Are Independent Directors and Supervisory Directors Effective in Constraining Earnings Management?

Murya Habbash, Lijuan Xiao, Aly Salama, Robert Dixon

Research output: Contribution to journalArticlepeer-review

Abstract

Extant academic literatures on earnings management indicate that it has attracted considerable attention of scholars. With the eruption of Internet bubble in 2000, the ugly truth started to expose in front of the public. The financial scandal from Xerox shocked the capital market, disclosed by $1.4 billion overstated profits over the past four years. However, it was merely a tip of an iceberg. Followed Xerox incident, more influential accounting frauds subsequently were revealed, including WorldCom1, Adelphia, Tyco and Global Crossing. The investors suffered huge losses in the corporate scandals, which undermined the investors' confidence in the integrity of the capital markets (Ronen and Yaari 2008).

The most influential definitions of earnings management in existing literature are from Schipper (1989) and Healy and Wahlen (1999). The former defines earnings management as a 'purposeful intervention in the external financial reporting process, with the intent of obtaining some private gain'. The latter defines 'earnings management occurs when managers use judgment in financial reporting and in structuring transactions to alter financial reports to either mislead some stakeholders about the underlying economic performance of the company, or to influence contractual outcomes that depend on reported numbers'.

More recently, studies of earning management in emerging countries have flourished, because there is a higher demand for capital in the emerging stock markets. Mainland China (excluding Hong Kong, Macau and Taiwan) is a special and interesting case to be studied with its unique political, social and economic environment. Chinese government led by the Chinese Communist Party. Since the Economic Reform2started in 1978, China has transferred from a centrally planned economy to a market economic system with socialist characteristics. The single form of the economic entity at that time was state-owned enterprise (SOE)3. China started demutualization in the early 1990s, because the government found that the ownership structure of SOEs hinders enterprises' economic efficiency (Tan and Wang 2004; Chen 2005).China is the largest developing country with startling economic growth(GDP quadrupled) which attracts considerable attention of researchers and potential investors all over the world (Ding, Zhang et al. 2007).Both institutional and individual investors are seeking investment opportunities in the Chinese capital market4. Meanwhile, the Chinese stock market has been criticized for high speculation and extensive insider dealings (Hu, Tam et al. 2010).

As stated by Chen et al.(2008), earnings management is an indicator of corporate governance quality and investor protection standard, suggesting the effectiveness of market regulation and policy enforcement. Previous studies have documented that rampant earnings management phenomenon does exist in China driven by stringent CSRC regulations (Aharony, Lee et al. 2000; Chen and Yuan 2004; Haw, Qi et al. 2005; Ding, Zhang et al. 2007; Chen, Wang et al. 2008). The incidents of accounting scandals in China, such as Yin Guang Xia, Lantian, and Zhengzhou Baiwen, in which the interests of minority shareholders are exploited by controlling shareholders via related party transactions and falsifications of financial reports (Hu, Tam et al. 2010). Ding et al.(2007) claim that 'the conflict of interests between controlling shareholders (the State) and minority shareholders is the root cause of earnings management in China.' Even worse, the State is playing dual roles as both controlling shareholder and regulator (Clarke 2003; Chen, Firth et al. 2006;Liu and Lu 2007).

In order to help SOEs to raise capital and improve their economic efficiency, Chinese stock market was established with the opening of Shanghai Stock Exchange (SHSE) in 1990 and the Shenzhen Stock Exchange (SZSE) in 1991. With the development of Chinese capital market, Tricker (2009, p. …
Original languageEnglish
Pages (from-to)125-160
JournalJournal of Business Finance and Accounting
Volume5
Issue number1
Publication statusPublished - Jan 2014
Externally publishedYes

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