Control-ownership Structure, Audit Committee and Earnings Management Evidence from East Asia

Transcription

1 Journal of Business Administration and Management Sciences Research Vol. 3(8), pp , September, 04 Available online athttp:// ISSN Apex Journal International Full Length Research Control-ownership Structure, Aud Commtee and Earnings Management Evidence from East Asia Yin-Hua Yeh * and Hsin-I Chou Graduate Instute of Finance, National Chiao Tung Universy, 00 Ta-Hsueh Rd., Hsinchu Cy, Taiwan Department of Finance, La Trobe Business School, La Trobe Universy Bundoora, VIC 3083, Australia. Accepted 5 September, 04 Since the Asian financial crisis, Asian economies have focused on the reform of corporate governance regulations. One of the major areas of reform is the establishment of aud commtees to protect minory shareholder rights and improve the credibily of financial reporting. This paper investigates the impact of the aud commtee independence and independent directors wh financial accounting or legal expertise on firms qualy of earnings, under the concentrated ownership structure of largest listed companies from Hong Kong, Malaysia and Singapore. The results show that the higher the divergence of cash-flow rights from voting rights of controlling shareholders (that is, the larger the control-ownership wedge), the greater the tendency to manage earnings, which decreases the qualy of earnings reporting. However, the introduction of independent aud commtees and of independent aud commtee directors who have expertise in accounting, finance or law is generally ineffective for improving the qualy of earnings. The control-ownership wedge can serve as a proxy for measuring the entrenchment effect and the agency problem between the controlling and minory shareholders. This implies that although Asian countries have required listed firms to establish aud commtees, these commtees have failed to migate the problem of earnings management by controlling shareholders. Keywords: Corporate Governance; Ownership; Earnings Management; Aud Commtee. INTRODUCTION The U.S. business management lerature indicates that having independent aud commtees and appointing financial experts to aud commtees can enhance the qualy of financial information and improve the credibily of financial reporting (e.g., Klein, 00; Carcello and Neal 003; Bedard et al., 004; Krishnan, 005; Man and Wong, 03). However, such evidence from the U.S. is based on studies of Western listed firms in which the usual ownership structure is much more widely dispersed than is commonly the case in Asian firms. This study investigates the effects of independent aud commtees wh financial expertise in firms that have concentrated ownership. The Asian financial crisis in 997 caused enormous economic losses. One cricism arising from this crisis *Corresponding author. yhyeh@nctu.edu.tw regarded the imperfect corporate governance mechanisms of East Asian economies (Johnson et al., 000). Hence, Asian economies have enhanced their regulatory requirements by mandating or recommending the establishment of an aud commtee on the boards of listed firms. Another important requirement is that a certain percentage of aud commtee members should be independent directors. These reforms provide an opportuny to empirically investigate how effectively the aud commtees have been able to monor and improve the integry of financial statements in firms wh concentrated ownership. A firm s ownership structure has a significant influence on s earnings qualy. Warfield et al. (995) find that managerial ownership is posively related to earnings informativeness and negatively related to the magnude of accounting accrual adjustments. These findings suggest that higher managerial ownership causes better earnings qualy. Wang (006) investigates the

2 64 J. Bus. Admin. Manage. Sci. Res relationship between family controlled firms ownership and earnings qualy among S&P 500 firms. This paper shows that founding family ownership is posively correlated to earnings informativeness, and negatively associated wh abnormal accruals. Francis et al. (005) find no relationship between managerial ownership and earnings informativeness, but they do find that divergence between cash-flow rights and voting rights or dual-class shares are negatively related to earnings informativeness. Fan and Wong (00) point out that the ownership structures of companies in seven East Asian countries are different from their U.S. and U.K. counterparts. The controlling shareholders of Asian firms usually use their concentrated ownership and decision rights to lim information transparency. By such actions they lim scrutiny from competors and reduce the monoring power of shareholders. Jung and Kwon (00) investigate the relationship between ownership structure and earnings informativeness in Korea. Their findings show that the divergence of cash-flow rights from voting rights of controlling shareholders (the control-ownership wedge) is negatively associated wh earnings informativeness. Investors tend to respond by giving negative evaluations to companies wh such low-qualy reporting. The independence of aud commtees and of independent directors wh professional backgrounds on the aud commtees has shown a significant effect on earnings qualy according to U.S. studies. For example, Klein (00) finds that aud commtee independence is negatively related to abnormal accruals. Carcello and Neal (003) and Krishnan (005) find that independent aud commtees are better able to monor the qualy of financial reporting. Moreover, numerous U.S. studies point out that appointing independent director wh financial or legal expertise to aud commtees tends to enhance the qualy of financial reporting and earnings informativeness. Company stock prices commonly rise following announcements that financial experts have been appointed to aud commtees. Companies wh more independent aud commtee wh expert independent directors also have a lower probabily of restatements (e.g., Davidson III et al., 004; DeFond et al., 005; Agrawal and Chadha, 005; Karamanou and Vafeas, 005; Krishnan et al., 0). In Asia, however, more than half of the listed companies are controlled by family groups. These family groups typically use stock pyramids, dual-class