Corporate Governance and Earnings Management: The Implications of Corporate Governance Best-Practice Principles for Taiwanese Listed Companies

Ken Y. Chen Associate Professor of Accounting National Cheng Kung University Department of Accounting Tainan, Taiwan 701 yachen@mail.ncku.edu.tw (886-6) 275-7575 ext. 53441

Randal J. Elder Associate Professor of Accounting Syracuse University Whitman School of Management Syracuse, NY 13244 rjelder@som.syr.edu (315) 443-3359

Yung-Ming Hsieh Lecturer of Accounting Soochow University Department of Accounting Taipei, Taiwan 100 armin@scu.edu.tw (886-9) 20512043

April 2007

We appreciate the valuable comments and suggestions from Ferdinand A. Gul (editor), Jeong-Bon Kim (discussant), and participants at the 2006 Journal of Contemporary Accounting and Economics Symposium, and Mike Willenborg (discussant) and participants at the 2006 American Accounting Association Auditing Section Mid-Year Conference.

Electronic copy of this paper is available at: http://ssrn.com/abstract=981926

Corporate Governance and Earnings Management: The Implications of Corporate Governance Best-Practice Principles for Taiwanese Listed Companies

Abstract This study investigates whether corporate governance characteristics, mandated by the Corporate Governance Best-Practice Principles (CGBPP) for companies listed in Taiwan, are associated with earnings management. In particular, we examine whether the independence, financial expertise, and voluntary formation of independent directorship (supervisorship) are associated with the absolute value of discretionary accruals. Our findings suggest that the independence of supervisors, financial expertise of independent directors, and voluntary formation of independent directorship (supervisorship) are associated with lower likelihood of earnings management. These findings are stronger after the CGBPP was enacted, suggesting that the implementation of CGBPP has lowered the likelihood of earnings management. Keywords: corporate governance, earnings management, financial expertise, family control, group-affiliation

Electronic copy of this paper is available at: http://ssrn.com/abstract=981926

1. Introduction The integrity of financial reporting has been a consistent concern among regulators and practitioners, especially after high-profile accounting scandals involving once well-respected companies such as Enron and WorldCom. Earnings management has also been a concern of regulators and practitioners for several years (e.g., Levitt 1998), because it erodes the quality of financial reporting. In response to calls for strengthening corporate governance mechanisms to enhance the oversight function of the board of directors and to restore public confidence in the integrity of financial reporting, the Taiwan Stock Exchange Corporation (TSEC) and GreTai Securities Market (GTSM) promulgated the Taiwan Corporate Governance Code. This code requires companies listed on the TSEC and GTSM to appoint independent directors and supervisors, including at least one financial expert, and to establish an audit committee.1 Motivated by the adoption of the newly enacted Corporate Governance Best-Practice Principles (CGBPP), we examine the association between these corporate governance mechanisms and earnings management in Taiwan.2 Prior studies address the importance of corporate governance in constraining earnings management in the U.S., the U.K., or Canada (e.g., Beasley 1996; Klein 2002; Park and Shin 2004; Peasnell et al. 2005), and in emerging markets (e.g. Claessens et al. 2000; La Porta et al. 2000; Kim and Yi 2006). Our study differs from prior research that examines the relation between corporate governance and earnings management in emerging markets (e.g., Kim and Yi 2006; Lee and Liao 2004) by

TSEC was established in the early 1960s whereas GTSM, a computerized over-the-counter market, was established in the early 1990s. The Emerging Stock Exchange, a second computerized over-the-counter market, was established in January 2002 to offer growth enterprises an avenue to raise capital. 2 The CGBPP can be retrieved from http://eng.selaw.com.tw/ShowNews.asp?LSID=FL020553. 3

