Managerial Ownership Structure and

Earnings Management

Chi-Yih Yang
Minghsin University of Science and Technology, Taiwan and
Xi’an Jiaotong-Liverpool University, China.
Email: chiyih.yang@xjtlu.edu.cn

Hung-Neng Lai
National Central University, Taiwan

Boon Leing Tan

Xi’an Jiaotong-Liverpool University, China

This study examines the relation between managerial ownership structure

and earnings management. Unlike previous research which treats insiders as
a homogeneous group, we further classify insiders into executives, outside
directors, and blockholders to conduct an in-depth study. Earnings
management is captured by discretionary accruals that are estimated using
the modified Jones model. For a large sample of Taiwanese listed firms over
the period 1997 and 2004, we find that discretionary accruals first increase
and then decrease with executive ownership, forming an inverted U-shaped
relationship. However, discretionary accruals are positively affected by
director ownership and blockholder ownership. The results suggest that equity
stake owned by top officers of a firm should be encouraged in order to reduce
agency cost, thus enhancing information content of earnings.
Keyword: Agency Cost, Managerial Ownership, Earnings Management,
Discretionary Accruals.

Introduction

The existence of accounting-based contractual constraints encourages

managers to exploit latitude available in accepted accounting procedures,
yielding accounting numbers not necessarily reflecting the economic substance
of underlying transactions. Schipper (1989) defines earnings management as
purposeful intervention in the external financial reporting process, with the
intent of obtaining some private gain. Healy and Wahlen (1999) also provide a
good definition of earnings management. They state:

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Journal of Financial Reporting & Accounting

“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 accounting numbers.” (p. 368).
A very important part of the definitions above is the intent to mislead or
influence outcomes for private gains. Managers can use earnings management
to extract rents from shareholders. Such gains could take the form of increased
compensation (Healy, 1985) or reduced likelihood of dismissal when performance
is low (Weisbach, 1988). Much accounting research investigates whether
managers exercise their accounting discretion to influence reported earnings.
Following Healy’s (1985) seminal paper, a considerable number of studies have
examined management’s motivation to “adjust” earnings, such as initial public
offerings (Roosenboom et al., 2003), and seasoned equity offerings (Rangan,
1998). However, relatively little work has examined factors that constrain earnings
management. The purpose of this study is to examine the role of corporate
governance in constraining earnings management, especially focusing on the
mechanism of managerial ownership.
The main tasks of corporate governance mechanisms are to reduce equity
agency cost and to enhance the information transparency of public-listed
companies. Jensen and Meckling (1976) argue that the interests of managers
and external shareholders converge when managers own greater shares of the
firm. In this case, the incentive to fool the stock market declines and earnings
quality is expected to increase with the level of managerial ownership. Warfield
et al. (1995) observe a negative relationship between managerial ownership and
the magnitude of absolute discretionary accruals. However, much of the work
done to date has merely documented the effect of insider ownership as a whole,
with little attempt to assess the impact of managerial ownership structure. Nunn
et al. (1983) propose a hierarchy among the insiders, i.e. a broad definition of
management, regarding their functional roles within a firm. With direct
responsibility for promoting all major corporation policies, executives are
expected to have the greatest access to non-public information. Outside
directors, sometimes referred to as non-executive directors, are members of
board of directors of a company who are not employees of the corporation.
They are not involved in the day-to-day running of business but monitor the
executive activity and contribute to the development of strategy. Blockholders,
those holding 5% or more of the outstanding shares, do not take part in the
day-to-day operations of the firm and would not normally be consulted on
major corporate decisions. In this paper, insiders are thus classified into
executives, directors, and blockholders to carry out a more detailed analysis. To
the best of our knowledge, this is the first earnings management study to
account for the composition of managerial ownership.
We consider the Taiwanese setting because Taiwan is “the hidden center
of the global economy” and “the global economy couldn’t function without it”

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 Managerial Ownership Structure and Earnings Management