shares and cross-shareholdings to effectively control their companies. Their use of such strategies often leads to a deviation of cash-flow rights from voting rights (Claessens et al., 000, 00). This structure of concentrated ownership places greater authory in the hands of controlling shareholders, who therefore have more opportuny to expropriate wealth from the minory shareholders (e.g., Grossman and Hart, 988; Shleifer and Vishny, 997). If the preparation of financial reports is controlled and monored by the controlling shareholders, the qualy of financial reporting is questionable. The controlling shareholders can manipulate the earnings to benef themselves. To decrease this type of manipulation and increase the qualy of financial reporting, the main mechanism available is to establish an aud commtee to monor the integry of financial information. East Asian countries have tried to enhance their accounting regulations and disclosure rules for the sake of increased information transparency. However, the qualy of company financial reports is still commonly poor (Fan and Wong, 00). Have aud commtees helped to migate the problems of false reports and misleading financial information among listed firms wh concentrated ownership structures since the Asian financial crisis? Does making aud commtees independent and appointing independent directors wh financial accounting or legal expertise enhance the function of aud commtees? This study seeks to address these questions. The authors measure earnings management as a proxy for earnings qualy, and use two measures to evaluate earnings management: discretionary accruals and income smoothing. We use the performance-matched method proposed by Kothari et al. (005) as a proxy for earnings management to evaluate discretionary accruals. Income smoothing is evaluated by comparing variation of cash flow from operations to variation in net income. For our research sample, we use large listed companies in Hong Kong, Malaysia and Singapore. These firms share similar ownership structures (most are family-controlled) and have similar corporate governance regulations wh common law originate. The results show that if the controlling shareholder of a firm has a higher deviation of cash-flow rights from voting rights, the company is more likely to use earnings management to manipulate accounting information. Therefore, the earnings qualy is reduced. When the controlling shareholder s cash-flow rights show greater divergence from voting rights, the controlling shareholders are more likely to expropriate wealth from the minory shareholders. To avoid inspection from outside shareholders, the controlling shareholders are more likely to undertake window dressing of the financial statements. Furthermore, the controlling shareholders may try to smooth income, thereby preventing specific information from flowing to the markets, and keeping that information private. These findings suggest that higher entrenchment power for the controlling shareholders decreases earnings qualy. This study also show that aud commtees independence and appointing independent directors wh financial accounting or legal backgrounds to those aud commtees does not improve earnings qualy among firms wh concentrated ownership. A plausible reason is that the controlling shareholders may choose aud commtee directors who only appear to fulfill the independence requirements or to have financial expertise.

3 Yin-Hua and Hsin-I 65 In that case, the function of the aud commtee is not enhanced. To deal wh this issue, government policy could focus on restricting the controlling shareholders voting power in selecting independent directors for the aud commtees. Such a reform may increase the independence level of aud commtee directors. This study contributes to the corporate governance and accounting qualy lerature. This study investigate not only the influence of concentrated ownership on earnings qualy, but also how the independence of aud commtees and the professional backgrounds of independent directors affect the qualy of earnings reports. Our results show that there is a negative relationship between the control-ownership wedge and earnings qualy. This finding complements that of other recent studies on the effects of the control-ownership wedge on financial policy (Masulis et al., 009; Lin et al., 0, 0, 03; Jiang et al., 0). The control-ownership wedge between controlling shareholders and managers can serve as a proxy in measuring entrenchment and the agency problem. The remainder of the study is organized as follows. Section provides a brief discussion of the rules and requirements for aud commtees in Hong Kong, Malaysia and Singapore. Section 3 develops the hypotheses to be tested. Section 4 explains the sample selection, variable definions and the regression models for testing. Section 5 describes the statistics of our sample and reports the main empirical results. Section 6 presents the conclusions of our study. THE RULES AND REQUIREMENTS OF AUDIT COMMITTEES Malaysia and Singapore have mandated that publicly listed companies must have aud commtees on their boards since 989 and 994, respectively. The Hong Kong government previously asked all listed companies to establish an aud commtee, but did not make this compulsory until 005. The mandatory or voluntary establishment of aud commtees in these three countries happened prior to the Asian financial crisis, and there have been addional reforms since then. In 989, Singapore required that aud commtees should include at least three directors, wh the majory of members being independent. The Some other researchers have investigated how aud commtee independence and professionalism relate to earnings qualy in Malaysia and Singapore. The experimental designs and evidence from their studies are similar to those of U.S. studies that do not consider the influence of both ownership structure (the divergence of the controlling shareholders cash-flow rights from voting rights) and aud commtee independence in relation to earnings management. Please refer to Van der Zahn and Tower (004), Bradbury et al. (006), Zan et al. (006), Saleh et al. (007), Buk and Iskandar (009) and Ismail and Rahman (0). Singapore Stock Exchange further strengthened aud commtees