Electronic copy of this paper is available at: http://ssrn.com/abstract=981926

focusing on the corporate governance mechanisms mandated by the CGBPP regulation in the Taiwanese market, which was designed to strengthen the corporate governance function and enhance the integrity of financial reporting following the 1997 Asian financial crisis. Specifically, we use board independence and financial expertise of independent directors (supervisors) mandated by the CGBPP as measures of corporate governance, and posit that firms with better corporate governance mechanisms are associated with less earnings management in Taiwan. We also examine whether the voluntary formation of independent directorship and/or supervisorship is associated with the lower likelihood of earnings management in Taiwan. Moreover, we focus on the role of the CGBPP regulation in firms after the enactment of the CGBPP to further examine the relation between corporate governance mechanisms and earnings management. Using the CGBPP sample, this setting provides deeper insights to understand how firms respond to corporate governance regulation with the aim of enhancing the quality of financial reporting. We select the sample from the Market Observation Post System (MOPS) and the Taiwan Economic Journal (TEJ) database, which includes companies listed on the TSEC and GTSM.3 Our sample period covers the pre-CGBPP period (years 2000 and 2001) and post-CGBPP period (years 2002 and 2003), allowing us to examine whether and how the CGBPP influences firms earnings management behaviors. We use the absolute value of discretionary accruals as a proxy for the earnings management dependent variable, and independence, financial expertise and voluntary

The MOPS was established by the TSEC and GTSM in June 2002. It provides a channel for public companies to submit information to TSEC/GTSM as required via the internet. The information comprises financial statements, financial forecasts, proxy statements, and information related to directors, supervisors, and managers, such as changes in shareholdings and pledges of shares, dividends, material information, etc. 4

formation of independent directorship and/or supervisorship are the research variables of interest. Using a sample of 2,024 firms listed on the TSEC/GTSM, we find that firms with independent supervisors are associated with lower discretionary accruals for the full sample, suggesting that more board seats for independent supervisors is associated with lower likelihood of earnings management.4 We also find that firms with independent directors having financial expertise are associated with lower levels of earnings management. Consistent with the signaling hypothesis, we find that firms that have voluntarily hired independent directors and/or supervisors are associated with lower earnings management when compared with firms where independent directors and supervisors are not voluntarily hired. This suggests that the voluntary formation of independent directors and/or supervisors in firms gives a credible signal of corporate governance practices. These findings are stronger for the 654 firms in the CGBPP sample. Since family-control and business group affiliation are dominant characteristics in Taiwanese listed companies, we further examine whether family-controlled firms and group-affiliated firms are more likely to engage in opportunistic earnings management in this emerging market. We use the deviation between control rights and cash flow rights to measure the control-ownership wedge, and use the threshold of at least three listed firms from either the TSEC or GTSM to define the group-affiliation membership. We provide evidence that family-controlled firms, but not

group-affiliated firms, are more likely to engage in opportunistic earnings management.

Under Article 216 of the Company Law, supervisors of a company shall be elected by a shareholders meeting, and at least one supervisor shall have a domicile within the territory of Taiwan. Supervisors in Taiwan are responsible for monitoring directors and management, and their function is equivalent to the audit committee in the United States. 5

Our study extends the existing literature linking corporate governance and earnings management by examining changes in regulation in an emerging market where weak corporate governance is prevalent. Our study provides policy implications for other emerging markets by documenting that board independence and financial expertise of independent directors mandated by the CGBPP are important factors in constraining earnings management in this setting. The remainder of this paper is organized as follows. The next section describes the corporate governance environment in Taiwan. Section III discusses related research and the development of the hypotheses, followed by the research design and sample description in Section IV. Section V discusses the empirical test results and additional analyses, and Section VI concludes the study.

2. Corporate Governance Environment in Taiwan 2.1 Background Although the concept of corporate governance did not appear in Taiwan until the 1997 Asian financial crisis, some internal governance systems, such as enhancing information disclosure and transparency and implementing internal control systems, were required by the Company Law and Securities Law.5 The regulatory two-tier structure of corporations in Taiwan consists of a board of directors and supervisors, which differs from the board single apex decision control system in public corporations described in Fama and Jensen (1983), but is intended to assume the same oversight responsibilities in the best interests of shareholders.

Neither the Company Law nor Securities Law is sufficient to provide effective mechanisms to monitor the self-interest of managers or owners. Taiwan was heavily dampened by the 1997 Asian Financial Crisis. Several explanations are proposed to explain the 1997 Asian Financial Crisis: unfavorable macroeconomic conditions, weak corporate governance, and lack of reliable accounting information. 6

