Family Control, Board Independence and Earnings Management PDF

J. Account.
Public Policy 28 (2009) 281300
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J. Account. Public Policy

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Family control, board independence and earnings

management: Evidence based on Hong Kong rms
Bikki Jaggi a,b,*, Sidney Leung c, Ferdinand Gul d,e
a
Department of Accounting and Information Systems, School of Business, Rutgers University, Levin Building,
Piscataway, NJ 08854, United States
b
The Hong Kong Polytechnic University, Hong Kong
c
Department of Accountancy, City University of Hong Kong, Hong Kong
d
School of Accounting and Finance, The Hong Kong Polytechnic University, Hong Kong
e
The Faculty of Business and Accountancy, University of Malaya, Kuala Lumpur, Malaysia
a r t i c l e i n f o a b s t r a c t
JEL classication: In this study, we document that independent corporate boards of

G32 Hong Kong rms provide effective monitoring of earnings manage-
G34 ment, which suggests that despite differences in institutional envi-
M41 ronments, corporate board independence is important to ensure
high-quality nancial reporting. The ndings also show that the
Keywords:
monitoring effectiveness of corporate boards is moderated in fam-
Corporate governance
Earnings management ily-controlled rms, either through ownership concentration or the
Earnings quality presence of family members on corporate boards. The results based
Family ownership concentration on rms reporting small earnings increases provide additional sup-
Family board members port for our nding that the monitoring effectiveness of indepen-
dent corporate boards is moderated in family-controlled rms.
2009 Elsevier Inc. All rights reserved.
1. Introduction
Studies based on data for US and UK rms document that corporations with independent boards
tend to have less earnings management (see Dechow and Dichev, 2002; Peasnell et al., 2000). The Sar-
banes-Oxley Act (2002) especially emphasizes the need for corporate board independence to improve
earnings quality by reducing earnings management. Another strand of research indicates that the
institutional arrangements of a country have a signicant impact on the magnitude of earnings man-
* Corresponding author. Address: Department of Accounting and Information Systems, School of Business, Rutgers University,
Levin Building, Piscataway, NJ 08854, United States. Tel.: +1 732 445 3539; fax: +1 732 445 32091.
E-mail addresses: jaggi@rbsmail.rutgers.edu, jaggi@business.rutgers.edu (B. Jaggi).
0278-4254/$ - see front matter 2009 Elsevier Inc. All rights reserved.
doi:10.1016/j.jaccpubpol.2009.06.002
282 B. Jaggi et al. / J. Account. Public Policy 28 (2009) 281300
agement and earnings quality. For example, Leuz et al. (2003) document higher earnings management
in countries with low investor protection. Ball et al. (2003) argue that institutional factors have a
strong inuence on the private benets of control and managerial incentives for nancial reporting.
Recently, some authors have argued that family ownership concentration also inuences rm perfor-
mance and earnings quality (e.g., Anderson and Reeb, 2004; Ali et al., 2007).
We extend the existing research by investigating whether independent corporate boards provide
effective monitoring of earnings management in rms operating in institutional environments which
differ from those of US and UK rms. More importantly, we evaluate whether the monitoring effec-
tiveness of independent corporate boards is affected by the family ownership control or the appoint-
ment of family members on corporate boards. We conduct analyses on the Hong Kong rms, which
operate in an environment where family ownership control and appointment of family members to
corporate boards are well documented. Hong Kong has the third highest percentage of family owner-
ship of listed companies in the region after Indonesia and Malaysia (SCMP, 2002), and the Hong Kong
Society of Accountants (HKSA, 1997) documents that members of controlling families are routinely
appointed to corporate boards. On the other hand, Hong Kong regulations emphasize corporate board
independence (HKSE, 2004).
In this study, we rst evaluate whether the negative association between board independence and
earnings management that has been documented in the US and UK (see Dechow and Dichev, 2002;
Peasnell et al., 2000) also holds for Hong Kong rms. Given the markedly different ownership structure
of Hong Kong-based rms, a separate study of this setting is warranted. Furthermore, as the leading
nancial center in the region and one of the largest international nancial centers, the Hong Kong
nancial market attracts local and international investors, which has created demand for high-quality
earnings information. Investors are interested to know whether board independence, which has re-
ceived increased attention in the Hong Kong institutional environment, improves earnings quality.
We argue that despite differences in the institutional environments between Hong Kong and the US
and the UK, independent corporate boards are likely to provide stricter monitoring of managerial
behavior with respect to earnings management, which will lead to better earnings quality. Thus, we
expect earnings management to be low and earnings quality to be high in the Hong Kong rms with
more independent corporate boards.
Second, we examine whether family ownership control or family members on corporate boards
moderate the monitoring effectiveness of independent boards. Two opposing arguments exist as to
the effect of family control through ownership or the appointment of family members to corporate
boards on the effective monitoring by boards of earnings management. On one hand, family control
may not result in higher earnings management because founding families will limit the ability of man-
agers to manipulate earnings, and there will be less pressure on management to manage earnings to
look good in the short term since the controlling family will have a long-term interest in the rm (e.g.,
Jiraporn and DaDalt, 2007). This argument is consistent with family control reducing the Type I agency
problem (conict between managers and shareholders). On the other hand, earnings management is
higher in countries where family ownership concentration is higher because of weak investor protec-
tion (e.g., Leuz et al., 2003) and majority shareholder motivation to expropriate minority shareholders
interests (e.g., Fan and Wong, 2002; Cheung et al., 2006). This second argument is consistent with
rms operating in institutional environments in which the Type II agency problem (conict between
controlling shareholder and minority shareholders) is more common. Thus, the overall effect of family
control on earnings management depends on whether the Type I or Type II agency problem
dominates.
In this study, we conjecture that the prevalence of family control in Hong Kong is likely to moder-
ate the monitoring effectiveness of independent corporate boards. The following three arguments are
presented in support of this conjecture. First, we argue that when insider ownership is high, the mon-
itoring role of corporate boards decreases (Jensen and Meckling, 1976). Second, controlling families
are more likely to appoint independent directors to seek expertise and advice on strategic direction
rather than give them the responsibility of monitoring and controlling managerial activities (Anderson
and Reeb, 2004; Johnson et al., 1996), thus weakening the monitoring effectiveness of independent
directors. Third, director independence is likely to be compromised when a family controls a rm
either through ownership domination or appointing family members to the board, because family
B. Jaggi et al. / J. Account. Public Policy 28 (2009) 281300 283
members will have control over the appointment and reappointment of independent directors. Inde-
pendent directors are less likely to go against the wishes of controlling family members, especially
when they sit on corporate boards.
We use the proportion of independent non-executive directors (INED) on corporate boards as a
proxy for corporate board independence. Following Anderson and Reeb (2003), we use fractional equi-
ty ownership of the family as a measure of ownership control concentration. A cutoff of 20% owner-
ship is used to identify rms with family control concentration. We also conduct sensitivity analyses
on different cut-off points for family ownership concentration. Because of interlocking relationship
among rms and insufcient disclosure in annual reports about director ownership via corporate pyr-
amids, effective ultimate ownership and the ratio of family voting control over ultimate ownership are
not determinable. Therefore, we use the appointment of controlling family members on corporate
boards as an additional proxy for family control. We consider the board as family controlled when
two or more members of the controlling family are present on the board on the assumption that
two or more family members will exercise a signicant inuence on the boards decisions. We use
two widely adopted proxies for earnings management: the magnitude of discretionary accruals, and
the discretionary component of accrual quality (see, for example, Kothari et al., 2005; Francis et al.,
2005). Discretionary accruals are measured on the basis of the performance-adjusted discretionary
accruals model (PACDA), suggested by Ashbaugh et al. (2003). The discretionary component of quality
of accrual (AQ) is measured based on the model suggested by Francis et al. (2005). A lower magnitude
of discretionary accruals and a lower discretionary component of AQ reect lower earnings manage-
ment (or higher earnings quality).
Our study is based on all rms traded on the Hong Kong Stock Exchange (HKSE) during the period
19982000 for which nancial data are available on the Global Vantage database. The nal sample for
PACDA analysis consists of 770 rm-year observations. Because of non-availability of data, the AQ
analysis is based on 309 observations.1 We conduct 2SLS regression with discretionary accruals (PACDA)
and discretionary component of accrual quality (AQ) as dependent variables, and use the predicted value
of ownership in the analyses to control for the potential endogeneity associated with family ownership.
We also conduct OLS regression analyses as a sensitivity analysis.
The 2SLS regression results, which control for the endogeneity problem, show a negative associa-
tion between earnings management and board independence, suggesting that a higher proportion of
INEDs on corporate boards results in more effective monitoring of earnings management that in-
creases earnings quality. The results based on family-controlled and non-family-controlled rms show
that the negative association between board independence and earnings management is moderated
by family ownership and control. We test the robustness of our ndings by examining whether family
ownership and family board control have an impact on the effectiveness of independent boards to
control earnings management when rms report small earnings increases. The results of this test indi-
cate that more independent boards are associated with a reduced likelihood of reporting small earn-
ings increases. The results on the impact of family control show that the negative association between
earnings management and board independence is weak for family-controlled rms. Sensitivity tests
performed on different cut-off points for family ownership concentration for identifying family-con-
trolled rms do not change the result. Overall, our ndings indicate that independent boards tend
to be effective in controlling earnings management only in non-family-controlled rms. Board inde-
pendence does not appear to improve earnings quality in family-controlled rms. An alternative
explanation for the results could be that independent directors and family control are substitutes
for controlling earnings management.2
The ndings of this study make the following contributions. First, the results indicate that, on aver-
age, INEDs provide effective monitoring of earnings management in Hong Kong rms. This nding
suggests that strengthening the independence of boards by appointing more INEDs is a positive step
toward improving earnings quality. Second, the monitoring effectiveness of independent directors is
moderated in family-controlled rms. Third, given similarities in the business and institutional
1
The number of AQ observations is much smaller than that of PACDA observations because of non-availability of observations
for running the time-series regression model to obtain the residuals that are used as a proxy of AQ.
2
We thank a reviewer for suggesting this alternative explanation of our results.