(Businessweek, 2005). Taiwan enjoys global competitive advantage in high-

tech industry, and is the number 1 manufacturer of 40 IT products, such as 79%
of the world’s PDAs, 72% of the world’s laptops, 68% of the world’s LCD
monitors, and so on. Taiwan’s success is also China’s. 40% to 80% of China’s
exports in information and communications hardware are made in Taiwanese-
owned factories. It is often claimed that one of the major reasons for the success
of Taiwan’s information technology sector is due to the adoption of a unique
stock-based compensation plan since the early 1990s (Han, 2003). In this so-
called “Taiwan-style profit sharing and employee stock ownership plans”,
companies distribute shares, rather than stock options, to employees as a bonus.
However, earnings manipulation in this newly industrialized country is an issue
more severe than in most of the other countries around the world. Leuz et al.
(2003) examine data across 31 countries and document that Taiwan is ranked
the sixth highest in terms of earnings management score. Accordingly, investors,
both domestic and international, are faced with higher risk and need more
guidance when encountering Taiwanese firms. To provide a valuable lesson for
other developing economies in terms of corporate governance, empirical
evidence on whether managerial stock ownership affects earnings management
in Taiwan is thus worth exploring.
The remainder of the paper is organized as follows. Section 2 briefly reviews
the literature on managerial ownership and earnings management. Section 3
reports research methodology and data. Section 4 presents the statistical tests
and results. Concluding comments appear in Section 5.

Literature Review

Managerial Ownership and Agency Cost

Despite the importance of potential implications, there exists no theoretical or

empirical consensus on whether managerial ownership reduces agency cost.
On the one hand, agency theory predicts a positive relation between ownership
retention and firm performance. Jensen and Meckling (1976) suggest that
managers deviate from the goal of shareholder wealth-maximization by
consuming prerequisites when they do not have an ownership stake in the firm.
Accordingly, higher managerial stock ownership is hypothesized to align
managerial interests with shareholder interests. Leland and Pyle (1977) show
that the entrepreneur’s willingness to invest in his own project can serve as a
signal of project quality, and that the value of the firm increases with the share
of the firm held by the entrepreneur.
On the other hand, the risk of entrenchment also increases with greater
managerial ownership, as management is protected from the threat of a hostile
takeover. In a seminal study of Morck et al. (1988), the existence of a nonlinear
relationship between management ownership and firm performance has been

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Journal of Financial Reporting & Accounting

proposed. They find a positive relationship between Tobin’s q and insider

ownership for the 0% to 5% board ownership range, a negative relationship in the
5% to 25% board ownership range (where managers are entrenched), and a positive
relationship again for board ownership exceeding 25%. McConnel and Servaes
(1990) then observe an inverted U-shaped relationship between insider ownership
and Tobin’s q, where insiders are defined as the officers and directors of a firm.
In addition, several investigators have proposed that managerial ownership
and firm performance are irrelevant, such as Demsetz and Lehn (1985), Agrawal
and Knoeber (1996), and Himmelberg et al. (1999).

Managerial Ownership and Earnings Management

Healy and Wahlen (1999) conclude that earnings management occurs in four
cases, where managers manage earnings to (1) window dress the financial
statement prior to the offering of securities to the public, (2) increase manager
compensation or job security, (3) avoid violating debt covenants, or (4) reduce
regulatory costs and/or increase benefits. Although earnings management has
received considerable attention in the accounting literature, there is little empirical
evidence on the relation between equity incentives and earnings management.
Moreover, the results are mixed and can be grouped into negative relation, no
relation, U-shaped relation, and positive relation as follows.
According to Jensen and Meckling’s (1976) agency theory, Warfield et al.
(1995) hypothesize that managers of low managerial ownership have greater
incentives to manage accounting numbers to relieve or relax the behavioral
constraints imposed in accounting-based contracts. Warfield et al. examine US
data from 1988 to 1990 and find a negative relationship between managerial
ownership and the absolute value of discretionary accruals.
Interestingly, in contrast to the results of Warfield et al. (1995), Francis et
al. (1999) analyze US data in 1994 and conclude that there is no systematic
relationship between management ownership and accounting accruals.
Gabrielsen et al. (2002) examine Danish data from 1991 to 1995 and report no
relationship between managerial ownership and absolute abnormal accruals.
Yeo et al. (2002) examine Singapore-listed companies from 1990 to 1992 and
observe a U-shaped relation between director ownership and income-increasing
discretionary accruals. Earnings management decreases with managerial
ownership at low levels (£ 25%) but increases at higher levels of managerial
ownership where the entrenchment effect sets in. That is to say, high ownership
by management implies sufficient voting power to guarantee future employment
and as a consequence, becomes ineffective in aligning managers to take value-
maximizing decisions.
However, as stated by Michael Jensen, “Once a firm’s shares become
overvalued, it is in managers’ interests to keep them that way, or to encourage
even more overvaluation, in the hope of cashing out before the bubble bursts”