The board of directors in Taiwan should consist of at least three directors (192 Company Law), and boards of public companies should include at least five directors (17 Supplementary Rules to TSEC Listing Rules). This two-tier regulatory structure has a unique characteristic that supervisors are responsible for monitoring the directors while directors are responsible for managing the company. Supervisors in Taiwan do not participate in decision-making or the voting process, but they are designated to monitor the board of directors. They are responsible for providing an independent and objective review of the financial reporting process, internal controls, and the audit function. Therefore, supervisors in Taiwan can wield significant oversight power and are potentially powerful. Taiwanese listed companies are characterized by family-control, group-affiliation, cross-shareholding and lower institutional ownership. Family-control is a dominant feature of small- and medium-sized enterprises in Taiwan, and even typical of listed companies (Claessens et al. 2000; La Porta et al. 1999; Yeh et al. 2001).6 Most businesses in Taiwan start from a primary industry and gradually diversify to reduce risk and expand their business. Group-affiliated companies may also use cross-shareholding to strengthen their control; however, funds transferred within the group are less transparent. Under the 2001 amended Company Law (167), cross-shareholding among affiliated corporations is prohibited. Individual investors, constituting around 80 percent of the trading volume, are the major participants in the Taiwanese stock market. 7 According to a report by the Financial Supervisory Commission (FSC), foreign institutional investors own about 10.9 percent, domestic
6

Claessens et al. (2000) find that 80 percent of management in Taiwanese listed companies are from the controlling family. Yeh et al. (2001) report that 76 percent of Taiwanese listed companies are controlled by family shareholders. 7 Taiwan opened its securities market to foreign investors in three stages. It first allowed foreign investment in its securities markets indirectly through investment funds in 1982. Then, it opened the market for foreign institutional investors in 1990. In 1996, all foreign institutions and individuals were allowed to invest in Taiwans securities market. 7

institutional investors hold 11.6 percent, and domestic individual investors own 75.9 percent of outstanding shares in year 2004 (SFB 2005).8 2.2 The Newly Enacted CGBPP The Taiwan securities regulator (SFB) has advocated improved corporate governance for public companies since 1998. Recent well-publicized accounting scandals in the U.S., such as Enron and WorldCom, have triggered the regulator to enact the CGBPP for companies listed on TSEC and GTSM. Its contents consist of protection of shareholders rights, functions and responsibilities of Boards and Supervisors (i.e., the Supervisory Board), the role of stakeholders in corporate governance, disclosure and transparency, and the special managerial circumstances that companies face (SFI 2005). Under the CGBPP, it is mandatory for firms applying for initial public offerings (IPOs) on TSEC (starting February 22, 2002) and GTSM (starting February 25, 2002) to first adopt the newly enacted features including: (1) increased board independence (at least two independent directors and one independent supervisor on the board); (2) separation of board chairman and CEO; (3) establishment of independent committees on the board (such as an audit committee, nomination committee, and compensation committee); (4) disclosure of corporate governance practices; and (5) Director & officer liability insurance for board members. Securities firms and other financial institutions, such as banks and insurance companies, have followed suit to develop their own best-practice principles. Starting January 1, 2007, all public companies must establish audit committees to replace independent supervisors, and appoint independent directors as required by the Securities Law (183 and 14-2).

On July 1, 2004, the Security and Future Commission, the Securities Exchange Commission (SEC in U.S.) counterpart in Taiwan, was renamed as the Securities and Futures Bureau (SFB), and is directly governed by the FSC. 8

3. Related Research and Development of Hypotheses According to the agency theory, separation of ownership and control leads to a divergence between manager and owner interests (Jensen and Meckling 1976). Thus monitoring managerial decisions becomes essential for boards of directors to assure that shareholders interests are protected (Fama and Jensen 1983). However, the fundamental agency problem for listed companies in emerging markets is not a conflict of interest between outside investors and managers as argued by Berle and Means (1932), but a conflict of interest between controlling shareholders and minority shareholders (Shleifer and Vishny 1997). Effective monitoring from boards and audit committees is very important to ensure reliable and complete financial reporting. Since earnings management misleads users of financial statements by providing them with false information about a firms true operating performance, the internal corporate governance of the board of directors and audit committees serves a monitoring role in constraining the occurrence of earnings management. 3.1 Earnings Management and Corporate Governance Best-Practice Principles Earnings management has been of consistent concern to regulators (e.g., Levitt 1998). Prior studies address the importance of corporate governance in constraining earnings management in the U.S., the U.K., or Canada (e.g., Beasley 1996; Bdard et al. 2004; Klein 2002; Park and Shin 2004; Peasnell et al. 2005; Xie et al. 2003), and in emerging markets (e.g. La Porta et al. 2000; Kim and Yi 2006), as well as limited studies in Taiwan (e.g., Lee and Liao 2004). These studies provide evidence that better corporate governance characteristics are associated with lower levels of earnings management. As described in the subsection of the Section II, the newly enacted CGBPP mainly focuses on the independent function of board directors and supervisors (e.g.,
9