arrangements of Hong Kong and countries in East and Southeast Asia (e.g., Taiwan), the ndings based
on this study provide useful information for regulators in these countries. Fourth, the results suggest
the policy makers in Hong Kong and other Southeast Asian countries should be careful in borrowing
rules/regulations from the US/UK because they may not work as effectively in a different institutional
setting. Finally, the ndings also provide useful information to investors in evaluating the impact of
board independence on earnings quality, especially in family-controlled rms.
The remainder of the paper is organized as follows: Section 2 introduces the background of the
study. Section 3 contains discussion on the development of hypotheses, and Section 4 presents re-
search design, including the sample selection procedures and research methodology. Discussion of re-
sults is provided in Section 5, and Section 6 presents the summary and conclusions.
2. Background of the study
2.1. Institutional environments of Hong Kong rms
La Porta et al. (1998) highlight the differences in the institutional and cultural environments among
different countries. Though Hong Kongs legal framework is inuenced by English common law, sig-
nicant differences exist between the business environment of Hong Kong and the business environ-
ments of western industrialized countries, especially with regard to corporate governance, ownership
and control. The corporate governance structure of Hong Kong rms is characterized by a personal
networking system (guanxi), which revolves around informal relationships rather than formal written
contracts. As a result, family ownership concentration in rms and the appointment of family mem-
bers to corporate boards are common (e.g., Claessens et al., 2000; Mok et al., 1992). The 10 most prom-
inent business families control 32.1% of all the corporate assets in Hong Kong (Tsui and Stott, 2004).
Additionally, according to the 1994 statistics, family ownership of Hong Kong rms was worth about
US$155 billion, representing 60% of total market capitalization (for example, see Weidenbaum and
Hughes, 1996).
As a result of family ownership concentration, market control mechanisms are weak in Hong Kong:
hostile takeovers and mergers and acquisitions are almost non-existent. Moreover, because of family
ownership concentration, institutional shareholdings is not very common (Tsui and Stott, 2004). Hong
Kong rms also differ from US rms with regard to corporate borrowings: private borrowing through
banks rather than issuing public debt is more common in Hong Kong.
2.2. Agency problems in the Hong Kong ownership structure
Family-controlled rms are likely to face agency problems different from those of non-family-con-
trolled rms. The phenomenon of family ownership concentration results in two distinct groups of
shareholders, i.e., majority and minority shareholders. As a result of these two groups of shareholders,
family-controlled rms are more likely to suffer from the Type II agency problem (conict between
majority and minority shareholders) than the Type I agency problem (conict between managers
and shareholders) (see Anderson and Reeb, 2004; Ali et al., 2007). Controlling shareholders have an
opportunity to maximize their private benets by expropriating minority shareholders (e.g., Fan
and Wong, 2002; Cheung et al., 2006). Thus, some managerial actions in family-controlled rms
may not be in the best interest of outside (minority) shareholders.
2.3. Regulations on the presence of INEDs on corporate boards
The Hong Kong Stock Exchanges (HKSE) guidelines at the time of this study required that rms ap-
point at least two independent non-executive directors on corporate boards. To strengthen corporate
board independence, the HKSE appointed a committee to improve the Stock Exchanges operations
and strengthen the listing requirements so that corporate boards would assume greater responsibility
and accountability in ensuring reliability of reported information. The HKSE Committee (2004) recom-
mended that the number of independent directors on Hong Kong corporate boards be raised from two
to three members effective for accounting periods starting on or after January 1, 2005.
3. Research questions and hypotheses
3.1. Corporate board independence and earnings management
The rst research question addressed in this study is whether a higher degree of corporate board
independence of Hong Kong rms, proxied by the proportion of INEDs on corporate boards, is associ-
ated with lower earnings management.
The impact of corporate board independence on monitoring effectiveness has been examined in
prior studies. Most of these studies emphasize the importance of independent corporate boards, prox-
ied by a higher proportion of independent non-executive directors, to monitor managerial activities.3
Fama and Jensen (1983) emphasize the importance of corporate board independence to provide effective
monitoring of managerial activities and initiatives. Williamson (1981) argues that the independence of
corporate boards is needed to protect investor interests. Roe (1991) supports the monitoring role of cor-
porate boards on the ground that managerial activities could not be targeted by legislative actions, and
argued that effective monitoring by corporate boards prevent the abuse of powers by managers.
Some studies have examined empirically the impact of board independence on earnings manage-
ment; these studies have primarily been based on data from the US and UK rms. Dechow et al. (1996)
evaluate the causes and consequences of earnings manipulation based on rms subject to enforce-
ment actions by the Securities and Exchange Commission (SEC). Their ndings indicate that the like-
lihood of earnings manipulation is systematically related to weaknesses in the oversight of
management (p. 3), and they argue that rms with greater earnings manipulation are more likely
to have a board dominated by insiders. In another study, Beasley (1996) concludes that inclusion of
a larger proportion of outside directors on boards reduces the likelihood of nancial statement fraud.
In a recent study based on a small sample of US rms, Xie et al. (2003) nd a negative association be-
tween corporate board independence and discretionary accruals. Peasnell et al. (2000) nd a similar
result using a sample of UK rms for pre- and post-Cadbury periods. Their ndings show that in
the post-Cadbury period, there is less income-increasing accrual management to avoid earnings losses
or declines when the proportion of non-executive directors is high.
We extend the existing empirical research by evaluating whether the negative association between
corporate board independence and earnings management is also valid for Hong Kong rms, which
operate in a different institutional environment than US or UK. Based on the conceptual arguments
presented in the literature, we postulate that independent corporate boards provide effective monitor-
ing of managerial behavior in Hong Kong. Furthermore, in the absence of audit committees during the
study period, responsibility for ensuring high-quality earnings information falls on the boards. We test
the following hypothesis, stated in the alternative form:
H1: Higher independence of Hong Kong corporate boards, proxied by the percentage of INEDs on
corporate boards, is associated with lower earnings management.
3.2. Impact of family control on the association between board independence and earnings management
Our second research question examines whether family control has a moderating effect on the
monitoring effectiveness of independent boards. There are two opposing theoretical viewpoints on
the impact of family control on earnings management. On one hand, earnings management is ex-
pected to be lower in family-controlled rms. The results of studies based on US rms show that fam-
ily rms are signicantly less likely to manage earnings (Jiraporn and DaDalt, 2007; Ali et al., 2007;
Wang, 2006). The following arguments are presented based on this nding. First, controlling families
3
Among others, these studies include those of Brickley et al. (1994), CALPERS (1998), Cadbury (1992), Fama (1980), Dahya and
McConnell (2005), American Law Institute (1982), Byrd and Hickman (1992), Mayers et al. (1997), and Dalton et al. (1998).
are expected to monitor managerial behavior and actions effectively, which will reduce managerial
opportunities to engage in earnings management. Second, in accordance with the stewardship theory,
earnings are less likely to be manipulated because controlling families would identify their interests
more closely with the rms wealth (e.g., Tosi and Gomez-Mejia, 1989). Third, there will be less pres-
sure on management to meet short-term earnings expectations because controlling families focus
more on the long term.
On the other hand, family control of a rm is likely to result in the Type II agency problems, i.e., a
conict of interests between majority and minority shareholders (e.g., Anderson and Reeb, 2004). In
this case, the majority controlling shareholders may use earnings management to camouage the re-
ported earnings and hide expropriation from minority shareholders. Some studies nd that the own-
ers of family-controlled rms extract private benets at the cost of minority shareholders (e.g., Morck
et al., 1988; DeAngelo and DeAngelo, 2000). Type II agency problems are more serious in the East Asia
countries, where controlling family ownership is widespread, legal protection of minority sharehold-
ers is weaker, and nancial reporting is less transparent (Fan and Wong, 2002; Ball et al., 2003). Empir-
ical studies also document higher earnings management in countries with lower investor protection
(e.g., Faccio et al., 2001; Leuz et al., 2003). These studies suggest that earnings management may be
used to maximize the private benets of majority shareholders.4
In view of the different expectations regarding the effect of family control on earnings manage-
ment, it is an empirical question whether family control moderates the monitoring effectiveness of
independent boards. We conjecture that family control through family ownership concentration or
appointment of family members to the board is likely to moderate the monitoring effectiveness of IN-
EDs for the following reasons. First, controlling families will appoint INEDs to seek their advice rather
than giving them the responsibility to monitor managerial activities (Anderson and Reeb, 2004). Sec-
ond, consistent with the Type II agency problem, controlling families will have a motivation to expro-
priate minority shareholders interest, and thus they will have an incentive to limit monitoring by
INEDs they appoint. Third, INEDs independence may also be compromised because of their closeness
and loyalty to the controlling family that appoints or reappoints them to corporate boards. We develop
the following hypothesis to test this expectation:
H2: The negative association between corporate board independence and earnings management is
moderated in rms with family ownership control or corporate board control through family board
members.
4. Sample selection and research methodology
4.1. Sample selection and data collection procedures
We started the sample selection process by searching the Global Vantage database (CD dated
December 2002) for Hong Kong rms for the three-year period from 1998 to 2000. The number of
Hong Kong rms that have nancial data in Global Vantage by year is as follows: 391 rms in 1998,
394 rms in 1999 and 399 rms in 2000. In the second step, we examined the Global Vantage database
for nancial data to estimate current discretionary accrual (PACDA) and total discretionary accruals
(TDA). Because of the requirement of at least 10 observations in a two-digit SIC code per year, we
could measure discretionary accruals for 943 of rm-years.
In the third step, we manually collected data on corporate governance and family control variables
from the annual reports of sample rms for each study year. As a result of missing reports or missing
values in the available statements, the sample size was reduced to 876 rm-year observations. As a
result of some missing values for the control variables, the nal sample consists of 770 rm-year
observations. The data for measuring the quality of accruals based on the model of Francis et al.
4
The controlling shareholders may also use other means to expropriate minority shareholders, such as selling assets, goods, or
services to other companies under their control (e.g., Cheung et al., 2006). However, the Type II agency problem can come at a price
to the controlling owners and their rms because investors can discount the share prices in response to the agency conict
(Claessens et al., 2000; La Porta et al., 2002).
Table 1
Sample by industry and year.
Two-digit SIC group Year Total