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 Managerial Ownership Structure and Earnings Management

(The Economist, 2002). That is, managers with high equity incentives could
benefit from earnings management with the objective of keeping stock prices
high and increasing the value of their shares to be sold in the future. According
to this argument, Cheng and Warfield (2005) hypothesize that managers with
high equity incentives are likely to sell shares and such trading behavior
motivates managers to care about short-tem stock prices and to manage
earnings. Unlike Warfield et al. (1995), Cheng and Warfield focus on the relation
between equity incentives and signed abnormal accruals and find that CEO
ownership is positively correlated with abnormal accruals.
All the previous studies regard managerial ownership as a whole without
looking into its composition. Traditional agency theorists treat property rights
as a “bundle” and neglect the knowledge and competence dimension of
governance (Grandori, 2004). In other words, “ownership” is considered as a
“package” of residual rights of control (which include decision rights) and
residual reward rights that can hardly be separated. However, organization
theory helps to overcome this limitation by proposing that decision rights
should be assigned to actors possessing relevant knowledge. Aghion and
Tirole (1997) and Prendergast (2002) suggest that if managers have private
information (i.e. specific knowledge), greater managerial shareholdings may
serve the purpose of inducing them to use this information so as to maximize
firm value. Grandori and Soda (2004) define a governance regime as a
combination of an allocation of property rights and an array of other
organizational mechanisms. They consider two categories of principals: investors
of human capital (highly qualified managers) and investors of financial capital
or their delegates in boards of directors, and suggest that decision rights should
be allocated where the relevant knowledge resides.
According to Nunn et al. (1983), there is a reason to believe that not all
insiders have equal access to non-public information. Sheu and Yang (2005a),
Sheu and Yang (2005b), and Yang and Sheu (2006) decompose insiders (a broad
definition of management) into executives, outside directors, and blockholders
to study the relationship between managerial ownership structure and different
measures of firm performance. They find that increasing executive ownership
beyond a certain percentage will help improve total factor productivity, technical
efficiency, and IPO survivability. Extending the above series of research on
managerial ownership structure, this study continues to contribute to the
corporate governance literature by investigating its influence on the behaviors
of earnings management.

Methodology

To examine whether the three components of managerial ownership, i.e., executive

ownership, director ownership, and blockholder ownership influence managers

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Journal of Financial Reporting & Accounting

in their reporting of earnings, we use a modified version of the Jones model

(Jones, 1991) developed in the accounting literature to estimate discretionary
accruals. Discretionary accruals are then modeled as a function of managers’
propensity to manage earnings and their actions to encourage or deter such
earnings management.

Measuring Earnings Management

Manipulation of operating accruals is likely to be a favored instrument for

opportunistic earnings management because they generally have no direct
cash flow consequences and are relatively difficult to detect. Healy (1985)
estimates the extent of such manipulation as the total accounting accruals,
defined as the difference between reported earnings and cash flows from
operations, since information on operational cash flow presents a more objective
measure of real economic performance than earnings. Total accruals are calculated
as the change in noncash working capital before income taxes payable less
total depreciation expenses. Thus:
TAit = (DCAit - DCashit) - (DCLit - DSTDit - DTPit) - Depit (1)
where for firm i in year t:
TAit = total accruals;
DCAit = change in current assets;
DCashit = change in cash and cash equivalents;
DCLit = change in current liabilities;
DSTDit = change in long-term debt included in current liabilities;
DTPit = change in income taxes payable; and
Depit = depreciation and amortization expenses.

Healy (1985) and DeAngelo (1986) decompose total accruals into

discretionary and nondiscretionary parts. Nondiscretionary accruals depend
on the level of activity of the firm, whereas discretionary accruals reflect
subjective accounting choices made by managers. Managers can exercise their
discretion over accounting methods and estimates as well as over the timing of
recognizing these accruals. The discretionary portion of total accruals is then
used as the proxy for earnings management.
The most frequently used models for separating nondiscretionary and
discretionary accruals are the Jones (1991) and modified Jones (Dechow et al.
1995) models. The current study adopts the modified Jones model under which
total accruals are regressed on gross property, plant and equipment and the
change in revenues adjusted for changes in receivables.
TAit ª 1 º ª ' REV it - ' AR it º ª PPE it º
D0 « »  D1 « »  D2 « »  H it (2)
Ait 1 ¬ A it -1 ¼ ¬ A it -1 ¼ ¬ A it -1 ¼

