How Does Regulation Affect the Relation Between Family Control and Reported Cash Flows? Comparative Evidence from India and the United States

• Author: Neerav Nagar,Kaustav Sen
• DOI: http://doi.org/10.1111/corg.12157
• Date: 01 September 2016
• Published date: 01 September 2016

How Does Regulation Affect the Relation Between

Family Control and Reported Cash Flows?

Comparative Evidence from India and the United

States

Neerav Nagar*and Kaustav Sen

ABSTRACT

Manuscript Type: Empirical.

Research Question/Issue: We conduct a two-countrystudy to understand (i) how family and non-family firms engagein clas-

sification shiftingto manage reported operatingcash flows in each country; (ii) howthis behavior varies between thetwo coun-

tries; and (iii) how corporate governance regulation introduced independently in each country moderates the observed

behavior.

Research Findings/Insights: We find that family ownership has different effects on quality of cash flow reporting in the two

countries. Furthermore, country-level regulation moderates these effects differently. In particular, (i) firms in both countries

engage in manipulating operating cash flows,but the evidence is stronger in the UnitedStates; (ii) family firms in India engage

in more shifting than non-family firms, but this is not observed in the United States;and (iii) family (non-family) firms in India

increase(reduce) shifting, whereasonly non-family firms in the United Statesincrease shifting after regulation. Since non-family

firms in India raise more external capital than family firms after regulation, we infer that family firms in India reacted to this

competition for capital and resorted to shifting.

Theoretical/Academic Implications: Most studies assume thatthe incentives for family firm behavior arethe same in different

market settings. However, factors such as efficiency of public capital markets, enforcement of corporate laws and regulations,

and other institutional practices can cause differences in family firm behavior across different market settings. We investigate

the behavior of family and non-family firms in each of these markets and study how a feature of the national governance

system, regulatory design, moderates this behavior.

Practitioner/Pol icy Implications: Our findings should be usefulto global investors and regulatorsin both emerging and devel-

oped markets. The results indicate how similarregulation in the two different settingscan trigger differences in the behavior of

firms.

Keywords: Corporate Governance, Cash Flow Manipulation, Operating Cash Flows, Family Firms, Regulation

INTRODUCTION

In an increasingly globalized and connected world, inves-

tors have demanded improvements from the capital mar-

kets around the world due to a variety of reasons. Countries

responded by improving their institutions and firms by im-

proving theirgovernance practices, withan overall goal of im-

proving thenational governance bundle(e.g. see Millar,2014).

Reforms were introduced in developed markets to restore

investor confidencethat was lost due to excessive managerial

greed and in emerging markets to attract capital, primarily

from foreign investors. In this paper, we investigate how a

particular bundle, country-level regulatory design and firm-

level familyownership, has impacted financialreporting qual-

ity of firms in two contrasting settings, India and the United

States (US), where the role played by intergenerational busi-

ness families andenforcement of investor protection laws dif-

fer significantly. Our goal is to examine if this bundle leads to

different outcomes in these two markets.

Weare not the first to examine a particular governance bun-

dle to understand corporate behavior. Focusing on two spe-

cificfirm-level agency problems, Aslan and Kumar (2014)

investigate how national governance factors can be combined

into national governance bundles to address costs associated

with controlling shareholders and debt financing. Kim and

Ozdemir (2014) find that national governance systems based

on investor protection, rule of law, open market institutions

*Address for correspondence: Neerav Nagar, Indian Institute of Management

Ahmedabad Vastrapur, Ahmedabad-380,015, India. Tel: +917,966,324,944; E-mail:

neeravn@iima.ac.in

© 2016 JohnWiley & Sons Ltd

doi:10.1111/corg.12157

490

Corporate Governance: An International Review, 2016, 24(5): 490–508

act as complements or substitutes to how boards are struc-

tured to perform their role as creators and protectors of

wealth. Using a sample of large transnational firms,

Markarian, Parbonetti, and Previts (2007) find that non-Anglo

Saxon firms have developed control mechanisms to emulate

the Anglo-Saxongovernance regime. We extend this literature

to include the role of regulatory design.

We focus on family ownership since the literature has well

documented that family owned businesses not only play an

important role in emerging markets (Khanna & Palepu,

2000) but also continue to flourish in developed economies

(see Anderson& Reeb, 2003). There are bothbenefits and costs

to family controlfrom the outside investor’s perspective. Fam-

ily members are actively involved in the business and thus

able to monitor managers better (James,1999); however, since

they have substantial control through ownership and board

representation, they extract private benefits (Shleifer &

Vishny, 1997). Examining the role of national governance

systems, Rees and Rodionova (2015) find that in liberal as

compared to coordinated (i.e. open vs. closed) market econo-

mies, improvements in governance can leadto better environ-

mental and social outcomes even when equity is closely held

by institutional investors but not by families, thus pointing

out the importance ofdiversified ownership. However, given

informal mechanisms that exist in different parts ofthe world,

some recent papers question whether national governance

systems should converge (e.g. Buchanan, Chai, & Deakin,

2014; Millar, 2014). It is in this context we try to understand

the efficacy of corporate governance regulation in these two

countries by examining how family firms react to it. In partic-

ular, we examine how (i) family firms react to regulation as

compared to non-family firms in each market;(ii) family firms

react to regulation across these two markets; and (iii) family

firms react to regulation as compared to their non-family

counterparts across these two markets.