1998 1999 2000
15 11 13 13 37
20 8 9 6 23
22 5 6 5 16
23 14 15 12 41
2427 16 18 15 49
2829 7 8 9 24
3031 8 13 13 34
3234 8 7 7 22
35 17 17 15 49
36 37 38 35 110
3739 19 21 21 61
47 5 5 7 17
48 9 10 11 30
5051 37 42 45 124
53 11 13 11 35
58 8 9 7 24
70 9 9 8 26
73 9 10 11 30
7989 6 6 6 18
Total 244 269 257 770
(2005) were obtained from the PACAP databases.5 Because of the strict data requirement of the AQ esti-
mation that is based on the Fama and French (1997) portfolio approach, which requires residual values
for ve years, the number of data observations was reduced to 309 for this variable.
The number of rm-year observations by SIC code and year is provided in Table 1.
The sample distribution indicates that there is no signicant difference in the number of observa-
tions across the sample years. The sample distribution by industry classication shows a higher num-
ber of observations for SIC code 36 (electronic and other electric equipment), SIC code 50 (wholesale
trade durable goods), and SIC code 51 (wholesale trade nondurable goods). There is relatively a
small number of observations for SIC codes 22 (textile mill products) and 47 (transport services). Dis-
tribution of our sample is similar to the industry distribution of Hong Kong rms in the database.
4.2. Family board members and family ownership
The directors and management prole in the annual reports of Hong Kong rms provides a prole
of each director. According to the listing rules of the Hong Kong Companies Ordinance and Stock Ex-
change, companies are required to disclose the prole of all directors and senior management and
their relationships, if any. The annual reports also contain the shareholding information for each direc-
tor, and disclosure of this information is done at three levels, namely personal interest, family interest
and corporate and other interest. Information contained in the annual reports enabled us to identify re-
lated family members on corporate boards. Based on this information, we could identify the following
relationships: father/mother and son/daughter, husband and wife, father/mother-in-law, son/daugh-
ter-in-law, brothers and sisters, nieces and nephews. The board is dened as family controlled when
two or more members of the controlling family are appointed as directors. Consistent with the liter-
ature (e.g. Ho and Wong, 2001), we nd that controlling family members are routinely appointed as
chairman or as executive director to control board decisions (Ho and Wong, 2001).
5
We use the PACAP database for AQ estimation because it covers Hong Kong rms more extensively than does the Global
Vantage database. The PACAP databases are compiled by the Pacic-Basin Capital Markets Research Center at the University of
Rhode Island College of Business, and provide historical research data for Hong Kong, Indonesia, Japan, Korea, Malaysia, Singapore,
Taiwan and Thailand.
Our analyses are based on data for 1999. Among 269 rms in 1999, 141 (52.4%) have family mem-
bers representing family interest on the board, and 72 (51.1%) out of the 141 family-controlled rms
have two family members serving as directors. The number of rms with three family members on the
board is 36 (25.5%), and the number with four or more members is 33 (23.4%). Additionally, we nd
that in 132 (93.6%) of the family-controlled rms, family members hold the position of Board Chair-
man, and an overwhelming majority of family board members (86.7% of rms) hold one of the key
positions (i.e., chairman, CEO, or executive directors). Also, the family-controlled rms with three or
more family members on the board occasionally appoint a family member as a non-executive director.
Additional analyses indicates that in half of the family-controlled rms (N = 70), a father/mother
and son/daughter relationship exists among family board members, which shows that family rms
have a tendency to keep the business within the family over generations. In 26.2% of the 141 family
rms, husband and wife jointly represent the family interest on the board. Descriptive statistics also
indicate that controlling shareholders tend to have family members holding key managerial positions.
Information contained in annual reports also indicates families ultimate share ownership.6 We use
a 20% cut-off point for family ultimate ownership control to identify the family-controlled rm.7
4.3. Corporate board independence
The corporate board independence is measured by the proportion of INED on corporate boards.
Directors are considered to be INEDs if they do not hold any executive position in the rm, have no
relationship to the rm, and have no related-party transactions with the rm. Thus, grey directors
are excluded from the INED category.
4.4. Calculation of discretionary accruals and accrual quality
Our rst proxy for earnings management is the magnitude of discretionary accruals. We calculate
both total and current discretionary accruals. Total discretionary accruals (TDA) are calculated using
the cross-sectional discretionary accruals model suggested by Jones (1991) and modied by Dechow
et al. (1995). Recently, some researchers have argued that current discretionary accruals are more sus-
ceptible to earnings manipulation (e.g., Ashbaugh et al., 2003), and others have argued that rm per-
formance should also be considered in calculating discretionary accruals (Kothari et al., 2005). Our
main results are based on the performance-adjusted current discretionary accruals (PACDA) model,
which takes both of these factors into consideration, and TDA is used in a sensitivity test. Details
for estimation of PACDA and TDA are provided in Appendix A.8
As a second proxy, we use the quality of accruals, as suggested by Francis et al. (2005). Because of
estimation errors9 in calculating discretionary accruals, the quality of accruals has recently been sug-
gested as an alternative proxy for earnings management (Francis et al., 2005). Dechow and Dichev
(2002) argue that earnings quality is better if accruals are better associated with realized cash ows
in the preceding, current and subsequent periods. The model of Francis et al. (2005) extends the Dechow
and Dichev (2002) accrual quality model by adding two variables, namely the change in revenues (DRev),
and property, plant and equipment (PPE), both of which are scaled by the average total assets. McNichols
6
Family ownership is calculated as the fractional ordinary shares held by family directors as the sum of benecial interests at
the personal, family and corporate levels. It represents the ultimate voting control of the family in the rm. Because the majority of
footnotes associated with corporate interest of directors are unclear about the effective ownership of family members, we cannot
measure the disparity between family voting control and ownership rights.
7
A similar ownership cutoff point for concentrated ownership has been used by Morck et al. (1988) and by Hermalin and
Weisbach (1991). Our results, however, are not sensitive to this cut-off.
8
Because the results for PACDA and TDA are qualitatively similar, the results on the magnitude of discretionary accruals are
tabulated for PACDA only.
9
Discretionary accrual models of earnings management have limitations (see Erickson et al., 2004). The measurement of
discretionary accruals is surrounded by the controversy whether discretionary accruals can be isolated from non-discretionary
accruals with precisions (Guay et al., 1996). Furthermore, discretionary accruals may not always represent opportunistic earnings
management. They could be used to signal managers private information to investors (Dechow, 1994, p.5).
(2002) argues that in order to extract the estimation error in the form of a residual, it is necessary to
control for these two variables. The model is as follows:
TCAi;t a0 a1 CFOi;t1 a2 CFOi;t a3 CFOi;t1 a4 DRevi;t a5 PPEi;t ei;t 1
where TCA is total current accruals, CFO is cash ow from operations, DRev is change in revenue and
PPE is net property, plant and equipment.10 All variables are scaled by the average of total assets.
Eq. (1) is estimated cross-sectionally for all rms (minimum of 10 rms) within each one of the 48
industry groups dened by Fama and French (1997) for each year. AQ is dened as the standard devi-
ation of the residual, ei,t for years t 4 to year t (a minimum of 3 years rm residual data is required). A
higher value of AQ means higher standard deviation, meaning higher variation in reported earnings,
and this reects lower earnings quality.
Francis et al. (2005) decompose AQ into discretionary and innate components, where discretionary
component is more prone to managerial manipulation. We identify the discretionary component of AQ
by separating it from the innate component. Francis et al. (2005) suggest the use of the following ve
factors to estimate the innate component of AQ: rm size, standard deviation of cash ow from oper-
ations (r(CFO)), standard deviation of sales (r(SALES), operating cycle, and incidence of losses. We
cannot calculate the operating cycle for Hong Kong rms because data on cost of sales (COGS) is
not available during the study period. As a result, we estimate the innate component of AQ by the fol-
lowing annual estimations:
AQ it bi0 b1 SIZEit b2 rCFOit b3 rSALESit b4 NEGEARNit eit 2
where SIZE is the log of total assets, r(CFOit) and r(SALESit) are the standard deviation of cash ow
from operations and sales respectively, calculated over the past seven years, NEGEARN is the propor-
tion of loss (negative earnings) years out of the past seven years. We require at least four observations
in the 7-year window.11 The discretionary component of AQ (DISC_AQ) is the residual eit from Eq. (2).
4.5. Regression models
We evaluate the association between the proportion of INEDs on corporate boards (PINED) and
earnings management, after controlling for the impact of other relevant variables. The use of control
variables is based on their relevance to earnings management, as discussed in the literature. The nd-
ings of Xie et al. (2003) suggest that board size (BD_SIZE) is related to the extent of earnings manage-
ment. Fama and Jensen (1983) as well as the Cadbury Committee (1992) have argued that corporate
boards would be more independent if the board chairman is independent of the rms chief executive
ofcer (CEO). To highlight corporate board independence through PINED, we use board chairman/CEO
duality as a control variable. The variable CEO is coded 1 when the board chairman and CEO positions
are held by one individual, and 0 otherwise. Because some Hong Kong rms established audit commit-
tees voluntarily during the study period, we also include an indicator variable for audit committee in
the model because it is likely to improve earnings quality (Klein, 2002). We use log of total assets
(F_SIZE) as a control variable to control for rm size. The impact of rm performance, rm growth
and liquidity are controlled through the use of return on assets (ROA), market-to-book ratio (MB)
and debt-to-equity-ratio (DE) respectively. In addition, we include a dummy variable for Big5 auditors
and we control for the effect of time periods by including year dummy variables.
The following model is used to evaluate the association between earnings management (EM) and
PINED:
EMitj a b1 PINEDit b2 BD SIZEit b3 CEOit b4 ACit b5 ROAit b6 DEit b7 BIG5it
b8 F SIZEit b9 MBit b10 DUM YEAR99 b11 DUM YEAR00 eit 3
10
Data on gross PPE are not available in the PACAP database. As a result, we use net PPE in the estimation of Eq. (1).
11
We use a 7-year rolling window and require at least four observations in the past 7 years, whereas Francis et al. (2005) use a
10-year window and require at least ve observations in the past 10 years. We use a narrower window because the number of
Hong Kong rms covered in the database is much smaller in the earlier years.
290
Table 2
Descriptive statistics and correlations.
B. Jaggi et al. / J. Account. Public Policy 28 (2009) 281300

