only.

9

Discretionary accrual models of earnings management have limitations (see Erickson et al., 2004 ) The measurement of discretionary accruals is surrounded by the controversy whether discretionary accruals can be isolated from non-discretionary accruals with precisions ( Guay et al., 1996 ) Furthermore, discretionary accruals may not always represent opportunistic earnings

(2002)argues that in order to ‘‘extract” the estimation error in the form of a residual, it is necessary to control for these two variables The model is as follows:

where TCA is total current accruals, CFO is cash flow from operations,DRev is change in revenue and PPE is net property, plant and equipment.10All variables are scaled by the average of total assets

Eq.(1)is estimated cross-sectionally for all firms (minimum of 10 firms) within each one of the 48 industry groups defined byFama and French (1997)for each year AQ is defined as the standard devi-ation of the residual,ei,tfor years t  4 to year t (a minimum of 3 years firm residual data is required) A higher value of AQ means higher standard deviation, meaning higher variation in reported earnings, and this reflects lower earnings quality

component is more prone to managerial manipulation We identify the discretionary component of AQ

by separating it from the innate component.Francis et al (2005)suggest the use of the following five factors to estimate the innate component of AQ: firm size, standard deviation of cash flow from oper-ations (r(CFO)), standard deviation of sales (r(SALES), operating cycle, and incidence of losses We cannot calculate the operating cycle for Hong Kong firms because data on cost of sales (COGS) is not available during the study period As a result, we estimate the innate component of AQ by the fol-lowing annual estimations:

where SIZE is the log of total assets,r(CFOit) andr(SALESit) are the standard deviation of cash flow from operations and sales respectively, calculated over the past seven years, NEGEARN is the propor-tion of loss (negative earnings) years out of the past seven years We require at least four observapropor-tions

in the 7-year window.11The discretionary component of AQ (DISC_AQ) is the residual eitfrom Eq.(2) 4.5 Regression models

We evaluate the association between the proportion of INEDs on corporate boards (PINED) and earnings management, after controlling for the impact of other relevant variables The use of control variables is based on their relevance to earnings management, as discussed in the literature The find-ings ofXie et al (2003)suggest that board size (BD_SIZE) is related to the extent of earnings manage-ment.Fama and Jensen (1983)as well as theCadbury Committee (1992)have argued that corporate boards would be more independent if the board chairman is independent of the firm’s chief executive officer (CEO) To highlight corporate board independence through PINED, we use board chairman/CEO duality as a control variable The variable CEO is coded 1 when the board chairman and CEO positions are held by one individual, and 0 otherwise Because some Hong Kong firms established audit commit-tees voluntarily during the study period, we also include an indicator variable for audit committee in the model because it is likely to improve earnings quality (Klein, 2002) We use log of total assets (F_SIZE) as a control variable to control for firm size The impact of firm performance, firm growth and liquidity are controlled through the use of return on assets (ROA), market-to-book ratio (MB) and debt-to-equity-ratio (DE) respectively In addition, we include a dummy variable for Big5 auditors and we control for the effect of time periods by including year dummy variables

The following model is used to evaluate the association between earnings management (EM) and PINED:

10 Data on gross PPE are not available in the PACAP database As a result, we use net PPE in the estimation of Eq (1) 11

We use a 7-year rolling window and require at least four observations in the past 7 years, whereas Francis et al (2005) use a 10-year window and require at least five observations in the past 10 years We use a narrower window because the number of

B Jaggi et al / J Account Public Policy 28 (2009) 281–300

Table 2

Descriptive statistics and correlations.

Panel A: descriptive statistics of all variables

YEAR99 Panel B: Pearson correlation coefficients between variables

DISC_AQ 0.332 ** 0.893 **

PINED 0.105 ** 0.109 * 0.039

FAMOWN 0.071 * 0.055 0.033 0.010