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 Managerial Ownership Structure and Earnings Management

Where, for firm i in year t :

Ait-1 = lagged total assets;
DREVit = change in sales revenues;
DARit = change in account receivables;
PPEit = gross property, plant and equipment; and
eit = error term.
According to Jones (1991), nondiscretionary accruals (NDAit) are defined
as the fitted TAit from equation (2). Discretionary accruals (DAit) are estimated
as the difference between reported TAit and its NDAit. In the equation, total
accruals include changes in working capital accounts, such as accounts
receivables, inventory and accounts payable, that depend to some extent on
changes in revenues. Revenues are employed to control for the economic
environment of the firm because they are an objective measure of the firms’
operations before managers’ manipulations. Gross property, plant and equipment
are included to control for the portion of total accruals related to nondiscretionary
depreciation expense. All variables in the accrual expectations model are scaled
by lagged assets to reduce heteroscedasticity. A positive DAit derived from
equation (2) is an income-increasing accrual because current asset is accrued
to overstate revenue, and a negative DAit is an income-decreasing accrual
because current liability is accrued to overstate expenses.
Assuming that changes in credit sales could also be a source of earnings
management, Dechow et al. (1995) modified the Jones model by adjusting the
changes in the revenues by subtracting the corresponding change in
receivables. This modified version of Jones model controls for both economic
transactions and firms’ credit policies. However, it implicitly assumes that all
changes in credit sales in the event period result from earnings management.
Under this assumption, Dechow et al. evaluate five alternative accrual-based
models (i.e., the Healey model, 1985; the DeAngelo model, 1986; the Jones
model, 1991; the industry model, 1991; the modified Jones model, 1995), and
find that the modified-Jones model provides the most powerful test in detecting
earnings management. The modified Jones model is also more effective at
modeling the time-series process generating nondiscretionary accruals and
suffers less from misspecifications caused by omitted determinants of
nondiscretionary accruals.

Empirical Models

To test the hypothesis whether large managerial shareholdings curtail managers’

incentives to use income-increasing or income-decreasing discretionary accruals,
we construct the following regression models
DA it E 0  E1 (INSit ) 2  E 2 INSit  E 3 OCFit  E 4 LEVit  E 5 SIZE it  E 6 AUD it
¦ j YEAR j  ¦K k SIC k  e it , (3)
j k

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Journal of Financial Reporting & Accounting

DA it J 0  J 1 (EXE it ) 2  J 2 EXE it  J 3 (DIR it ) 2  J 4 DIR it  J 5 (BLK it ) 2  J 6 BLK it

 J 7 OCFit  J 8 LEVit  J 9 SIZE it  J 10 AUDit  ¦ G j YEAR j  ¦K k SIC k  e it , (4)
j k

where DAit is signed firm i’s discretionary accruals at year t. To be comparable

with previous empirical studies, this study first follows the traditional approach
considering managerial ownership as a whole in equation (3). Therefore, INSit is
total insider holding ratio. Then total managerial ownership is decomposed into
three parts and further examined in equation (4). EXEit is executive holding ratio,
DIRit is outside director holding ratio, and BLKit is blockholder holding ratio,
respectively.
Since managerial ownership is unlikely to be the sole determinant of
discretionary accounting accruals, we need to control for other factors. To this
end, OCF, LEV, SIZE, AUD, YEAR, and SIC are included as control variables.
OCFit denotes cash flows from operations. Dechow et al. (1995) propose using
operating cash flows as a control variable in the specification of earnings
management models and Becker et al. (1998) report a negative relationship
between discretionary accruals and cash flow performance. LEVit represents
financial leverage. High leverage has been found to be related to the violation
of debt covenants. Positive accounting theory predicts that firms approaching
covenant violation will make income-increasing accounting choices to loosen
their debt constraints (Watts and Zimmerman, 1986, DeFond and Jiambalvo,
1994). However, DeAngelo et al. (1994) find that financially distressed companies
may manage earnings downward to get more concessions from the creditor.
SIZEit denotes firm size. Collins et al. (1987) show that the information content
of earnings is inversely related to firm size. Thus, larger companies are more
likely to have opportunities to manage their earnings for self-interest purpose.
However, size may also be associated with other economic characteristics of
the firm, e.g. political costs (Zimmerman, 1983). Larger companies may have less
incentive to engage in earnings management because they are subject to more
scrutiny from financial analysts and investors. Therefore, we include cash flows
from operations, leverage, and the log of total assets to control for the potential
effects on the choice of discretionary accruals. AUDit is an indicator variable
whether the firm has a Big 4 auditor. High-quality auditors are more likely to
restrain clients from using positive (income-increasing) discretionary accruals
to avoid shareholder litigation and to protect their hard-won reputations. Becker
et al. (1998), Francis et al. (1999), and Chung et al. (2005) have documented that
the level of discretionary accruals is lower for Big-6 audited companies. YEARj
is a dummy variable for year j, and SICk is a dummy variable for industry k. They
are added to control for the potential time-specific effects and the potential
industry-specific effects on discretionary accruals, respectively. Government
ownership in Taiwanese listed companies is minimal and thus not considered in
this study, because most state-owned enterprises in Taiwan have been privatized