N Mean Std. dev. Minimum Median Maximum
Panel A: descriptive statistics of all variables
PACDA 770 0.117 0.175 0.000 0.068 2.141
AQ 352 0.066 0.043 0.004 0.057 0.294
DISC_AQ 309 0.000 0.038 0.099 0.004 0.208
PINED 770 0.432 0.177 0.125 0.400 1.000
FAMOWN 770 0.196 0.246 0.000 0.000 0.932
NUMFAM 770 1.508 1.708 0.000 2.000 8.000
NBD_SIZE 770 8.260 2.394 2.000 8.000 20.000
ROA 770 0.079 0.528 7.975 0.015 3.366
DE 770 0.297 1.133 0.000 0.166 23.452
F_SIZE 770 4.866 1.285 0.579 4.765 9.092
MB 770 1.116 2.283 12.286 0.583 23.194
Dichotomous variables 0 1
CEO 384 (49.87%) 386 (50.13%)
AC 372 (48.31%) 398 (51.69%)
BIG5 43 (5.58%) 727 (94.42%)
DUM_YEAR99 501 (65.06%) 269 (34.94%)
DUM_YEAR00 513 (66.62%) 257 (33.38%)
PACDA AQ DISC_AQ PINED FAMOWN NUMFAM BD_SIZE CEO AC ROA DE BIG5 F_SIZE MB DUM_
YEAR99
Panel B: Pearson correlation coefcients between variables
AQ 0.411**
DISC_AQ 0.332** 0.893**
PINED 0.105** 0.109* 0.039
FAMOWN 0.071* 0.055 0.033 0.010
NUMFAM 0.115** 0.150** 0.062 0.025 0.721**
BD_SIZE 0.056 0.004 0.028 0.152** 0.048 0.143**
CEO 0.009 0.097 0.050 0.024 0.060 0.026 0.213**
AC 0.029 0.069 0.013 0.041 0.024 0.049 0.104** 0.073*
ROA 0.205** 0.134* 0.115* 0.057 0.023 0.053 0.078* 0.092* 0.077*
DE 0.038 0.214** 0.197** 0.028 0.007 0.009 0.040 0.059 0.089* 0.567**
BIG5 0.018 0.041 0.016 0.032 0.051 0.027 0.030 0.005 0.104** 0.004 0.002
F_SIZE 0.171** 0.097 0.027 0.185** 0.077* 0.054 0.313** 0.089* 0.128** 0.295** 0.176** 0.085*
MB 0.025 0.077 0.144** 0.001 0.055 0.074** 0.006 0.033 0.042 0.007 0.069 0.055 0.023
DUM_YEAR99 0.012 0.019 0.000 0.004 0.004 0.005 0.013 0.005 0.170** 0.008 0.060 0.048 0.012 0.097**
DUM_YEAR00 0.042 0.131* 0.000 0.004 0.024 0.020 0.020 0.038 0.279** 0.071* 0.056 0.052 0.005 0.035 0.519**
PACDA = The absolute value of discretionary current accruals, scaled by lagged total assets.
B. Jaggi et al. / J. Account. Public Policy 28 (2009) 281300