in 996 by adding Chapter 9B to s Listing Manual. Chapter 9B provides detailed regulations concerning the establishment, membership, roles and duties of board commtees, including aud, remuneration, nomination and compensation commtees. Singapore s Corporate Governance Commtee proposes that all companies listed on the Singapore Exchange be required to provide a complete description (in the Listing Manual) of their corporate governance practices, wh specific reference to each of the guidelines set out in the Code of Corporate Governance (the Code) and disclosures of how their corporate practices deviate from these best practices, along wh appropriate explanations. Since 003, has been required that listed companies disclose their corporate governance practices and give explanations for deviations from the Code in the annual reports for their annual general meetings. However, listed companies are encouraged to comply wh the Code before such disclosures must be made, if they are able to do so. According to the Code, the aud commtee should comprise at least three directors, all non-executive, the majory of whom (including the chairman) should be independent. The board should ensure that the members of the aud commtee are appropriately qualified to discharge their responsibilies. At least two aud commtee members should have accounting or related financial management expertise or experience, as the board interprets such qualifications in s business judgment. In Malaysia, the requirement for aud commtees was adopted in 994. In March 000, the Malaysian regulatory authories responded to the Asian financial crisis by establishing the High Level Finance Commtee on Corporate Governance. This commtee published a Proposed Malaysian Code of Corporate Governance. In accordance wh a recommendation from the commtee, the Securies Commission in Malaysia further expanded s disclosure requirements in 00 to improve timeliness and accuracy. According to the Code, aud commtees should comprise at least three members, the majory of commtee members should be independent, at least one of the members should have expertise in financial accounting and the chairman of the commtee should be an independent director. These recommendations were mandated in 00 as part of the Bursa Malaysia (formerly the Kuala Lumpur Stock Exchange) listing requirements. In Hong Kong, the setup of aud commtees remained voluntary until 005. The Hong Kong Exchange recommends that aud commtees should include at least three non-executive directors. The majory of the commtee members should be independent, and at least one independent non-executive director should have appropriate accounting or financial management expertise. The chairman of each aud commtee should also be an independent non-executive director.

4 66 J. Bus. Admin. Manage. Sci. Res HYPOTHESIS DEVELOPMENT Control-ownership wedge and earnings qualy The U.S. lerature shows that managerial ownership has a clear influence on earnings informativeness and the qualy of accounting reports. For example, Warfield et al. (995) find that managerial ownership is posively related to earnings informativeness and negatively related to discretionary accruals. Carlson and Bathala (997) find evidence that insider ownership (by managers and directors) is posively related to the likelihood of income smoothing activies. La Porta et al. (999), Claessens et al. (000) and Faccio and Lang (00) find that controlling shareholders use pyramid structures, cross-holdings and management participation to control their companies. The agency problem in firms wh concentrated ownership is primarily between controlling shareholders and minory shareholders. Such entrenchment power for controlling shareholders is more effective if the divergence of cashflow rights from voting rights is larger. Fan and Wong (00) empirically examine two effects of this controlownership structure on earnings informativeness in East Asia countries. According to this study, controlling shareholders are more likely to expropriate the minory shareholders wealth if the divergence of cash-flow rights from voting rights increases. This entrenchment effect predicts that the divergence of cash-flow rights from voting rights is negatively associated wh earnings informativeness. This effect grows dominant in firms of concentrated ownership when the controlling shareholders prevent the leakage of crical information to the public or in suations where lobbying activies are lucrative and commonplace. Such barriers to information flow illustrate that the control-ownership wedge is negatively related to the earnings informativeness and qualy of earnings information. Francis et al. (005) and Wang (006) find similar evidence. In accordance wh the entrenchment effect theory proposed by Fan and Wong (00), this study propose that a greater divergence between the cash-flow rights and the voting rights of controlling shareholders decreases the qualy of financial reporting. In extending this entrenchment effect theory, we propose that when controlling shareholders wish to expropriate the resources and wealth of outside shareholders, they have an incentive to undertake earnings management activies and thereby evade inspection by outside shareholders. We suggest that firms wh higher divergence between cash-flow rights and voting rights of the controlling shareholders will have higher levels of earnings management. Moreover, extending the information effect, we suggest that if controlling shareholders would like to hide certain specific information, they commonly use income smoothing to avoid revealing earnings fluctuations. Such smoothing makes difficult for outside investors to detect certain kinds of information from the evidence of changes in earnings. Hence, when the gap between cash-flow rights and voting rights of controlling shareholders is larger, the company s tendency to practice income smoothing is larger. Thus, we pos a hypothesis: H: The divergence between cash-flow rights and voting rights of controlling shareholders is posively associated wh the tendency to use earnings management. Aud commtee and earnings qualy Establishing or improving the qualy of aud commtees is one major way to strengthen corporate governance. The U.S. government has clear