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 Managerial Ownership Structure and Earnings Management

during the early 1990s in order to improve their productivity and administrative
operation (Wu, 2003).

Data and Variables

The empirical analysis is conducted by testing for earnings management using

a sample of panel data. Data are collected from 1306 Taiwan-listed firms found in
the Taiwan Economic Journal (TEJ) database. The sample period extends from
1997 to 2004. The final sample has a total of 7213 firm-year observations. Financial
firms are excluded from the sample because they use different accrual
procedures. Since the modified Jones model is effective at modeling the time-
series process, our panel-data sample seems to produce reasonably better
specified tests than the cross-sectional studies. Because panel data require
special statistical methods to estimate the regression function other than the
Ordinary Least Square (OLS) method, this study employs a longitudinal mixed
model and an inferential method named Restricted (or Residual) Maximum
Likelihood (REML) (McCulloch and Searle, 2000). The regression diagnostic
for REML is Akaike Information Criterion (AIC); a smaller value of AIC refers to
a better model.
To avoid the possible effects of reverse causality from performance to
ownership, the independent variable of insider stockholding takes value at the
beginning of the year. This approach of lagging the endogenous variables by
one-period is commonly used in longitudinal studies (see Palia and Lichtenberg,
1999, and Han, 2003). Detailed definitions of the variables are given as follows.
Discretionary accruals (DA) = Outcome of managers’ opportunistic choices of
discretionary accruals.
Total insider ownership (INS) = Percentage of outstanding shares owned by
insiders, which includes executives, outside directors, and large
shareholders. To be consistent with the managerial ownership literature
(Morck et al., 1988; McConnell and Servaes, 1990, etc.), employee stock
option is not regarded as management holding of shares.
Executive ownership (EXE) = Percentage of outstanding shares owned by
executives, including executive directors, sometimes referred to as inside
directors, who are the senior managers and also board members of a
company.
Board ownership (DIR) = Percentage of outstanding shares owned by outside
directors, excluding executive directors.
Blockholder ownership (BLK) = Percentage of outstanding shares owned by
large shareholders who own more than 5% shares or are among top 10
biggest owners of the firm.
Operating cash flows (OCF) = Cash flows from operations deflated by lagged
total assets.

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Journal of Financial Reporting & Accounting

Leverage (LEV) = Total liabilities divided by total assets.

Firm size (SIZE) = Natural log of total assets.
Auditor (AUD) = Dummy variable for Big-4 auditors (coded 1 if the observation
is audited by a Big 4 auditor and 0 otherwise).
Year dummy (YEAR) = Dummy variables for years within the test period.
Industry dummy (SIC) = Dummy variables according to the two-digit
standardized industry classification code from Taiwan Stock Exchange
Corporation (TSEC).

Results

Descriptive Statistics

Table 1 provides details about the sample distribution by year and by TSEC
industry code. The electronics industry has the largest number of companies,
with more than 51 percent of the total observations in the sample. This is
congruent with the statistics that in 2000 the electronics industry alone
accounted for 40% of the total sales and 72% of the total profits before taxes
generated by all firms listed on the TSEC. The remaining sample companies are
widely distributed across TSEC industry codes.

