Do related party transactions affect earnings quality? Evidence from East Asia

• Pages: 147-166
• DOI: https://doi.org/10.1108/IJAIM-12-2018-0146
• Published date: 28 January 2020
• Date: 28 January 2020
• Author: Mohd Mohid Rahmat,Balachandran Muniandy,Kamran Ahmed
• Subject Matter: Accounting/accountancy,Accounting & Finance

Do related party transactions

af‌fect earnings quality? Evidence

from East Asia

Mohd Mohid Rahmat

School of Accounting, University Kebangsaan Malaysia, Kuala Lumpur, Malaysia, and

Balachandran Muniandy and Kamran Ahmed

Department of Accounting and Data Analytics, La Trobe University,

Melbourne, Australia

Abstract

Purpose –The purpose of thispaper is to examine the effect of related party transactions(RPTs) and types

of RPTs (complex, simple and loan)on earnings quality in four East Asian countries: Hong Kong, Malaysia,

Singaporeand Thailand.

Design/methodology/approach –RPTs and types of RPTs are measured using two approaches,

magnitude and abnormal (magnitude change). Earnings quality is measured using proxies for accrual

earnings management and identif‌iedas discretionary accruals (DAC) and performance matched discretional

accruals(PMDAC).

Findings –The results suggestthat f‌irms in these countries experience poor earningsquality when they are

engaged in RPT. The effect of RPT-simpleon earnings quality is more severe than RPT-complex. However,

the presence of higher investorprotection and stricter enforcement of regulations in countrieslike Singapore

and Hong Kongreduce the negative impact of RPTs on earningsquality.

Research limitations/implications –The results support the argument that the presence of controlling

shareholders in East Asia is likely to lead to engagement with RPTs, which will increase the likelihood of f‌irms’

earnings manipulation via DAC. This study has two limitations. It only focuses on Hong Kong, Malaysia,

SingaporeandThailand,andtheresultsmaynotbegeneralizable to other countries. Second, this study only

measures the magnitude and abnormal RPTs based on the disclosures available in annual reports.

Originality/value –This paper contributesto the literature by examining the effect of RPTs and types of

RPTs on earningsquality in four selected East Asian countries.

Keywords East Asia, Earnings quality, Related party transactions, Investor protection

Paper type Research paper

Introduction

We examine the effect of related party transactions(RPTs) on earnings quality for four East

Asian countries –Hong Kong, Malaysia, Singapore and Thailand to determine whether

regulatory changes thatwere implemented post the Asian crisis helped in alteringreporting

practices. Although RPTs are associated with real earnings management (Aharony et al.,

2010;Chen et al.,2011), the evidence on its implication for discretionary accruals (DAC)

remain inconclusive (Jian and Wong, 2010;Kuan et al.,2010;Munir et al.,2013).

Additionally, RPTs have received continual attention in the aftermath of corporate failures.

Thus, the need to properly articulate its implication for corporate reporting remains

paramount.

JEL classif‌ication –M41

Evidence from

East Asia

147

Received7 December 2018

Revised1 February 2019

Accepted10 February 2019

InternationalJournal of

Accounting& Information

Management

Vol.28 No. 1, 2020

pp. 147-166

© Emerald Publishing Limited

1834-7649

DOI 10.1108/IJAIM-12-2018-0146

The current issue and full text archive of this journal is available on Emerald Insight at:

https://www.emerald.com/insight/1834-7649.htm

We focus on these four East Asian countries as they are all characterized by a higher

level of ownership concentration (La Porta et al.,2008;Tareq et al., 2017) with controlling

shareholders occupyingkey managerial positions (Claessens et al., 2000;Sarkar et al.,2008).

Nonetheless, there are some distinctions in the area of regulatory enforcement and level of

investor protection (Peng and Jiang, 2010;World Bank, 2012) which further provide an

interesting contextfor the examination of RPTs.

An RPT is a transfer of resources, services or obligations between related parties,

regardless of whether a price is charged (International Accounting Standards, IASB 2009)

and where a related party is a person or an entity related to the entity preparing f‌inancial

statements (Habib et al., 2015). RPTs have been identif‌ied as a mechanism for abuse in a

controlling-minority shareholder relationship (Kang et al., 2014;Larcker et al.,2007;Tong

and Wang, 2008;Wang, 2006). Consistent with this notion, Sherman and Young (2001) and

Lee et al. (2016) have highlighted the use of RPTs by controlling shareholders to distort

reporting quality.

Our study is motivated by several factors. First, we assess the implications of RPTsin a

different corporate governance context. Prior studies present evidence from contexts with

widely dispersed shareholding and strong investor protection (Aguilera et al., 2006;El-

Helaly, 2016;Ahmed and Mather, 2016) and higher government shareholding (Wang and

Lin, 2017;Jian and Wong, 2010). Among East Asian countries, corporate governance

practices, ownership structureand investor protection tend to exhibit similar characteristics

(Lemmon and Lins, 2003;Aswadi Abdul Wahab et al., 2011). The share ownership

structures of corporations are concentrated by single shareholders (Claessens et al., 2000;

Johnson et al., 2000),particularly by families (Munir et al., 2013;Rahmat and Ali, 2016) . Prior

studies also argue that there is lack of investor protection rights and legal enforcement in

East Asian capital markets (Claessens et al., 2000,La Porta et al., 2000;Lemmon and Lins,

2003). Additionally, the corporate governance practices in some of these East Asian

countries are consideredpoor (O.E.C.D, 2011).

Second, the nature of RPTs for East Asian countries is different from the type of RPTs

which have been examined from the US context.Although US RPTs ref‌lect individual-level

transactions, RPTsfor East Asian countries are predominantly f‌irm aff‌iliate driven(Rahmat

and Ali, 2016). Additionally,RPTs are likely to have different implications for private f‌irms

as against Chinese state-owned f‌irms (Jian and Wong, 2010;Ji et al.,2015). Our study thus

focuses on four East Asian countries to highlight the implication of RPTs for earnings

quality when shareholding is concentrated, and investor protection is minimal. We run a

panel regression with DAC as the proxy for earnings quality, the dependent variable and

RPTs as the explanatory variableof interest (proxied by simple-RPTs and complex-RPTs).

Our f‌indings indicate that f‌irms in these East Asiancountries experience lower earnings

quality when they are engaged in RPTs. The effect of RPT-simple, including RPT-loan on

earnings quality is more severe than RPT-complex. Furthermore, our results show that

RPTs have positive impact on earnings quality in countries like Singapore and Hong Kong

because of the presenceof better investor protection.

Our study makes several important contributions to the existing literature. It provides

further evidence on the associationbetween RPTs and earnings quality by classifying RPTs

in terms of complexity (Kohlbeck and Mayhew, 2010) with respect to both magnitude and

abnormality. Prior studiesto date have not tested the effects of RPT complexity onearnings

quality. Cheung et al. (2006) classif‌iedRPTs according to the likelihood of such transactions

being used to expropriatewealth, primarily through tunneling. RPTs’complexityenables us

to better understand managers’behavior in using earnings management to mask wealth

expropriation activities. Although RPTs vary considerably in type (Ryngaertand Thomas,

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