and define regulations concerning aud commtees, including their definions, functions, independence and their relations wh accountants. Other countries have similar regulations. After the Enron fraud of 00, the U.S. government passed the Sarbanes-Oxley Act to raise investor confidence and enhance information transparency in financial reporting. This act overcomes some of the previous limations of aud commtees and strengthens their functions. McMullen (996) points out that a company is more likely to establish an aud commtee when decides to provide higher qualy financial reports. A company whout an aud commtee is more likely to use earnings management. The aud commtee should monor the credabily of a firm s financial reports. Hence, the independence of commtee members should improve the qualy of monoring. Klein (00) investigates the determinants of economic factors for aud commtee independence. She finds that if an aud commtee contains independent outside directors, is less likely to manipulate earnings. If a company has two years of continuous losses and shows reduced value in s financial reports, then the level of the aud commtee s independence is probably low. Furthermore, to effectively monor aud qualy, the aud commtee members should be not only independent but should also have higher qualifications. Davidson III et al. (004) report that the market reacts posively to news that an aud commtee member has financial background. DeFond et al. (005) investigate the effects of the Sarbanes-Oxley Act s requirement that publicly listed companies must have at least one aud commtee member wh professional financial expertise. These researchers also divide aud commtee members into three groups (accounting financial experts, nonaccounting financial experts and non-financial experts.) and examine the market reaction to appointments of each kind of member. The results show that the market reaction is significantly posive if the aud commtee contains accounting financial experts, especially when the company adopts stronger governance rules.

5 Yin-Hua and Hsin-I 67 McDaniel et al. (00) indicate that an increased number of financial experts on the aud commtee can influence the earnings qualy. McMullen and Raghunandan (996) find that if the aud commtee contains qualified accountants, the possibily of financial reporting problems decreases. Abbott et al. (003) find that if the aud commtee contains financial experts, is less likely to restate financial reports or to report fraud. Xie et al. (003), Krishnan (005) and Woidtke and Yeh (03) all find similar results. Concerning the effect that legal experts on the aud commtees have on earnings management, Xie et al. (003) fail to find a significant relationship between these two variables. However, Krishnan et al. (0) further investigate whether having directors wh legal backgrounds on the aud commtee enhances the qualy of financial reporting. Using two measures of financial reporting qualy (discretionary accruals and accruals qualy), these researchers find that the proportion of aud commtee directors wh legal expertise is posively associated wh financial reporting qualy. This result still holds after controlling for the proportion of accounting experts on the aud commtees. Some researchers have investigated aud commtee independence and professionalism in relation to earnings qualy in Malaysia and Singapore. Van der Zahn and Tower (004) examine the influence of aud commtee characteristics in Singapore s publicly listed corporations. They report a significantly negative association between the proportion of independent aud commtee members and earnings management. Bradbury et al. (006) examine the relationship between aud commtee characteristics and abnormal accruals in Malaysia and Singapore. They find that aud commtee independence is negatively related to increases in income due to abnormal accruals. Zan et al. (006) use survey data from 76 Malaysian listed firms and find that the proportion of independent aud commtee members and their professional experience in accounting and auding have a significantly posive effect on the qualy of internal aud assessments. Saleh et al. (007) find results similar to those of Zan et al. (006). Ismail and Rahman (0) also find that among Malaysian listed firms, aud commtees having two or more members wh financial backgrounds are less likely to engage in quarterly report amendments. Overall, having independent members wh professional expertise on aud commtees tends to enhance the qualy of financial reporting, enable effective monoring and migate the possibily of earnings management. Buk and Iskandar (009) also show that independent aud commtees help companies wh high levels of surplus free cash flow to reduce their incomeincreasing earnings management practices. In addion, Chen and Jaggi (000) conclude from a sample of Hong Kong listed companies that the ratio of independent non-executive directors to the total number of directors on corporate boards is posively associated wh the comprehensiveness of financial disclosure. However, the lerature supporting this conclusion relies heavily on investigations conducted in the U.S. Furthermore, although several papers have investigated the relations between aud commtee characteristics and earnings qualy in Malaysia and Singapore, no study has yet incorporated an examination on the effects of ownership structure. Hence, is important to investigate the relationships between aud commtee independence and expertise and the level of earnings management under condions of concentrated ownership. Hence, we pos two further hypotheses: Ha: The independence of aud commtees is negatively related to earnings management. Hb: Having independent directors wh financial accounting or legal expertise on aud commtees is negatively related to earnings management. SAMPLE SELECTION AND METHODOLOGY Sample Selection Procedure This study investigates the large publicly listed corporations in three East Asian countries, Hong Kong, Malaysia and Singapore. The major companies in these countries share similar ownership structures. Most of these companies are family-controlled and have similar corporate governance regulations based on common law. Due to the difficulty of collecting comprehensive data by hand, we focus on these three East Asian countries, which represent three out of the four East Asian countries included in studies by Ball et al. (003), Fan and Wong (00) and Leuz et al. (003). We are also able to collect the data on aud commtee composion for these countries, which enables us to examine whether the composion of the aud commtees is associated wh improved earnings reliabily. Moreover, characteristics that are common across East Asia such as concentrated ownership and family control are also common in these countries. The three countries in our study have eher four or five out of six provisions in place to protect shareholder rights, compared to an average score of four for common law countries and five for the Uned States (La Porta et al., 998) 3. 