24, 43, 27), and the requirement for financial experts (28). In the succeeding subsections, we develop our hypotheses based on the corporate governance characteristics applied to independent directors and supervisors. 3.2 Independence Outside or independent directors perform an important monitoring function in public corporations. They have greater incentives than inside directors to be effective monitors of management in order to preserve their reputational capital (Fama and Jensen 1983). Thus, they can mitigate agency conflicts between shareholders and management. Moreover, outside directors are more vigilant than inside directors because the former focuses on financial performance, which is a central component of monitoring (Fama and Jensen 1983; Johnson et al. 1993). Independent directors are more likely to draw on their wider experience and expertise in monitoring management and perform better as board members (Kosnik 1987). Prior studies suggest that board independence is associated with greater monitoring. For example, Beasley (1996) and Dechow et al. (1996) find that the proportion of independent directors on the board is negatively associated with the likelihood of financial statement fraud, suggesting that independent directors enhance a boards ability to properly execute its oversight function. Peasnell et al. (2005) report that in the U.K. outside directors are effective in constraining earnings management only after the issuance of the Cadbury Committee Report. Klein (2002) finds a negative relation between audit committee independence and abnormal accruals. Using two groups of U.S. firms (i.e., relatively high versus relatively low levels of abnormal accruals for the year 1996), Bdard et al. (2004) find that an audit committee composed entirely of non-related directors is negatively associated with the likelihood of aggressive earnings management. In a related study in Taiwan, Lee

10

and Liao (2004) find a significantly negative relation between board independence and the absolute value of abnormal accruals for non-family-controlled firms, but not for the overall sample of Taiwanese company observations for the year 2001. Under Article 24 (Article 43) of the CGBPP, a TSEC/GTSM listed company should stipulate an appropriate number of independent directors (supervisors) to be elected in the shareholders meeting after proceeding with the process set forth in Article 22 (Article 42) of the CGBPP.9 To fulfill their monitoring role and protect shareholders interests, a director and a supervisor must be independent of management. Based on the results demonstrated in prior studies and the requirements mandated by the CGBPP, we expect that more independent directors (supervisors) are more likely to be an effective monitoring mechanism and thus be more likely to constrain earnings management. Hence, we hypothesize the following: Hypothesis 1a: Firms with more independent directors will be less likely to engage in earnings management. Hypothesis 1b: Firms with more independent supervisors will be less likely to engage in earnings management. 3.3 Financial Expertise The third recommendation of the Blue Ribbon Committee requires that every audit committee should have at least one financial expert, which is even more restrictively defined under Section 407 of the Sarbanes-Oxley Act.10 In Taiwan, based

Under Article 22 (Article 42) of the CGBPP, it is advisable that the qualifications, education, working experience, background, and the existence of any other matters set forth in the Company Law with respect to the candidates recommended by shareholders or directors be reviewed in advance before being elected as the directors (supervisors) in a shareholders meeting. 10 Section 407 states: (a) the Commission shall consider whether a person has, through education and experience as a public accountant or auditor or a principal financial officer, comptroller, or principal accounting officer of an issuer, or from a position involving the performance of similar functions (1) an understanding of generally accepted accounting principles and financial statements; (2) experience in (A) the preparation or auditing of financial statements of generally comparable issuers; and (B) the application of such principles in connection with the accounting for estimates, accruals, and 11

on the Company Law and the Securities Law, the legal framework of corporate governance did not require firms listed on TSEC/GTSM to set up an audit committee until the enactment of the CGBPP. Under the CGBPP, at least one of the independent directors in the audit committee and supervisory board (28 and 51) should have professional expertise in accounting or finance. Audit committee members with financial expertise can perform their oversight roles in the financial reporting process more effectively and competently, such as evaluation of internal controls or detection of material misstatements (Abbott et al. 2004; Krishnan 2005; Raghunandan et al. 2001; Scarbrough et al. 1998). Xie et al. (2003) also find that firms having board members and audit committee members with financial expertise have lower discretionary current accruals. Abbott et al. (2004) find a significantly negative association between an audit committee having at least one member with financial expertise and the incidence of financial restatement. Bdard et al. (2004) find that the presence of at least one financial expert on the audit committee is associated with lower likelihood of aggressive earnings management. DeFond et al. (2005) find significantly positive cumulative abnormal returns around the appointment of accounting financial experts to the audit committee, suggesting that audit committee members with accounting financial expertise improve the audit committees ability to ensure high-quality financial reporting. These studies suggest that financial experts on boards and audit committees have the ability to improve the quality of financial reporting, which is consistent with the argument that financial expertise is essential for board and audit committee members to fulfill their primary responsibilities of overseeing the financial reporting process and enhancing financial reporting quality (SEC 2003). Therefore, we expect that an
reserves; (3) experience with internal accounting controls; and (4) an understanding of audit committee functions. 12