AQ = Standard deviation of rm residuals, from years t 4 to t from annual cross-sectional estimations of the Francis et al.(2005) model.
DISC_AQ = Discretionary component of AQ.
PINED = Proportion of non-executive directors on the board of directors.
FAMOWN = The fraction of shares owned by family members on Corporate board.
NUMFAM = Number of directors from the same family on the board of directors.
BD_SIZE = Dummy variable: 1 if the total number of directors on the board is greater than the median value of the sample; 0 if the total number of directors on the board is smaller than or
equal to the median value of the sample.
CEO = Dummy variable: 1 if the CEO and the chairman of the board of directors are the same person and 0 otherwise.
AC = Dummy variable: 1 for presence of audit committee; 0 otherwise.
ROA = Ratio of net income before extraordinary items to total assets.
DE = Ratio of total debt to total assets.
BIG5 = Dummy variable: 1 for big5 auditor; 0 for non-big5 auditor.
F_SIZE = Natural log of the total assets.
MB = Ratio of the rms market value of common equity to book value of common equity.
DUM_YEAR99 = Dummy variable: 1 if year = 1999; 0 if year = 1998 and 2000.
*
Correlation is signicant at the 0.05 level (two-tailed).
**
Correlation is signicant at the 0.01 level (two-tailed).
291
where
EMit earnings management of rm i for period t by using different proxies for EM (i.e., PACDA and
DISC_AQ)
PINED proportion of independent non-executive directors on the board of directors12
BD_SIZE dummy variable: 1 if the total number of directors on the board is greater than the median va-
lue of the sample; 0 if the total number of directors on the board is smaller or equal to the med-
ian value of the sample
CEO dummy variable: 1 if the CEO and the chairman of the board of directors are the same person
and 0 otherwise
AC dummy variable: 1 for the presence of an audit committee; 0 otherwise
ROA ratio of net income before extraordinary items to total assets
DE ratio of total debt to total assets
BIG5 dummy variable: 1 for big5 auditor; 0 for non-big5 auditor
F_SIZE natural log of total assets
MB ratio of the rms market value of common equity to book value of common equity
DUM_YEAR99 dummy variable: 1 if year = 1999; 0 if year = 1998 and 2000
DUM_YEAR00 dummy variable: 1 if year = 2000; 0 if year = 1998 and 1999
eit residual term
We evaluate the impact of family control on the association between PINED and earnings manage-
ment by including an interaction term between PINED and family control.
EMitj a b1 PINEDit b2 FAMitj b3 FAMitj PINEDit b4 BD SIZEit b5 CEOit b6 ACit
b7 ROAit b8 DEit b9 BIG5it b10 F SIZEit b11 MBit b12 DUM YEAR99
b13 DUM YEAR00 eit 4
where FAMit is family control of rm i for period t, and is measured as the fraction of shares owned by
a family (FAM_OWN). We expect that b3 > 0.
5. Discussion of results
5.1. Descriptive statistics
Descriptive statistics on the variables used in the regression tests are provided in Table 2.
The mean (median) of absolute values of performance-adjusted current discretionary accruals
(PACDA) is 0.117 (0.068), and the mean and median values of discretionary AQ are 0.000 and
0.004 respectively. On average, 43.2% of directors are INEDs. This percentage shows that a signicant
number of board members are executive directors. The median number of directors on corporate
boards is 8. The sample rms are almost equally divided between those that have and those that
do not have a dual board chairman/CEO (50.13% vs. 49.87%). The mean and median numbers of direc-
tors from the same family are 1.508 and 2, respectively. On average, 19.6% of outstanding ordinary
shares are owned by one family.
The results (unreported) of annual regression of Eq. (2) show that the coefcient estimates on
r(CFO), r(SALES), and NEGEARN are in the expected direction, positive and signicant for all three
years (the mean coefcient estimates are 0.172, 0.030, and 0.032 respectively). The coefcient esti-
mate on SIZE is positive, but insignicant (mean coefcient estimate is 0.0032). The explanatory
power of the equation averages 15.7% across yearly estimations.
The operating performance (ROA) of sample rms varies signicantly, and on average it is negative
possibly because of recessionary conditions during the period. The average debt ratio is 29.7%, and
12
It is not uncommon that annual reports of Hong Kong rms in the sample years only label directors as either executive
directors or non-executive directors without providing further classication whether they are independent non-executive
directors. We exclude those grey non-executive directors who have a relationship to the rm or related-party transactions from
the INED category based on the information in the annual reports.
the median value shows that 50% of the sample observations have less than 17% debt. There is a sig-
nicant variation in the market-to-book (MB) ratio; the median for this ratio is 58.3%.
The correlation matrix is provided in Panel B of Table 2. The correlations indicate that the absolute
value of PACDA is signicantly negatively associated with PINED, P_FAM, D_LG_BD, BD_SIZE, F_SIZE,
and ROA. These results suggest that earnings management is lower when the proportion of INEDs
on corporate boards is high, corporate board size and rm size are large, rms operating performance
is high, and family members are present on corporate boards. As expected, DISC_AQ is signicantly
positively associated with PACDA (0.294), indicating that rms with higher levels of discretionary
accruals have lower accrual quality (high DISC_AQ values mean lower accrual quality).
5.2. Regression results
5.2.1. INEDs and earnings management