3 La Porta et al. (998) indicates six provisions of shareholder protection rights are: () the country allows shareholders to mail their proxy vote to the firm, () shareholders are not required to depos their shares prior to the general shareholders meeting, (3) cumulative voting or proportional representation of minories in the board of directors is allowed, (4) an oppressed minories mechanism is in place, (5) the minimum percentage of share capal that entles a shareholder to call for an extraordinary shareholders meeting is less than or equal to 0 percent (the sample median), or (6) shareholders have preemptive rights that can be waived only by a shareholders vote. In addion, Cred Lyonnais Securies Asia rates these three countries near the top of ten Asian emerging markets in 004, based on the following five dimensions: rules and regulations; enforcement; polical/regulatory interference; the use of

6 68 J. Bus. Admin. Manage. Sci. Res Compared to other Asian economies, Hong Kong, Malaysia and Singapore adopted and implemented aud commtee reform at an early stage. Therefore, we choose these three markets to evaluate the influence of ownership structure (divergence of the controlling shareholders cash-flow rights from voting rights) and of aud commtee independence in relation to earnings management. As an inial sample, we select the 50 companies wh the highest market capalization in each country as of fiscal year 000. We exclude financial instutions, insurance companies and securies companies (SIC codes ) because of the different regulatory requirements that apply in financial reporting and the distinct characteristics of these companies. We also exclude companies that have no aud commtee. The final sample is 79 companies, which include 66 Hong Kong companies, 0 Malaysia companies and Singapore companies. In this study, two proxies were used to verify the levels of earnings management: discretionary accruals and income smoothing. The average discretionary accruals is evaluated by using accounting data between 000 and 00, and average income smoothing is determined by evaluating the variance in cash flows from operations over the variance in net income between 000 and 004. There seem to be only minor changes in ownership structure and aud commtee composion among firms wh concentrated ownership. Therefore, we assume that the factors of ownership structure, aud commtee independence and the professional backgrounds of independent directors have not changed significantly 5. Relevant information was collected on each company s aud commtee, ownership, accounting reports and stock prices for the fiscal year 000. The aud commtees and company ownership information for the three countries are obtained from the companies annual reports and webses. Annual reports are gathered from the CDs published by the stock exchanges in each country, or from company web pages. The accounting and the stock price information for each company are collected from Compustat Global and Datastream. Methodology and variables definion Discretionary accruals and income smoothing To investigate whether the aud commtee members backgrounds have significant effects on the earnings qualy of their firms, we define earnings management in international Generally Accepted Accounting Principles ; and instutional mechanisms and corporate governance culture. 4 The SIC codes are disclosed in Compustat Global. 5 As the composion of aud commtees usually does not change significantly, we select 000 as the base year of investigation. two ways. First, average discretionary accruals between 000 and 00 were used to verify the levels of earnings management. Second, we use the variance of discretionary accruals between 000 and 004 to measure income smoothing. Furthermore, we combine the ownership structure and aud commtee characteristics to examine whether the independence of aud commtees and the presence of independent directors wh accounting financial or legal backgrounds on the aud commtees enhance earnings qualy. Previous studies have often used discretionary accruals as a proxy for a firm s level of earnings management. Three types of models have been used for this analysis: the Jones model, the modified Jones model and the performance-matched model. The Jones model is defined by time series, and therefore involves selection bias according to the periods of company data selected. DeFond and Jiambalov (994) further measure discretionary accruals by using a cross-sectional model (the modified Jones model). This model can adjust for small sample and time series bias problems, and measures the volatily of discretionary accruals due to macro-economy variation (Teoh et al., 998). This study therefore uses the same sample of years for all three countries in calculating their discretionary accruals. Jones (99) suggests that non-discretionary accruals are not fixed and tend to change according to variations in external economic factors. He uses changes in revenue to control for external economic condions, and the value of property, plant and equipment to control for the depreciation costs of discretionary accruals. In the modified Jones model, the total accruals are net income minus the cash flow of operating activies. All variables are divided by the last year total assets. The regressed model is as follows: TACC () A - = REV PPE β 0 A + β β + - A + - A - where TACC is total accruals for firm i in year t (net income minus cash flow of operating activies for firm i in year t); A - is total assets for firm i in year t-; REV is changes of revenue for firm i in year t; PPE is property, plant and equipment for firm i in year t; and ε is the error term that indicates a discretionary accruals em. From () we can obtain the coefficients of β 0, β, β. Then, the numbers were put back into the model and get the non-discretionary accruals. The discretionary accruals are calculated from total accruals minus nondiscretionary accruals, as shown: DA TACC = A - - β 0 A - REV + β A - ε PPE + β A - ()