independent director (supervisor) with financial expertise is more likely to be an effective monitoring mechanism and is thus more likely to constrain earnings management. Hypothesis 2a: Firms with more independent directors having financial expertise will be less likely to engage in earnings management. Hypothesis 2b: Firms with more independent supervisors having financial expertise will be less likely to engage in earnings management. 3.4 Voluntary Formation of Independent Directorship and/or Supervisorship Prior research shows that the voluntary formation of audit committees is related to a greater percentage of outside directors to total directors (e.g., Pincus et al. 1989). Based on the signaling hypothesis (e.g., Spence 1973; Leland and Pyle 1977), we infer that it is less costly for firms with high quality (such as the case of voluntary adoption of independent directorship and supervisorship than for firms with low quality to give a credible signal of their corporate governance practices. Under the TSEC/GTSM listing rules, it is mandatory for firms applying for IPOs on TSEC (starting February 22, 2002) and GTSM (starting February 25, 2002) to have at least two independent directors and one independent supervisor. Accordingly, if the firm established independent directorship and supervisorship before February 22, 2002, we classify the firm as a voluntary formation firm. We argue that the incentives to implement better corporate governance practices are greater for voluntary formation firms than for mandatory formation firms. Therefore, we hypothesize that firms with voluntary formation of directorship and supervisorship will be associated with lower earnings management. Hypothesis 3: Firms with voluntary formation of independent directors and/or supervisors will be less likely to engage in earnings management than those with mandatory formation.
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4. Research Design and Sample Description 4.1 Discretionary Accruals Accruals are likely to capture evidence of earnings management because they reflect managers accounting estimates and accounting choices. Dechow et al. (1995) provide evidence that the modified Jones model is the most powerful model to detect earnings management among the alternative models to measure unexpected accruals. Therefore, we use the cross-sectional modified Jones model and incorporate prior period return on assets (ROA) as suggested by Kothari et al. (2005). The discretionary accruals are estimated as follows. First, total accruals are measured as net income minus cash flows from operations.

TAi ,t = NI i ,t - CFOi ,t

(1)

Then discretionary accruals, a proxy for earnings management, are estimated by subtracting nondiscretionary accruals from total accruals, where all accrual variables are scaled by lagged total assets to control for potential scale bias. Normal levels of working capital accruals related to sales are controlled through the changes in revenue adjusted for changes in accounts receivable. Normal levels of depreciation expense and related deferred tax accruals are controlled through property, plant and equipment. Lagged ROAi,t is added as suggested by Kothari et al. (2005). Finally, the residual ( it ) from the regression is the measure of discretionary accruals.

TAi ,t Ai ,t 1

= 1 (

1 Ai ,t 1

) +2(

REVi ,t REC i ,t Ai ,t 1

) + 3 (

PPE i ,t Ai ,t 1

) + 4 ROAi ,t 1 + i ,t

(2)

NDAi ,t Ai ,t 1

1 ( =

(REVi ,t RECi ,t ) PPEi ,t 1 2[ 3 ( 4 ROAi ,t 1 ) + ]+ ) + Ai ,t 1 Ai ,t 1 Ai ,t 1

14

(3)

DAi ,t Ai ,t 1

TAi ,t Ai ,t 1

1 ( {

(REVi ,t RECi ,t ) PPEi ,t 1 2[ 3 ( 4 ROAi ,t 1} ) + ]+ ) + Ai ,t 1 Ai ,t 1 Ai ,t 1

(4)

where: TAi,t NIi,t CFOi,t REVi,t RECi,t PPEi,t ROA i,t-1 Ai,t-1 NDAi,t DAi,t i,t = = = = = = = = = = = total accruals for company i in year t, defined as above. net income before discontinued segments and extraordinary items. cash flows from operations. change in revenue for company i in year t. change in receivables for company i in year t. net property, plant and equipment for company i in year t. return on assets for company i in year t-1. total assets for company i in year t-1. nondiscretionary accruals for company i in year t. discretionary accruals for company i in year t. residual for company i in year t.