We use quality of operating cash flows, as reported, to as-

sess the outcome ofthe governance bundle mentioned earlier.

Since cash flows play an important role in contracting e.g.

debt covenants and executive compensation, an increasing

number of analysts have started to issue cash flow forecasts

(DeFond & Hung, 2003). Further, stock prices react positively

when cash flow surprises are positive (Brown, Huang, &

Pinello, 2013). Consequently, the probability of manipulation

of operating cash flowshas increased over the years (Mulford

&Comiskey,2005).Wefind that cash flow manipulation

through classification shifting (i) occurs in both countries,

but is stronger in the US; (ii) is higher for family firms than

non-family firmsinIndia,butnotinthe US;(iii)hasincreased

for family firms in India subsequent to corporate governance

regulation, and (iv) has decreased (increased) for non-family

firms after regulation in India (the US) along with a simulta-

neous increase (decrease) of external financing.

CHOICE OF A TWO-COUNTRY SETTING

Two country studies are notuncommon in the regulation and

governanceliterature. Huberman (2013)examines the effect of

labor regulation in Belgium and Brazil in the 1920s; whereas

both replaced labor with capital due to increased regulation,

Belgium flourished by increasing labor productivity, thus

becominga better exporter whereas Brazildid not reap similar

gains, primarily because international trade was collapsing

due to increased tariffs. Elshandidy and Neri (2015) find that

while firms withefficient boards in Italy and United Kingdom

have better (mandatory and voluntary) disclosure of risk,

firms with better boards in Italy that disclose risk voluntarily

show improvements in liquidity. Lattemann, Fetscherin,Alon,

Li, and Schneider(2009) contrast the Corporate Social Respon-

sibility(CSR) activities of firms in China and Indiafinding that

Indian firms communicate CSR due to rule-based rather than

relation-based governance environment.

Multi-country studies have been carried out since it is diffi-

cult to conclude whether the results of single-country studies

are generalizable. These studies use a large set of diverse coun-

tries (e.g. Leuz, Nanda, & Wysocki, 2003), exploring legal ori-

gins and other factors to understand the differences that exist.

However, Black, De Carvalho, Khanna, Kim, and Yurtoglu

(2014) identify three limitations in multi-country studies: con-

struct validity, lack of time series data and endogeneity. We re-

solve construct validity by designing our study to examine one

country from two contrasting markets, developed and emerg-

ing. Our choice of countries, India and the US, have a long his-

tory of corporate activity, with well populated databases

archived over a sufficiently long time horizon. Finally, the

endogeneity problem in a multi-country setting is eliminated

in our study, since both the countries have been subjected to

a similar natural experiment i.e. regulation. In addition, since

these two countries have the same legal origin, similar political

systems and history of family owned enterprises, any struc-

tural reasons that may cause differences in outcomes to a regu-

lation are eliminated. So any dissimilarities we observe can

probably be attributed to variation in enforcement and/or

the influence of family firms in overall development of the

economy.

FAMILY FIRMS, REGULATION AND

ENFORCEMENT IN INDIA AND THE UNITED

STATES

Family Businesses

Ownership by Indians in the corporate sector started in the

19

th

century with setting up of textile mills. Most of the corpo-

rate growth up until the middle of the 20

th

century was from

family funds and retained earnings of these Indian owned

companies (Goswami, 1989). Indian owners would retain con-

trol over the companies in addition to performing the other

functions of a promoter. In contrast, given the strong rule of

law and well-developed institutions in the United States, fam-

ily firms are not expected to play a role in the corporate market.

However, large family businesses have been around in the

United States since the industrial revolution, with household

names such as Kohler and S.C. Johnson being around since

the mid-1800s. Using data from 1992 to 99, Anderson and Reeb

(2003) report that 35% of the firms in the S&P 500, representing

18% of the equity are owned by founding families.

At present, about 34% (28%) of the Indian (US) firms are

family-owned,accounting for approximately 27% (22%) of as-

sets and 42% (23%) of profits. For our sample, we find that the

ten largest family firmsaccountforabout21%(12%)ofthe

491CASH FLOW REPORTING: FAMILY CONTROL AND REGULATION

© 2016 JohnWiley & Sons Ltd Volume 24 Number 5 September 2016