7 Yin-Hua and Hsin-I 69 where DA is discretionary accruals for firm i in year t. All of the other variable definions are the same as those given in (). Dechow et al. (995) point out that in the Jones model, the cred account in the revenue is not fixed, and can be manipulated by management. Therefore, these researchers modify the Jones model and adjust the revenue em by subtracting the changes in accounts receivable. The revised model is as follows: DA TACC = A - - β 0 A - REV - AR + β A- PPE + β A- (3) where AR is the change in accounts receivable for firm i in year t. All other variable definions are the same as those given in () and (). Kothari et al. (005) find that when companies have extremes in financial performance, using the tradional Jones models to measure discretionary accruals is more likely to suggest that the companies are managing earnings. Therefore, these researchers add return on assets (ROA) to the Jones model and the modified Jones model to adjust the influence of extreme financial performance cases. The adjusted modified Jones model (usually called the performance-matched model) is as follows: TACC A - = REV - AR PPE β 0 3ROA A + β β + β + - A + - A - where ROA is return on assets for firm i in year t. All other variable definions are the same as those given in previous equations. From (4), the coefficients of 0 β, β, β, β 3 (4) ε were calculated. Then, the numbers were put back into the model and get the non-discretionary accruals. The discretionary accruals are calculated as follows: TACC DA = A - - β 0 A - + REV - AR β A- + PPE β A- + β 3 ROA (5) The performance-matched model adjusts accounts receivable and the errors of extreme financial performances for certain firms. Therefore, the performance-matched model was used to evaluate discretionary accruals as a proxy for earnings qualy. Higher discretionary accruals indicate higher earnings management, which means that earnings qualy is lower. In this model, a company s discretionary accruals may be posive or negative. These accruals imply that the company will adjust earnings upward or downward. We further calculate the absolute value for discretionary accruals. To evaluate income smoothing we use the method proposed by Tucker and Zarowin (006). Income smoothing means that the managers manipulate discretionary accruals to decrease the variations of cash flow from operations. The model for this analysis is as follows: VAR VAR CFO Income smoothing (IS) = (6) where IS is the level of income smoothing; VAR CFO is the variance of cash flow from operations, and VAR NI is the variance of net income. The net income of a firm is reported from the adjustment of accruals ems, which can be manipulated easily. However, cash flow is less likely to be manipulated by changing the accruals ems, so cash flow can better reflect the real condion of a firm. If a company s net income variance (VAR NI ) is less than the variance of cash flow from operations (VAR CFO ) whin a given period of time, this means that that company uses earnings management to smooth income, as the value of IS should be larger. However, if a company s net income variance is close to or equal to the variance of cash flow from operations, then the value of IS should be smaller. This implies that the company is less likely to conduct earnings management. Overall, when the value of income smoothing is larger, the company has a higher level of earnings management. Ownership structure and aud commtee The ownership structure variables are verified as follows. Fan and Wong (00) find that the controlling shareholders of East Asian companies use pyramid structures and cross-holdings to concentrate their ownership. The controlling shareholders voting rights are usually greater than their cash-flow rights. This suation implies that the controlling shareholders tend to manipulate earnings to disclose good news if they are trying to increase their private benefs, avoid monoring power from other shareholders or decrease the possibily of competors getting into the market. This manipulation also tends to entrench the minory shareholders wealth (usually called the entrenchment effect). In such a suation, the reported earnings are less informative. We can say that the ownership structure is one factor that will influence a firm s qualy of financial information. Ownership structures were analyze by distinguishing three kinds of owner control: voting rights, cash-flow rights and deviation of cash-flow rights from voting rights. The method proposed by La Porta et al. (999) was used to trace the ultimate controlling shareholder of each company. The ultimate owner(s) could be a family or an individual, the state, a widely held financial instution, a NI

8 70 J. Bus. Admin. Manage. Sci. Res widely held corporation, or another enty, as La Porta et al. (999) explain. After gathering the information on firm ownership, all of the data are converted into a clear map that details the ultimate owners and the interlocking stakes between firm groups. We define the controlling shareholder as the shareholder or family group found to have the largest control rights when the direct and indirect voting rights are summed up. We also consult La Porta et al. (999) and Claessens et al. (000) for our approach to calculating direct and indirect voting rights. Direct voting rights are the fraction of shares directly held by a firm s controlling shareholder. Indirect voting rights include the chain of shares held by other enties on behalf of the controlling shareholder, which are ranked according to the weakest link in the chain of shares (or the lowest percentage of all). Under this classification, voting rights are the proportion of the direct voting rights plus the indirect voting rights of the firm s