The Investment Opportunity Set and Earnings Management: Evidence from the Role of Controlling Shareholders

• Author: Ken Y. Chen,Shengmin Hung,Randal J. Elder
• Date: 01 May 2010
• Published date: 01 May 2010
• DOI: http://doi.org/10.1111/j.1467-8683.2010.00793.x

The Investment Opportunity Set and Earnings

Management: Evidence from the Role of

Controlling Shareholderscorg_793193..211

Ken Y. Chen,* Randal J. Elder, and Shengmin Hung

ABSTRACT

Manuscript Type: Empirical

Research Question/Issue: We examine the incentive and entrenchment effects of controlling shareholders on the associa-

tion between the investment opportunity set and earnings management in Taiwan.

Research Findings/Results: We f‌ind that f‌irms with more investment opportunities are more likely to engage in earnings

management.We also f‌ind incentive effects of controllingshareholders on f‌irm’s f‌inancial reporting behavior in that cash f‌low

rights are negatively associated with absolute abnormal accruals under a growth opportunity setting. Our results further

indicate that high-growth f‌irms with a high deviation between cash f‌low rights and control rights are more likely to engage

in earnings management. Further analyses indicate that as the controlling shareholders have effective control of a f‌irm, the

effect of controlling shareholder deviation between control and cash f‌low rights on earnings management becomes stronger.

Theoretical/Academic Implications: This study extends existing agency and contracting literature on the incentive and

entrenchment effects of controlling shareholders in East Asia on f‌irm value to the quality of f‌inancial reporting, which has

been a consistent concern of regulators, practitioners, and academia. Our f‌indings provide empirical evidence on the impact

of controlling shareholders on the quality of f‌inancial reporting in a growth opportunity setting.

Practitioner/Policy Implications: Our f‌indings suggest that the institutional environment, such as the growth opportunity

setting in Taiwan, matters to the f‌irm’s f‌inancial reporting behavior in an emerging market, where a corporate governance

code has been enacted to protect minority shareholders. This study offers insights to policy makers interested in enhancing

the mechanism of corporate governance in emerging markets, which have more potential conf‌lict of interests between

controlling shareholders and minority shareholders.

Keywords: Corporate Governance, Investment Opportunities, Earnings Management, Incentive Effects, Entrenchment

Effects, Controlling Shareholders

INTRODUCTION

Earnings management has been a consistent concern of

regulatorsand practitioners for several years (e.g., Levitt,

1998), because it has raised concerns about the credibility of

f‌inancial reporting, especially after high-prof‌ile accounting

scandals involving once well-respected companies such as

Enron and WorldComin the US and Parmalatin Italy.Agency

theory suggests that earnings management may arise when

managers have opportunities to promote their own self-

interest at the shareholders’ expense resulting frominforma-

tion asymmetry and agency problems that exist between

managers and shareholders (e.g., Shackelford, 1998).

Berle and Means (1932) indicate that the fundamental

agency conf‌lict is between shareholders and managers.

However, Shleifer and Vishny (1997) argue that the funda-

mental agency problem for listed companies in emerging

markets is a conf‌lict of interest between controlling share-

holders and minority shareholders. Following La Porta,

Lopez-de-Silanes, Shleifer, and Vishny (1999), Claessens,

Djankov, and Lang (2000) examine the issue of ultimate con-

trolling shareholders in East Asia, because managers of

East Asian corporations are usually related to the family

of the controlling shareholder. They document that large

*Address for correspondence: National Taiwan University, College of Management,1

Sec. 4, Roosevelt Rd., Taipei, Taiwan. Tel: (886-2) 3366-9780; E-mail: kenchen@

ntu.edu.tw

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Corporate Governance: An International Review, 2010, 18(3): 193–211