Table 1: Sample Firms by-year and by-industry Distribution

Industry (SIC) 1997 1998 1999 2000 2001 2002 2003 2004 Total (%)

Cement (01) 7 8 8 8 6 6 6 6 55 (0.76%)

Foods (02) 22 28 25 24 25 20 19 22 185 (2.56%)
Plastics (03) 18 20 18 20 20 23 23 21 163 (2.26%)
Textiles (04, 62) 52 59 59 54 56 54 53 50 437 (6.06%)
Electric & Machinery (05,63) 38 47 50 53 52 53 53 51 397 (5.50%)
Electric Cable (06) 14 15 14 14 13 15 15 14 114 (1.58%)
Chemicals (07,21) 33 37 47 54 60 60 67 69 427 (5.92%)
Glass & Ceramics (08) 7 5 6 6 6 6 6 7 49 (0.68%)
Paper (09) 5 6 5 5 5 5 6 6 43 (0.60%)
Iron & Steel (10) 32 34 35 35 31 26 25 25 243 (3.37%)
Rubber (11) 7 9 10 8 8 8 8 7 65 (0.90%)
Automobile (12) 5 4 4 5 3 2 3 1 27 (0.37%)
Electronics (13,22,23) 199 279 362 470 544 608 633 634 3,729 (51.70%)
Construction (14) 55 54 56 54 53 47 48 46 413 (5.73%)
Transportation (15) 13 15 18 16 18 15 17 17 129 (1.79%)
Tourism (16) 3 4 5 6 5 8 6 6 43 (0.60%)
Retailing (18) 12 13 12 13 12 13 13 14 102 (1.41%)
Others (19,20,80) 58 72 78 75 78 81 78 72 592 (8.21%)
Total 580 709 812 920 995 1050 1079 1068 7213 (100%)

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 Managerial Ownership Structure and Earnings Management

Table 2 provides the descriptive statistics for the sample. The average total
accrual deflated by lagged total assets is 0.0345 and its median is 0.0147. The
mean and median discretionary accruals are 0 and -0.0080. Insiders on average
own 45.49% of the shares of the firms, while executives, board members, and
blockholders hold 9.03%, 23.04%, and 13.42%, respectively. The mean and
median operating cash flows deflated by lagged total assets are 5.14% and
5.24%, respectively. The debt of the average firm equals 42.23% of its total
assets. About 80 percent of the listed firms are audited by a Big 4 auditor.

Table 2: Descriptive Statistics for the Sample (N = 7213)

Variable Mean Median Std. Deviation Min. Max.
TAit / Ait-1 0.0345 0.0147 0.1669 -1.3806 4.7737
DA 0 -0.0080 0.1587 -2.1730 3.6661
INS 45.49% 44.18% 18.47% 0.11% 100%
EXE 9.03% 5.61% 10.37% 0.01% 88.70%
DIR 23.04% 19.07% 16.10% 0% 98.37%
BLK 13.42% 11.84% 11.73% 0% 84.12%
OCF 5.14% 5.24% 15.86% -238.04% 373.81%
LEV 42.23% 41.20% 21.61% 1.84% 636.38%
SIZE 14.86 14.72% 1.28 10.96 20.00
AUD 0.8051 1 0.3962 0 1

Notes:
TA it / A it-1 = total accruals deflated by lagged total assets.
DA = outcome of managers’ opportunistic choices of discretionary accruals.
INS = percentage of outstanding shares owned by insiders, which includes
executives, outside directors, and large shareholders.
EXE = percentage of outstanding shares owned by executives, including
executive directors who are the senior managers and also board
members of a company.
DIR = percentage of outstanding shares owned by outside directors, excluding
executives directors.
BLK = percentage of outstanding shares owned by large shareholders who
own more than 5% shares or are among top ten biggest owners of the
firm.
OCF = cash flows from operations deflated by lagged total assets.
LEV = total liabilities divided by total assets.
SIZE = natural log of total assets.
AUD = dummy variable for Big-4 auditors (coded 1 if the observation is
audited by a Big 4 auditor and 0 otherwise).