controlling shareholder. Cash-flow rights are measured using the method developed by Claessens et al. (00). Cash-flow rights indicate a controlling owner s percentage of ownership over the profs, losses and dividends of the firm. If there are multiple chains of ownership, then the cash-flow rights along each chain are the products of all of the ownership rights in the intermediate companies of that chain. The total cash-flow rights are then equal to the sum of all of the cash-flow rights from all of the ownership chains. Deviation of cash-flow rights from voting rights (Deviation) is measured by the ratio of the voting rights to the cash-flow rights of the controlling shareholder. A detailed example is provided in Appendix. This measure indicates that if the deviation of cash-flow rights from voting rights is larger, the controlling shareholder is more likely to expropriate wealth from the minory shareholders. This suation also implies that the controlling shareholder may use earnings management to take benefs from the minory shareholders. According to the aud commtee member information as disclosed from the Hong Kong, Malaysia and Singapore corporations financial reports, we classify the aud commtee members information. The proportion of independent directors on the aud commtee (Independence) is the number of independent directors on the aud commtee divided by the total number of aud commtee members. The aud commtee independence dummy is a value that equals if all of the aud commtee members are independent directors, and otherwise 0. We use the aud commtee member background classification proposed by DeFond et al. (005) to identify independent directors who have or do not have financial expertise. An independent director wh financial expertise can be classified as eher an independent director wh expertise in accounting financial or a director wh non-accounting financial expertise. Furthermore, an independent director wh non-financial accounting expertise can be eher a legal expert or not (Xie et al., 003). To evaluate the degree of professionalism of independent aud commtee members, we assess the expertise score of each independent director. A director wh financial accounting expertise is defined as an independent director who is a certified accountant or has been a CFO in a listed company. For example, if an independent director is a certified accountant and has also been a CFO in a listed company, then he/she gets a score of. He/she gets a score of if he/she holds eher one of these tles, and gets 0 otherwise. The ratio of accounting financial experts (AFE) on the aud commtee is defined as the sum of the scores of s independent accounting financial experts to the total number of members on the aud commtee. A non-accounting financial expert is an independent director who has worked as a top executive and/or a director in a company or financial instution. As wh the measurements of accounting financial experts, an independent director who has worked both as a top executive and a director in a company or financial instution gets a score of. If the director has held eher one of these tles, he or she gets a score of, and otherwise 0. The ratio of non-accounting financial experts (NAFE) on the aud commtee is defined as the sum of the scores of independent non-accounting financial experts to the total number of members on the aud commtee. A legal expert is an independent director who is a lawyer or has working experience as a lawyer for a firm. Independent directors who are lawyers get a score of, and otherwise 0. The ratio of legal experts (Legal) on the aud commtee is defined as the sum of the scores of independent legal experts to the total number of members on the aud commtee. 6 Control variables We include several variables to control for earnings management. Larger companies have a lower incidence of earnings management, because they face higher polical costs (Watts and Zimmerman, 986) or higher ligation costs (Lang and Lundholm, 993). Dechow et al. (996) find that large companies usually have larger but stable accounting discretionary accruals. Thus, we use the logarhm of total assets as a proxy for company size (SIZE) to control for this effect. Companies that have higher debt ratios usually have 6 The number of aud commtee meetings is also an important characteristic that may influence earnings qualy. In our sample, 6% of the sample firms disclose their number of aud commtee meetings. We re-test the model by adding this variable. The result shows that the number of meetings is not statistically significant to earnings management, and this variable does not change the results of other variables.

9 Yin-Hua and Hsin-I 7 higher default rates. Hence, companies may manipulate their accounting reports to show higher earnings and avoid concerns over their likelihood of default (DeFond and Jiambalov, 994; Sweeney, 994). However, Beneish and Press (995) point out that when a company has a higher debt ratio or is under financial distress, may also manipulate s earnings report downward to increase s chance of re-negotiation. Therefore, we use the book value of total debt divided by the book value of total assets to define the debt ratio (LEV). A company that has higher profs may decide to use earnings management to avoid higher tax payments, to decrease polical risk, or to avoid the possibily of attracting potential competors into their market. We control for this effect by using return on assets (ROA), which is defined as net income divided by the book value of total assets. Operating cash flow is less likely to be influenced by discretionary accruals and more likely to reflect a company s operating performance. Dechow et al. (995) find that when operating cash flow is extremely large or small, the use of discretionary accruals as a proxy for earnings management involves significant measurement errors. Thus, we use operating cash flow (OCF) to control this effect. Palmrose (986) finds that markets respond badly when companies fail to report sufficient profs, and investors may suspect poorly performing firms of mismanaging their finances or operations. Therefore, companies wh weak profs may use earnings management to decorate their earnings reports. Burgstahler and Dichev (997) find that