We conduct regression tests to evaluate the association between independent corporate boards
(PINED) and absolute values of performance-adjusted current discretionary accruals (PACDA) and dis-
cretionary component of AQ as proxies for EM (Eq. (3)), The regression results are reported in Model 1
of Table 3. The results based on PACDA show that the coefcient for PINED is negative and statistically
signicant, suggesting that rms with a higher proportion of INEDs on corporate boards are associated
with lower discretionary accruals, i.e., lower earnings management. In other words, more independent
Hong Kong corporate boards, proxied by a higher proportion of INEDs, are associated with lower mag-
nitude of discretionary accruals. The results on the discretionary component of AQ, however, show
that the PINED coefcient is negative, but insignicant.13 The PINED coefcients in Eq. (4) are signi-
cantly negative for PACDA and DISC-AQ (see Model 2 in Table 3). These results support our hypothesis H1
that there is a negative association between independence of Hong Kong corporate boards and earnings
management.
5.2.2. Family control, INEDs and earnings management

To evaluate the impact of family control on the association between earnings management and
PINED, we include an interaction variable between PINED and family control (Eq. (4)). Prior studies
suggest that family ownership and rm performance may be endogenously determined (Anderson
and Reeb, 2003; Demsetz and Lehn, 1985), and this may bias the results based on the OLS regression.
We address this problem by using an instrumental variable in the two-stage least squares (IV-2SLS)
regression (e.g., Anderson and Reeb, 2003). Demsetz and Lehn (1985) suggest that ownership is a func-
tion of rm size and risk. Following Anderson and Reeb (2003), we rst regress family ownership (FA-
M_OWN) on the natural log of total assets, the square of the natural log of total assets and monthly
stock return volatility (standard deviation of the 60 monthly stock returns in the previous ve years)
to obtain the predicted value of family ownership. In the second stage, we use the predicted value of
the family ownership to replace the actual family ownership. The IV-2SLS regression results based on
the predicted value of family ownership are presented in Table 3 (Model 2).
The results show that the coefcient of PINED is signicantly negative for regression tests with
PACDA or discretionary AQ as the dependent variables. The interaction term on PINED * PFA-
M_OWN is positive and statistically signicant at the 0.05 level for PACDA and the 0.001 level
for discretionary AQ. These results are consistent with our hypothesis H2, indicating that family
control in Hong Kong rms moderates the negative association between independent corporate
boards and earnings management. These results suggest that higher independent corporate boards
in non-family-controlled rms are more effective in controlling earnings management than in fam-
ily-controlled rms.
13
As a result of the requirement of a minimum of 10 observations in each industry (based on Fama and French, 1997) for each
year for model estimation and a minimum of 3 years residual values for the computation of the standard deviation (AQ measure),
the sample size for this test is signicantly reduce. This test is based on 309 observations rather than 770 observations.
Table 3
Regression analysis of earning management, board independence and family control based on the predicted value of family
ownership.
PACDA DISC_AQ
Model 1 Model 2 Model 1 Model 2
Coeff. t-Stat. Coeff. t-Stat. Coeff. t-Stat. Coeff. t-Stat.
Intercept 0.196*** 3.43 0.235*** 3.81 0.015 1.00 0.033* 1.29
PINED 0.074*** 2.01 0.180** 2.10 0.013 0.71 0.087*** 3.03
PFAM_OWN 0.105** 2.13 0.032** 1.66
PINED * PFAM_OWN 0.182** 2.03 0.100*** 2.83
BD_SIZE 0.002 0.17 0.010 0.83 0.003 0.63 0.003 0.56
CEO 0.011 0.85 0.009 0.64 0.004 0.82 0.003 0.63
ROA 0.081 1.15 0.149*** 2.29 0.004 0.72 0.010* 1.44
DE 0.019 0.96 0.017** 1.71 0.024*** 2.65 0.023*** 2.56
BIG5 0.019 1.13 0.003 0.17 0.004 0.41 0.010 0.93
F_SIZE 0.016* 1.48 0.008 0.86 0.002 1.00 0.000 0.04
MB 0.003 1.18 0.003 1.03 0.003*** 2.24 0.003** 2.18
AC 0.008 0.58 0.003 0.20 0.000 0.09 0.000 0.10
DUM_YEAR99 0.019* 1.28 0.034** 2.09 0.003 0.62 0.004 0.82
DUM_YEAR00 0.026** 2.17 0.021* 1.56 0.002 0.45 0.003 0.68
N 770 627 309 290
Adj. R-SQ 0.0657 0.1539 0.0341 0.0688
F-value 5.92 9.76 1.99 2.64
The reported t-statistics are white-adjusted (White, 1980) values to control for heteroskedasticity.
PACDA = The absolute value of discretionary current accruals, scaled by lagged total assets.
DISC_AQ = Discretionary component of AQ.
PFAM_OWN = Predicted value of family ownerships is the predicted value of regressing family ownership on the natural log of
total assets, the square of the natural log of total assets, and return volatility (standard deviation of 60 month stock market rates
of return for the previous 5 years).
BD_SIZE = Dummy variable: 1 if the total number of directors on the board is greater than the median value of the sample; 0 if
the total number of directors on the board is smaller than or equal to the median value of the sample.
CEO = Dummy variable: 1 if the CEO and the chairman of the board of directors are the same person and 0 otherwise.
ROA = Ratio of net income before extraordinary items to total assets.
DE = Ratio of total debt to total assets.
F_SIZE = Natural log of the total assets.
AC = Dummy variable: 1 for presence of audit committee; 0 otherwise.
*
Designates statistical signicance at the 0.1 level, one-tailed test.
**
***
As an additional analysis, we conduct regression tests on the sub-samples of family-controlled and