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Journal of Financial Reporting & Accounting

Effect of Total Insider Ownership on Earnings Management

Table 3 presents the estimation results of the regression model (3) with total
insider holding ratio as the independent ownership variable, while the year
effects and the industry effects are omitted. Two models are reported: Model
3A contains the quadratic term of total insider ownership while Model 3B does
not.
In Model 3A, it is observed that the coefficient for (INS)2 is not statistically
significant (t-statistic = 0.28, p-value > 0.10), suggesting no quadratic relation
between total insider ownership and discretionary accruals. In Model 3B, the
square of total insider holding ratio is eliminated from Equation (3), and it is
found the coefficient for total insider ownership is significantly positive
(t-statistic = 5.77, p-value < 0.01), indicating a monotonic positive relationship
between total insider ownership and discretionary accruals. In terms of control
variables, the coefficient on OCF is significantly negative, suggesting firms
with strong operating cash flow positions are less likely to use discretionary
accruals to engage in earnings management. The significantly negative
coefficient on LEV suggests that firms with higher debt ratio tend to manage
earnings downward. The coefficient on SIZE is significantly positive, indicating
that larger companies have larger discretionary accruals. However, the
insignificant coefficient on AUD is inconsistent with that obtained by Becker et
al. (1998), Francis et al. (1999), and Chung et al. (2005). The year-effects and
industry-effects are statistically significant but the details for the 7 year-dummy
and 24 SIC-dummy variables are omitted.

Table 3: Regression of Discretionary Accruals on Total Insider Ownership

Independent Expected Model 3A Model 3B

Variable Sign Estimate (t-statistic) Estimate (t-statistic)
Intercept -0.2573 (-8.25)*** -0.2600 (-8.82)***
(INS)2 0.0117 (0.28) ¾ ¾
INS 0.0470 (1.12) 0.0584 (5.77)***
OCF - -0.2640 (-22.69)*** -0.2638 (-22.69)***
LEV + or - -0.0955 (10.42)*** -0.0953 (10.43)***
SIZE + or - 0.0176 (11.41)*** 0.0176 (11.45)***
AUD - -0.0023 (0.50) -0.0022 (-0.49)
YEAR YES*** YES***
SIC YES*** YES***
AIC (smaller is better) -6550.8 -6555.2
The dependent variable is discretionary accruals (DA).
YEAR, SIC: The year-effects and industry-effects are estimated in the regression though
not reported.
* significant at p < 0.1, ** significant at p < 0.05, *** significant p < 0.01.

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 Managerial Ownership Structure and Earnings Management

Evidence in Table 3 shows that discretionary accruals increase with insider

ownership as a whole, supporting the positive relation between managerial
ownership and signed abnormal accruals empirically determined by Cheng and
Warfield (2005). However, since distinct groups of insiders may have different
levels of involvement concerning strategic development and daily operation in
a firm, this research continues to carry out a detailed analysis for top officer
ownership and board member ownership, respectively.

Effects of Managerial Ownership Structure on Earnings Management

Table 4 presents the estimation results of the regression model with the
composition of managerial ownership as the independent ownership variables
(Equation 4), while the year effects and the industry effects are omitted. Two
models are reported: Model 4A contains the quadratic terms of executive holding
ratio, outside director holding ratio, and blockholder holding ratio, while model
4B eliminates those which are not statistically significant.
In Model 4A, it is observed that the coefficient for (EXE)2 is significantly
negative (t-statistic = -3.11, p-value < 0.01), showing an inverted U-shaped
relation between executive ownership and discretionary accruals. The coefficient
for (DIR)2 and (BLK)2 are not statistically significant (p-value > 0.10), suggesting
no quadratic relation between director ownership and discretionary accruals or
between blockholder ownership and discretionary accruals.
Consequently, in Model 4B we re-estimate equation (4) after eliminating
the insignificant independent variables (DIR)2 and (BLK)2, and observe that the
coefficient for (EXE)2 is still significantly positive (t-statistic = -3.09,
p-value < 0.01), indicating an inverted U-shaped relationship between executive
ownership and discretionary accruals. The coefficient for (DIR) is significantly
positive (t-statistic = 4.07, p-value < 0.01), and the coefficient for BLK is also
significantly positive (t-statistic = 3.66, p-value < 0.01), indicating a monotonic
positive relationship between both director ownership and blockholder
ownership and discretionary accruals. In terms of control variables, the results
are consistent with the findings in Table 3.
Summing up the results from the two models in Table 4, we can see that
discretionary accruals first increase and then decrease with the executive holding
ratio, whereas discretionary accruals are positively related to the outside director
and the blockholder holding ratios, respectively. The inverted U-shaped
relationship between executive ownership and discretionary accruals here is
consistent with the related analyses where increasing executive ownership
beyond a certain percentage will help improve firm performance such as total
factor productivity (Sheu and Yang, 2005a), technical efficiency (Sheu and
Yang, 2005b), and IPO survivability (Yang and Sheu, 2006), respectively. One
possible explanation for this phenomenon might be the fact that most executives
nowadays own proprietary knowledge and therefore the magnitude of

47
Journal of Financial Reporting & Accounting

information asymmetry between shareholders and managers is enhanced.