when a company s earnings are close to zero, the managers tend to use earnings management to avoid making negative reports. Therefore, we set a dummy variable (LOSS) which equals if net income is less than zero, and otherwise equals 0. We also include indicator variables to control for both country- and industry-level fixed effects in all of our regressions. Industries are classified according to the methodology used by Claessens et al. (00). These country and industry fixed effects are not reported in the tables for the sake of brevy. We use the two-dig SIC codes given in Compustat Global to control for industry effects. Our sample includes firms from seven industries, which are distributed as follows: agriculture, forest, fishing and mining (9); construction (); manufacturing (8); travelling, telecommunication, electronics and social health (46); retail (3); wholesale (9); services and others (4). We also control for country dummies. MODELS This study investigates whether independent and wellqualified aud commtees actually enhance the earnings qualy and decrease earnings management among listed companies in Hong Kong, Malaysia and Singapore. The companies in these three countries usually have a deviation between cash-flow rights and voting rights. We use regressions to examine how the independence of aud commtees and the presence of independent directors wh financial or legal expertise on these aud commtees affect the qualy of earnings. We use average discretionary accruals from the threeyears of as the dependent variable to evaluate earnings qualy. Higher discretionary accruals indicate that the managers use these accruals to adjust earnings, which means that the earnings qualy is lower. We also use average income smoothing for the five years of to evaluate levels of manipulation. Higher values of income smoothing suggest that the managers are manipulating accounting data. Therefore, the net income variance is less than the earnings variance, which indicates that the earnings qualy is lower. Therefore, we add the variables of ownership structure and independence of aud commtees into our model. We expect that independent aud commtees may monor financial reporting in a company, especially if the company has a higher deviation of cash-flow rights from voting rights. Thus, the earnings qualy could be improved by greater aud commtee independence. We also evaluate whether the commtees independent directors wh financial or legal expertise actually influence their companies earning qualy. Hence, we add the proxies of the independent directors backgrounds to analyze this effect. The two models used are as follows: ADA = β + β Control rights + β Cash flow rights + β Deviation IS 4 i= 0 i + β Independence + β NAFE + β AFE + β Legal η CountryDummy δ SIZE + δ LEV + δ ROA + δ OCF + δ LOSS i= i η CountryDummy j= 6 j= j 4 6 γ IndustryDummy + ε + β Independence + β NAFE + β AFE + β Legal + δ SIZE + δ LEV + δ ROA + δ OCF + δ LOSS j 4 6 γ IndustryDummy + ε i i (7) = β + β Control rights + β Cash flow rights + β Deviation + where ADA is the average discretionary accruals for the three years of , and IS is the average of income smoothing for the five years of The definions of the independent and control variables are presented in Table. In testing the hypotheses, we also measure the three- and five-year average values for each of the control variables. We add industry and country dummies to control for industry and country effects. Furthermore, we use the Whe (980) heteroskedasticy (8)

10 7 J. Bus. Admin. Manage. Sci. Res Table. Variables Definion. Dependent variables Variables Discretionary accruals (ADA) Income smoothing (IS) Description Average three-years (000-00) discretionary accruals, which is evaluated from Kothari et al. (005) performancematched model Average five-years ( ) variance of operating cash flow divided by average five-years variance of net income. Independent variables Voting rights Cash-flow rights Deviation Independence Non-accounting financial expertise director (NAFE) Accounting financial expertise director (AFE) Legal expertise director (Legal) The proportion of voting rights held by controlling shareholder (See appendix ) The proportion of cash-flow rights held by controlling shareholder (See appendix ) The ratio of voting rights to cash-flow rights The number of independent directors on the aud commtee divided by total number of aud commtee members Sum of scores of non-accounting financial expertise independent directors to total number of members on the aud commtee in fiscal year 000. Sum of scores of accounting financial expertise independent directors to total number of members on the aud commtee in fiscal year 000. Number of legal expertise independent directors to total number of members on the commtee in fiscal year 000. Control variables Firm size (SIZE) Logarhm of company s total assets Leverage (LEV) Total liabily divided by total assets Return on assets (ROA) Net income divided by total assets Variance (OCF) Variance of operating cash flow LOSS Dummy variable that equals one if company s average net income has negative value, otherwise zero standard error to adjust for the potential problem of heteroskedasticy. EMPIRICAL RESULTS Descriptive statistics and correlation Table presents the descriptive statistics concerning the effects of aud commtee independence in Hong Kong, Malaysia and Singapore. Panel A reports which sample companies have an aud commtee. As we know, Singapore and Malaysia have mandated that listed companies must have aud commtees, and for Hong Kong, 73% of the sample companies have aud commtees. Therefore, a majory of the large companies in these three countries have aud commtees. In Panel B, we find that the number of aud commtee members is normally around three. Some 56.44% of the sample companies in Malaysia, 76.79% of those in Singapore and 34.07% of those in Hong Kong have three members on their aud commtees. Concerning the sample of Singapore and Hong Kong companies, those that report having an aud commtee but give no details on the members are counted as having zero members. Under this crerion, there is one company (0.89%) in Singapore and five companies (5.49%) in Hong Kong that are counted as having an aud commtee, but zero commtee