non-family-controlled rms separately.14 The sample is divided into high and low family ownership
control by the using the cut-off point of 20% ownership15 (40.5% of the sample with family ownership
over 20% is dened as the high family ownership sub-sample). The sample is also divided into two groups
based on the corporate board control by using two or more family members on the corporate board as
the cut-off point. The subsample results for PACDA (untabulated) show that the coefcients of PINED for
14
It has been argued that tests based on full sample with an interaction variable may be less precise under certain circumstances
if the coefcients on the control variables differ between two groups. An analysis based on pooled data forces the coefcients of all
variables other than the test variables to be equal for the two groups. It has been further suggested that separate regression tests
on the two groups may provide better results when the association between the X variable (PINED) and Y variable (PACDA) is
hypothesized to be contingent on the moderator variable Z (family control) (e.g., Staw and Oldham, 1978; Wright et al., 1996, p.
452).
15
Morck et al. (1988) and Hermalin and Weisbach (1991) use a similar ownership cutoff for concentrated ownership.
both the family-controlled and non-family-controlled groups are negative, but the coefcient is signi-
cant only for non-family-controlled rms, and insignicant for family-controlled rms. Similarly, the
untabulated results for the discretionary component of AQ show that the PINED coefcient is negative
and signicant for non-family-controlled rms and is positive and insignicant for family-controlled
rms. Although the subsample analysis does not provide a direct test on the effect of family control,
these results indirectly support that family control moderates the negative association between indepen-
dent corporate boards, proxied by the proportion of INEDs, and earnings management.
5.2.3. Discussion on control variables

The results for control variables based on model 1 of Table 3 show that the CEO duality coefcient
is negative, but it is statistically insignicant. This nding thus indicates that the CEO duality does not
have any signicant impact on earnings management. The results on rm size consistently show low-
er earnings management by large rms. The results, however, do not show any signicant impact of
Big-5 on earnings management. The negative coefcient on ROA suggests good rm performance is
associated with lower earnings management. Results for DE are, however, mixed.
5.2.4. Earnings benchmark test

We also conduct an earnings benchmark test to evaluate whether family ownership control and
family board control have an effect on the effectiveness of independent boards to control earnings
management. Specically, we focus on the rms reporting small earnings increases (e.g., Degeorge
et al., 1999; Ashbaugh et al., 2003) and examine weather family control weakens the negative associ-
ation between board independence and the likelihood of small earnings increases. We modify Ashb-
augh et al.s (2003) logistic model (p. 630) for the earnings benchmark test as follows:
INCREASEit b0 b1 PINEDit b2 FAMitj b3 FAMitj PINEDit b4 LITIGATIONit b5 MBit
b6 lnMVEit b7 BIG5it b8 LOSSit b9 PACDAit eit 5
where INCREASE represents small earnings increases and is coded 1 when the difference between
the current year and previous years net income, scaled by beginning-of-year market capitalization
of equity, falls in the interval [0.00, 0.02], and 0 otherwise. We could not examine the impact of
independent boards on managing earnings to meet or beat analyst earnings forecasts because ana-
lyst forecasts were not commonly available for the sample rms for the study years.16 FAMitj is fam-
ily control of rm i for period t. The value of j is equal to 1 when family control is measured as the
fraction of shares owned by a family (FAM_OWN). The value of FAM_OWN is equal to 1 when family
ownership is more than 20%, and 0 otherwise. The value of j is equal to 2 when family control is mea-
sured as the family control on corporate boards (FAM_BD). The value of FAM_BD is equal to 1 when
two or more family members are on corporate boards, and 0 otherwise. We include PINED, FAM
and their interaction in the model as the experimental variables. We expect that b3 > 0. Other variables
are similar to those of Ashbaugh et al. (2003) with two exceptions. First, the audit fee variable is not
included because audit fee data are not available on the database. Instead, we include a BIG 5 auditor
variable (BIG5) to control for audit quality. Second, institutional shareholding is not included because
institutional shareholding in HK rms is generally small and such data are not publicly available. LIT-
IGATION is an indicator variable equal to 1 if the company operates in a high-risk industry.17 MB is the
market-to-book equity ratio for growth. LnMVE is rm size, dened as the log of the market value of
equity. LOSS is an indicator variable equal to 1 if the rm reports a net loss and PACDA is performance-
adjusted discretionary current accruals.
Due to non-availability of beginning-of-year market values on the database in the INCREASE
analysis, the sample is reduced to 593 observations, of which 70 observations report small earnings
increases. The results of the logistic regression are reported in Table 4. The results clearly indicate
16
We examined whether analyst forecasts are available for the time period of this study. Our search indicated that the IBES
database contained less than 20% of the sample rms for the studys time period.
17
We nd a negative and insignicant coefcient on LITIGATION. The result is consistent with the institutional environment in
Hong Kong that shareholder litigation is not an important issue.
Table 4
Logistic regression on meeting earning benchmark of small earnings increase.
INCREASEit b0 b1 PINEDit b2 FAMitj b3 FAMitj PINEDit b4 LITIGATIONit b5 MBit b6 lnMVEit b7 BIG5it

b8 LOSSit b9 PACDAit eit :
Family ownership Family board control

Coeff. Chi-square stat. Coeff. Chi-square stat.
Intercept 2.706 10.28*** 2.602 9.57***
PINED 1.763 3.02** 1.944 3.41**
FAM_OWN 1.224 2.61*
PINED FAM_OWN 2.883 3.27**
FAM_BD 1.360 3.29**
PINED FAM_BD 3.126 3.84**
LITIGATION 0.182 0.30 0.230 0.47
MB 0.011 0.04 0.011 0.03
LnMVE 0.433 18.39*** 0.433 18.74***
BIG5 0.094 0.02 0.088 0.02
LOSS 1.342 9.81*** 1.365 10.15***
PACDA 0.667 0.71 0.732 0.86
N 593 593
Pseudo R-SQ 0.1966 0.1983
The reported t-statistics are white-adjusted (White, 1980) values to control for heteroskedasticity.
INCREASE = Dummy variable: 1 when the difference between current year and previous years net income, scaled by MVE t 1,
falls in the interval [0, 0.02], and 0 otherwise.
FAM_OWN = Dummy variable: 1 if the fraction of shares owned by family members on Corporate board is greater than 20%, 0
otherwise.
FAM_BD = Dummy variable: 1 if the family has two or more members on the broad of directors; 0 otherwise.
PINED FAM_OWN = Interaction term between PINED and FAM_OWN.
PINED FAM_BD = Interaction term between PINED and FAM_BD.
LITIGATION = Dummy variable: 1 if the rm operates within a high-litigation industry and 0 otherwise, where high-litigation
industries are industries with SIC codes of 28332836, 35703577, 36003674, 52005961, 73707374.
LnMVE = Natural log of the rms market value of common equity.
LOSS = Dummy variable: 1 if the rm reports a net loss, 0 otherwise.
PACDA = Performance-adjusted discretionary current accruals, scaled by lagged total assets.
*
**
***
signicantly negative coefcients on PINED and signicantly positive coefcients on the interaction
variable between PINED and FAM irrespective of whether FAM is represented by family ownership
or family board control. The evidence suggests that higher board independence reduces the likeli-
hood of reporting small earnings increases, which is a potential outcome of earnings management.
The evidence also conrms the reduction in the INEDs monitoring effectiveness in family-controlled
rms. The ndings are consistent with our earlier reported discretionary accruals and accrual-qual-
ity results.
5.2.5. Additional robustness tests