© 2010 Blackwell Publishing Ltd

doi:10.1111/j.1467-8683.2010.00793.x

family-controlled f‌irms have a signif‌icant deviation between

ownership and control in Korea, Singapore, and Taiwan. The

current study extends this strand of research (e.g., Claessens

et al., 2000; La Porta et al., 1999) to further examine the

impact of the controlling shareholders on the quality of

f‌inancial reporting in Taiwan, a growth opportunity setting

that has not been examined by prior studies such as Fanand

Wong (2002), Francis, Schipper, and Vincent (2005), Leuz,

Nanda, and Wysocki (2003), and Solomon, Lin, Norton, and

Solomon (2003).1

Contracting theory suggests that the investment opportu-

nity setting (Ios) affects corporate f‌inancing, dividend, and

compensation policies (e.g., Smith & Watts, 1992). We argue

that earnings management is implicit in corporate f‌inancing,

dividend, and compensation policies, because managers

have incentives to engage in earnings management to meet

the f‌irm’s f‌inancing (e.g., for lower cost of capital), dividend

(e.g., meeting dividend threshold), and compensation (e.g.,

performance-based compensation) needs resulting from

asymmetric information and agency problems associated

with stakeholders. Moreover, contracting theory also sug-

gests that f‌irms with more investment opportunities and

greater access to positive net present value projects are more

diff‌icult to observe and monitor, because as the proportion

of f‌irm value represented by investment opportunities

increases, the observability of managerial actions decreases

(e.g., Gaver & Gaver, 1993; Smith & Watts, 1992). Thus,man-

agers in high-growth f‌irms are more likely to engage in

opportunistic behavior (Skinner, 1993; Watts & Zimmerman,

1986). In addition, high-growth f‌irms will be more risky

than non-growth f‌irms because controls in high-growth

f‌irms are less likely to be effective (Andersen, Francis, &

Stokes, 1993) in that the control system that has been

installed maykeep pace only with the original scale of opera-

tions. Therefore, a weak internal control environment has

the potential to allow “intentionally biased accruals through

earnings management” (Doyle, Ge, & Mcvay, 2007).

As a consequence, this study builds on agency theory and

contracting theory to examine the following two questions.

First, we examine whether f‌irms with higher investment

opportunities are more likely to engage in earnings manage-

ment. Second and more importantly, we examine the role of

controlling shareholders on earnings management when

f‌irms have greater investment opportunities, which, to our

knowledge, has not been previously examined.

Controlling shareholders have strong incentives to maxi-

mize the f‌irm’s value and discipline managers when they

retain substantial cash f‌low rights in addition to control

over f‌irms (e.g., Claessens, Djankov, Fan, & Lang, 2002;

Grossman & Hart, 1988), which restrains the diversion of

corporate resources by the controlling shareholders. This

suggests that controlling shareholders acting as an effective

monitoring mechanism help alleviate agency problems

between shareholders and managers (Claessens et al.,

2002). Using cash f‌low rights to proxy for incentive effects

as in Yeh and Woidtke (2005), we examine whether IOS-

f‌irms with more cash f‌low rights are less likely to engage

in earnings management.

On the other hand, the entrenchment effects of controlling

shareholders indicate that concentrated ownership creates

incentives for controlling shareholders to camouf‌lage their

self-serving behaviors and expropriate wealth from other

shareholders, especially when there is a signif‌icant diver-

gence between control and ownerships (e.g., Claessens et al.,

2002). Using the divergence between cash f‌low and control

rights to proxy for entrenchment effects as in Yeh and

Woidtke (2005), we further examine whether f‌irms with

more deviation between cash f‌low and control rights are

more likely to engage in earnings management.

The study uses Taiwan data to examine the roleof control-

ling shareholders on earnings management in a growth

opportunity setting for the following reasons. First, many

listed companies in Taiwan are high-tech companies, which

normally have higher future investment opportunities.

Second, Taiwanese listed companies are mostly character-

ized by family-control in that there is signif‌icant deviation

between cash f‌low and control rights. Third, the Taiwan

securities regulator recently enacted the Corporate Gover-

nance Best-Practice Principles (CGBPP) in early year 2002 to

enhance the integrity of corporate f‌inancial reporting

through strengthening corporate governance mechanisms.2

We select the sample from the Taiwan Economic Journal

(TEJ) database, which includes companies listed on the

Taiwan Stock Exchange Corporation (TSEC) and GreTai

Securities Market (GTSM). We obtain the ownership data

from the TEJ Corporate Governance Module, which has

information on control rights percentage and cash f‌low

rights percentage for most f‌irms listed on TSEC and GTSM.

To measure growth opportunities, we follow Baber, Jana-

kiraman, and Kang (1996) to select an IOSproxy extracted

from a common factor analysis of four proxies of growth

opportunities (described later), instead of using a noisy

proxy such as the market-to-book ratio.3We follow Ball and

Shivakumar (2006) and incorporate loss recognition asym-

metry in measuring discretionary accruals to improve the

model’s explanatory power.

The pooled regression results indicate that IOS f‌irms are

positively associated with higher discretionary accruals,

consistent with our view that IOS f‌irms are more likely to

engage in earnings management. We further examine the

incentive and entrenchment effects of controlling sharehold-

ers on the association between IOS and earnings manage-

ment. First, we f‌ind that the incentive effects of controlling

shareholders alone reduce absolute discretional accruals. On

the other hand, we f‌ind that the entrenchment effects alone

do not signif‌icantly increase absolute discretional accruals

until the deviation between control and cash f‌low rights

reaches a high level. Second, when the ranked IOS is inter-

acted with cash f‌low rights, and the deviation between

control and cash f‌low rights, respectively, the incentive and

entrenchment effects of controlling shareholders on f‌irms’

f‌inancial reporting behavior under a growth opportunity

setting still exist. Further analyses using certain characteris-

tics of controlling shareholders also conf‌irm the existence of

the incentive and entrenchment effects of controlling share-

holders on f‌irm’s earnings management under a growth

opportunity setting.

Our study extends the existing literature examining the

incentive and entrenchment effects of controlling sharehold-

ers in East Asia on f‌irm value to the quality of f‌inancial

reporting, which has been a consistent concern of regulators,

practitioners, and academia (Durisin & Puzone, 2009). More

194 CORPORATE GOVERNANCE

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