Greater executive shareholdings may serve the purpose of inducing them to
use this information so as to maximize firm value. Thus, agency costs are likely
to be reduced when the executive-to-insider holding ratio rises above a certain
level. On the other hand, the positive relationship between board and
blockholder ownership and discretionary accruals may be explained by the
argument of Wahal and McConnell (2000) that institutional investors focus on
short-term portfolio performance and individual investors generally are impatient.
Corporate managers, in turn, may behave myopically and manage their firms so
as to avoid the appearance of any sag in short-term earnings.

Table 4: Regression of Discretionary Accruals on Managerial

Ownership Structure

Independent Expected Model 4A Model 4B

Variable Sign Estimate (t-statistic) Estimate (t-statistic)
Intercept -0.2925 (-9.48)*** -0.2942 (-9.47)***
(EXE) 2
-0.2620 (-3.11)*** -0.2595 (-3.09)***
EXE 0.2175 (5.37)*** 0.2167 (5.36)***
(DIR) 2
0.0115 (0.23) ¾ ¾
DIR 0.0412 (1.18) 0.0488 (4.07)***
(BLK)2 0.0396 (0.46) ¾ ¾
BLK 0.0430 (1.13) 0.0588 (3.66)***
OCF - -0.2647 (-22.77)*** -0.2644 (-22.76)***
LEV + or - -0.0955 (-10.47)*** 0.0950 (-10.47)***
SIZE + or - 0.0195 (12.13)*** 0.0194 (12.23)***
AUD - -0.0019 (0.43) -0.0019 (-0.42)
YEAR YES*** YES***
SIC YES*** YES***
AIC (smaller is better) -6553.2 -6560.1
The dependent variable is discretionary accruals (DA).
YEAR, SIC: The year-effects and industry-effects are estimated in the regression though
not reported.
* significant at p < 0.1, ** significant at p < 0.05, *** significant at p < 0.01.

Conclusions

Theories and some previous empirical investigations suggest that the managerial
equity ownership may influence their behavior on earnings management. This
investigation attempts to shed light into the role that managerial ownership

48
 Managerial Ownership Structure and Earnings Management

structure plays in the accounting choices of a firm. Thus, the composition of

insider ownership is closely examined in this paper, which to our knowledge
has never been done in the earnings management literature.
Consistent with the result of Cheng and Warfield (2005), our research
identifies a statistically significant positive relationship between total insider
ownership and discretionary accruals. However, after decomposing total insider
ownership, we find that discretionary accruals first increase and then decrease
with executive ownership, forming an inverted U-shaped relationship.
Additionally, discretionary accruals are positively influenced by the increase in
outside director ownership and blockholder ownership.
The quality of corporate governance plays a major role in determining the
competitiveness and dynamism of the corporation and its markets. Accounting
scandal as a result of agent’s manipulation or management of earnings will go
far beyond the failure of the corporation because it erodes public confidence in
financial reporting. Thus, on a broader level, corporate governance ultimately
affects the stability and the growth of both domestic and global economies. In
any discussion on corporate governance, accountability is always considered
a major issue. However, earnings will not be managed unless there are incentives
for managing them. This study has explicitly pointed out that different types of
insiders might have different incentives in manipulating earnings. For executives,
sufficient stockholdings beyond a certain level would give these professional
managers a sense of commitment to the firm, and thus improve informational
transparency of earnings. But the other two types of insiders, i.e. directors and
blockholders, might merely act as plain investors; their market incentives to
manage earnings arise when perceiving a connection between reported earnings
and the corporation’s market value.
Our disaggregated results by the different types of insider ownership, i.e.
executive shareholding versus director and blockholder shareholdings, might
also support the argument for the efficient property rights allocation as a function
of the distribution of knowledge. For the two categories of principals, investors
of human capital (highly qualified managers) and investors of financial capital
(directors or blockholders), decision rights should be allocated to the investors
of human capital where the relevant knowledge resides. As the professional
managers take both roles of agents and principals at the same time, increasing
their stockholdings will align the interests of agents with the interests of
principals and reduce the agency cost of a firm.

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