First, we perform sensitivity checks by varying the family ownerships cut-off point from 20% to
25%, 30% and 50%. The results are robust to different cut-off points in classifying the family- and
non-family-controlled rms.
Second, we perform a robustness check to control for the effect of potential outliers. We winsorize
all variables that exceed four standard deviations of their respective means and rerun the regression
tests. The results based on these observations indicate that the results reported in the tables become
stronger in some cases, which suggests that the results are not affected by outliers.
6. Conclusion
This paper evaluates the association between corporate board independence and earnings manage-
ment in Hong Kong rms. Additionally, it examines whether family control inuences the association
between INEDs and earnings quality. Overall, the ndings provide evidence that a higher proportion of
INEDs is associated with more effective monitoring to constrain earnings management. This suggests
that a higher proportion of INEDs on corporate boards is likely to deter managers from manipulating
the reported earnings; thus the quality of reported earnings of rms with a higher proportion of INEDs
is expected to be high. However, the monitoring effectiveness of INEDs is reduced in family-controlled
rms, proxied by family ownership concentration or the presence of family members as board direc-
tors. These results suggest that an increase in the proportion of outside directors to strengthen board
monitoring is unlikely to be effective in family-controlled rms.
Like most studies of this nature, this study is subject to some limitations. First, the validity of these
ndings depends upon discretionary accruals and accrual quality as proper proxies for earnings qual-
ity. Second, although we have used two proxies for family control, the validity of the ndings is also
subject to proper estimation of family control of the rm. Third, our results are for the period 1998
2000, and caution should be exercised in extrapolating these results to more recent times. Finally, the
results may have been inuenced by the control variable of ROA which is on average negative, indi-
cating recessionary conditions during the study period.
Despite their inherent limitations, the ndings provide useful insights to regulators for developing
appropriate regulations on the corporate governance mechanism of Hong Kong rms, especially the
appointment of independent non-executive directors on corporate boards. The ndings are relevant
for countries with an institutional environment similar to that of Hong Kong. Investors may also ben-
et from the ndings because they provide insight into the impact of a higher proportion of INEDs on
the reliability of reported earnings. Last, but not least, the consideration of family board control adds
to the corporate governance literature on the role of family ownership.
Acknowledgement
Authors are grateful to the Research Grants Council of the Hong Kong Special Administrative Re-
gion, China for nancial support (Project No. CityU 1133/03H).
Appendix A
A.1. Calculation of performance-adjusted current discretionary accruals (PACDA)
The cross-sectional performance-adjusted current discretionary accruals (PACDA) are calculated by

including the lagged variable of ROA, as suggested by Kothari et al. (2005). The PACDA are similar to
RECDA calculated by Ashbaugh et al. (2003). The parameters for calculation of expected current accru-
als ECA are estimated by using the following equation:

TCAit 1 DREVit
a0 a1 a2 ROAit1 eit 1
ATit1 ATit1 ATit1
The expected current accruals (ECA) use the estimated parameters as follows:

ECAit 1 DREVit DARit
a0 a1 a2 ROAit1 2
ATit1 ATit1 ATit1
where
TCA total current accruals is net income (earnings before extraordinary items and discontinued oper-
ations) plus depreciation and amortization minus operating cash ows for rm i in the year t
DREV change in net revenue for rm i in the year t
DAR change in accounts receivable for rm i in the year t
ROA ratio of net income before extraordinary items to total assets for rm i in the year t 1
AT total assets for rm i in the year t
eit error term for rm i in year t
Consistent with the models developed by Kothari et al. (2005) and Ashbaugh et al. (2003), current
discretionary accruals are dened:

TCAit ECAit
PACDA
ATit1 ATit1
The model is estimated separately for each combination of two-digit SIC code and year to obtain
industry-specic estimates of the coefcients in Eq. (1).
A.2. Calculation of total discretionary accruals (TDA)
According to the modied Jones model, the scaled total discretionary accruals are calculated as a
difference between total accruals and non-discretionary accruals, scaled by total assets for the begin-
ning period, whereas the total accruals (TA) are the difference between net income and cash ows
from operations.

TAit NDAit
Discretionary accruals TDA 3
ATit1 ATit1
The parameters for calculation of non-discretionary accruals (NDA) are estimated by using the fol-
lowing equation:

TAit 1 DREVit PPEit
a0 a1 a2 eit 4
ATit1 ATit1 ATit1 ATit1
The NDA are estimated based on the parameters obtained from Eq. (4):

NDAit 1 DREVit DARit PPEit
a0 a1 a2 5
ATit1 ATit1 ATit1 ATit1
where
TA total accruals, measured as the difference between net income (earnings before extraordinary
items and discontinued operations) and operating cash ows for rm i in the year t
DREV change in net revenue for rm i in the year t
DAR change in accounts receivable for rm i in the year t
PPE property, plant and equipment for rm i in the year t
AT total assets for rm i in the year t
eit error term for rm i in year t
The model is estimated separately for each of two-digit SIC code and year to obtain industry-spe-
cic estimates of the coefcients. In case the number of observations for the two-digit SIC is less than
8, we combine the two-digit SIC codes. It should also be noted that, as suggested in the literature,
change in accounts receivable (DAR) is not included in estimating the parameters, but is included
in estimating non-discretionary accruals (e.g., Ashbaugh et al., 2003).
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J. Account.

Public Policy 28 (2009) 281300

Contents lists available at ScienceDirect

J. Account. Public Policy

Family control, board independence and earnings

JEL classication: In this study, we document that independent corporate boards of

2. Background of the study

2.1. Institutional environments of Hong Kong rms

2.2. Agency problems in the Hong Kong ownership structure

2.3. Regulations on the presence of INEDs on corporate boards

3. Research questions and hypotheses

3.1. Corporate board independence and earnings management

4. Sample selection and research methodology

4.1. Sample selection and data collection procedures

Two-digit SIC group Year Total

4.2. Family board members and family ownership

4.3. Corporate board independence

4.4. Calculation of discretionary accruals and accrual quality

4.5. Regression models

B. Jaggi et al. / J. Account. Public Policy 28 (2009) 281300

B. Jaggi et al. / J. Account. Public Policy 28 (2009) 281300

5.1. Descriptive statistics

5.2. Regression results

5.2.1. INEDs and earnings management

5.2.2. Family control, INEDs and earnings management

As an additional analysis, we conduct regression tests on the sub-samples of family-controlled and

5.2.3. Discussion on control variables

5.2.4. Earnings benchmark test

INCREASEit b0 b1 PINEDit b2 FAMitj b3 FAMitj PINEDit b4 LITIGATIONit b5 MBit b6 lnMVEit b7 BIG5it

Family ownership Family board control

5.2.5. Additional robustness tests

A.1. Calculation of performance-adjusted current discretionary accruals (PACDA)

The cross-sectional performance-adjusted current discretionary accruals (PACDA) are calculated by

A.2. Calculation of total discretionary accruals (TDA)

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