Related party transactions, corporate governance and earnings management
Published date | 03 December 2018 |
Pages | 1124-1146 |
DOI | https://doi.org/10.1108/CG-11-2017-0271 |
Date | 03 December 2018 |
Author | Pier Luigi Marchini,Tatiana Mazza,Alice Medioli |
Subject Matter | Strategy,Corporate governance |
Related party transactions, corporate
governance and earnings management
Pier Luigi Marchini, Tatiana Mazza and Alice Medioli
Abstract
Purpose –Following the contingency perspective, this paper aims to examine if a good corporate
governance structureis able to reduce earnings management made through relatedparty transactions.
The authors expect that a high-quality corporate governance influences private benefit acquisitionand
reducesthe positive association between related party transactionsand earnings management.
Design/methodology/approach –A two-stage leastsquares instrumental variable approachis used to
further address endogeneity concerns in this study. The model is organized into three parts: the
construction of the corporate governance indicator,the first stage regression to compute the predicted
corporate governance indicator and the second stage regression (ordinary least squares multivariate
regressions) to analyze the relationship between related party transactionsand earnings management.
The analysisfocuses on a sample of Italian listed companiesover the period 2007-2012.
Findings –The study finds that the interactionbetween sales-related party transactions and corporate
governance is negatively associated with abnormal accruals, signaling that corporate governance
quality reduces the positive association between sales-related party transactions and earnings
management,consistently with the contingencyperspective.
Originality/value –The research contributes to literature by empirically testing the assumption of
contingency perspective. In particular, the results provide new insights to the academic community,
underlyingthat good corporate governance mechanismhelps to reduce earnings management behavior
throughrelated party transactions.
Keywords Corporate governance, Earnings management, Related party transaction
Paper type Research paper
1. Introduction
The research aims to analyze the relationship between related party transactions (RPT), the
corporate governance (CG)structure/characteristics of the firms and earnings management
(EM).
RPT are a current issue worldwide, especially for listed companies. They have often
featured in recent high-profile accounting fraud scandals both in the US market, for
example, in the Enron and Adelphia cases (Henry et al.,2007), and also on the European
market, for example, in the Parmalat and Cirio cases (Melis, 2005). In these cases, RPT
appear to have been carried out to deceive rather than for genuine business purposes. At
the same time, some literature support the idea that when external financial resources are
scarce and uncertain, a corporate group maximizes the welfare and economic benefits,
reducing transaction costs (Coase, 1937;Fan and Goyal, 2006;Fisman and Khanna, 2004;
Hoshi et al.,1991;Khanna and Palepu,1997, 2000;Kim, 2004;Shin and Park, 1999).
Following this second point of view,RPT are seen as efficient transactions for the business.
Our study fits in a perspective that lies between these two, and our analyses are based on
the idea that RPT could not be considered a priori good or bad operations but their scope
depends on the context. Our research uses contingency theory (Otley, 1980) to explain the
Pier Luigi Marchini is
Professor at Department of
Economic and
Management Sciences,
University of Parma, Parma,
Italy.
Tatiana Mazza is based at
Facolta di Economia, Libera
Universita di Bolzano,
Bolzano, Italy.
Alice Medioli is Research
Assistant at Department of
Economics, University of
Parma, Parma, Italy.
Received 8 November 2017
Revised 23 March 2018
24 April 2018
Accepted 6 May 2018
PAGE 1124 jCORPORATE GOVERNANCE jVOL. 18 NO. 6 2018, pp. 1124-1146, ©Emerald Publishing Limited, ISSN 1472-0701 DOI 10.1108/CG-11-2017-0271
relationship between RPT and EM taking in consideration the contingency factors (Pizzo
2013) related to CG. The paper takes up the Otley (2016)’s suggestion that researchers
have not to isolate the results fromthe context (that in this example is the governance rules).
Therefore, we look at the CG structure as a contingency factor with the power to influence
the scope of the RPT undertaken.
We analyze the quality of CG system through CEO and board of directors’ characteristics,
and following the contingency perspective, we expect that a high-quality CG reduces the
positive association betweenRPT and EM.
Our sample includes non-financial listed firms in Italy over the period 2007-2012, excluding
companies with initial public offering after 2008. We hand collected RPT data from the
consolidated financial reporting and the CG data from the CG report.
Our model is organized into three parts: the construction of the CG Indicator, the
instrumental variable approachand the regression analysis of the relationship betweenRPT
and EM. In the construction of the CG Indicator,we perform a principal component analysis
(PCA) and a confirmatory factor analysis (CFA)(Larcker et al., 2007). After checking validity
and reliability, we selectfive variables: Board size, Duality, Board independence,Nationality
and No shareholder. In the instrumental variable approach, we use three instruments
(Cheng et al.,2016): the one-year lagged value of CG; the number of named executives
besides the CEO and the chairman; and an indicator variable, engagements, that is equal
to 1 if the current CEO has no other positions, and 0 otherwise. We use the instrumental
variables together with the control variables to compute the predicted CG Indicator. Finally,
we use a multivariate regression including the interaction between predicted CG Indicator
and RPT to analyze the relation with EM measured through the Francis and Wang (2008)
model.
Our results suggest that abnormal accruals are significantly associated with agency conflict
between controlling shareholders and minorities, proxied by sales RPT. Furthermore, in line
with the contingency perspective, the interaction between RPT sales and CG Indicator is
negatively associated with abnormalaccruals, signaling that CG quality reduces EM related
to RPT. We confirm our hypothesis and starting from previous conflicting results on the
efficient or fraudulent use of RPT, we concludethat these transactions have to be evaluated
considering the context. We contribute to the literature by both providing empirical
evidence based on the theoreticalprediction of contingency perspective and extending the
research on CG quality and RPT. For the first issue, we contribute to the contingency
perspective showing its support in the RPT setting. For the second issue, we contribute to
the literature on CG quality, showing the contribution provided by a good CG structure in
the firms.
The study consists of six sections. After the introduction, Section 2sets out the national and
international regulation of RPT. Section 3 reviews the literature on RPT and regards the
research hypothesis. Section 4 describes the research method and Section 5 shows our
results. Finally, in Section 6 we summarize our findings and illustrate some limitations and
further steps.
2. Background: national and international regulation
Despite in Italy, RPT are strictly regulated, they have been anyway used as opportunistic
tools. In fact, the International Accounting Standards/International Financial Reporting
Standards (IAS/IFRS), the Italian Civil Code and regulations issued by the Italian security
exchange commission (CONSOB)regulate these transactions both ex ante and ex post.
IAS 24 “Related Party Disclosures” and the Italian Civil Code deal with theex post discipline
on these transactions. After providing a definition of related party and some example of
RPT, they identify the information that companies have to provide in the financial statement
VOL. 18 NO. 6 2018 jCORPORATE GOVERNANCE jPAGE 1125
To continue reading
Request your trial