4.2 Regression Model We use the following regression model to test the relation between corporate governance mechanisms mandated by the CGBPP and earnings management after controlling for other factors identified by prior studies: ADA=+1 INBD+2 INSR+3 IDFE+4 ISFE+5 VOLUNTARY+6 SIZE +7 LEV +8 BIG5+9 LAGADA +10 CFFO +11 F_INSTI +12 MGT +13 A_CHNI +14 LOSS ++15 ROA +16 ROA2 where: ADA INBD INSR IDFE = absolute value of discretionary accruals calculated from equation (4) using the modified Jones model and controlling for firm performance. = percentage of independent directors on the board. = percentage of independent supervisors on the supervisory board. = indicator variable coded 1 if at least one independent director is a financial expert, and 0 otherwise.11

(5)

Following DeFond et al. (2005), we classify financial experts into the following two categories: a) Accounting Financial Experts all directors with experience as a public accountant, auditor, principal or chief financial officer, controller, or principal or chief accounting officer. This category are chosen based upon the suggestions included in the initial version of SOX proposed by the SEC; b) Non-Accounting Financial Experts all directors with experience as the chief executive officer or president of a for-profit corporation. This category is inferred from the final version of SOX drafted by 15

11

ISFE VOLUNTARY SIZE LEV BIG5 LAGADA CFFO F_INSTI MGT A_CHNI LOSS ROA ROA2

= indicator variable coded 1 if at least one independent supervisor is a financial expert, and 0 otherwise. = indicator variable coded 1 if a firm voluntarily formed independent directorship or supervisorship before February 22, 2002, and 0 otherwise. = Ln(sales). = ratio of total debt to total assets. = indicator variable coded 1 if the auditor is a Big 5 audit firm, and 0 otherwise. = absolute value of discretionary accruals in year t-1 divided by ending total assets in year t-2. = operating cash flows deflated by lagged total assets. = percentage of outstanding common shares held by foreign institutional shareholders. = percentage of outstanding common shares held by management. = the absolute value of change in the current years income before extraordinary items divided by lagged total assets. = indicator variable coded 1 if the firm experienced a net loss for two or more consecutive years, and 0 otherwise. = rate of return on lagged total assets. = square of rate of return on lagged total assets.

The dependent variable proxy for earnings management in the regression model used to test our hypotheses is the absolute value of discretionary accruals from the modified cross-sectional Jones model (DeFond and Jiambalvo 1994; Becker et al. 1998, Francis et al. 1999; Lee and Liao 2004). This measure captures the combined effect of income-increasing and income-decreasing earnings management. The research variables are corporate governance characteristics measured by board independence, financial expertise, and voluntary formation of independent directorship and/or supervisorship. We expect that corporate governance variables are significantly and negatively related to absolute discretionary accruals. In particular, hypotheses 1 and 2 predict that firms with corporate governance mechanisms (independence and financial expertise) as mandated by the CGBPP will engage in less earnings management. Hypothesis 3 predicts that firms with voluntary formation of

the SEC. 16

independent directorship and supervisorship as required by the CGBPP will engage in less earnings management. For alternative specifications of this model, we replace the continuous variables INBD and INSR with the dichotomous variables INBD_DV and INSR_DV to indicate whether the company has at least one independent director and supervisor, respectively. We also test for the interaction of variables INBD and INSR with the financial expert variables. The next section briefly explains the role of each of the control variables. 4.3 Control Variables Large companies may have less incentives to engage in earnings management because they are subject to more scrutiny from financial analysts and investors. However, they may have larger discretionary accruals than smaller companies, and are thus more likely to engage in earnings management. Therefore, we control for the effect of firm size (SIZE), but do not predict a sign for this variable. We control for leverage (LEV) because managers may use discretionary accruals to satisfy debt covenant requirements (DeFond and Jiambalvo 1994; Sweeney 1994). However, DeAngelo et al. (1994) find that financially distressed companies may manage earnings downward to gain more concessions from creditors. Hence, no sign is predicted for LEV. Prior studies find that firms hiring BIG 5 auditors are associated with less earnings management (e.g., Becker et al. 1998; Fan and Wong 2005; Francis et al. 1999; Kim et al. 2003). Therefore, we add an indicator variable BIG 5 to capture the effect of a BIG 5 auditor on earnings management. We also add lagged absolute discretionary accruals (LAGADA) to control for the possible effect of prior discretionary accruals that are reversed in the current period to influence the

17

measurement of current period discretionary accruals. Following Lee et al. (2003), we expect the coefficient of LAGADA to be positive. Dechow et al. (1995) find that operating cash flows (CFFO) are negatively associated with discretionary accruals. Therefore, CFFO is also added as a control variable. Prior studies suggest that institutional shareholders can serve as an effective monitoring mechanism (e.g., Matsumoto 2002). In Taiwan, Lee and Liao (2004) find a negative relation between foreign institutional ownership and the absolute value of discretionary accruals. Therefore, we expect the coefficient of F_INSTI to be negative. Prior research demonstrates a negative relationship between management ownership and earnings management measured by the absolute value of discretionary accruals (e.g., Warfield et al. 1995). Therefore, management ownership (MGT) is added as a control variable. Prior studies suggest that the absolute change in the previous years income before extraordinary items divided by total assets (A_CHNI) is positively associated with earnings management (e.g., Bartov et al. 2000; Klein 2002). Therefore, the coefficient of A_CHNI is expected to be positive. We include a loss indicator variable (LOSS) as Butler et al. (2004) suggest that discretionary accruals are high for financially distressed firms. We further include the squared ROA as Butler et al. (2004) also indicate that the relation between discretionary accruals and profitability may be nonlinear. 4.4 Sample Selection Table 1 provides details about the sample selection process and sample characteristics. Our sample period covers both the pre-CGBPP period (2000 and 2001) and post-CGBPP period (2002 and 2003), allowing us to examine whether the enactment of the CGBPP influences the role of corporate governance mechanisms in

18

earnings management behaviors. We begin our sample selection with companies listed on TSEC/GTSM during the sample period by searching the Market Observation Post System (MOPS) and the TEJ database. The financial data for the listed companies are selected from the Taiwan Economic Journal (TEJ) database. In the upper section of Panel A of Table 1, we report the full sample (3,862 firm-year observations) for years 2000 to 2003 (831, 917, 1,022, and 1,092), respectively. From the full sample, we exclude 253 observations in the financial services and insurance industries because the discretionary accruals model does not apply to financial industries. We further exclude 103 observations because of incomplete information on independent directors and supervisors. We also exclude 1,269 observations with incomplete financial data. The final sample after satisfying all the data requirements is 2,237 firm-year observations.12 In the lower section of Panel A, we report the CGBPP sample (654 firm-year observations) covering years 2002 and 2003 to further analyze the policy implications of the CGBPP. The total number of companies establishing independent directorship and/or supervisors increased by about 67 percent from 245 in year 2002 to 409 in year 2003, indicating that the importance of corporate governance has been widely recognized by the listed firms on TSEC/GTSM. [Insert Table 1] Panel B of Table 1 provides the sample distribution by year and by Taiwan Economic Journal (TEJ) industry code for the full and CGBPP samples. The electronics industry has the largest number of companies with more than 62 (75) percent of the total observations in the full (CGBPP) sample. The remaining sample companies are widely distributed across TEJ industry codes.
12

The sample size for the lagged discretionary accrual variable is 2,024 due to missing data. Therefore, our main analyses in the Table 4 and additional analyses in Tables 5 and 6 are based on 2,024 firm-year observations, rather than 2,237 firm-year observations, as described in Tables 1, 2, and 3. 19

5. Empirical Results 5.1 Descriptive Statistics Table 2 provides descriptive statistics for the full and CGBPP samples in Panel A and Panel B, respectively. The average absolute value of discretionary accruals is 0.074 (0.085) and the median of discretionary accruals is 0.052 (0.064) for the full (CGBPP) sample. The mean and median discretionary accruals are -0.001 (0.002) and -0.008 (-0.004) for the full (CGBPP) sample, respectively. On average, 15.5 (10.9) percent of directors (supervisors) are independent for the full sample, whereas 53.0 (37.2) percent of directors (supervisors) are independent for the CGBPP sample, suggesting the increasing trend of establishing independent directorship and/or supervisorship after the enactment of the CGBPP. About 53 (56) percent of independent directors (supervisors) include financial expert(s) on the board for the CGBPP sample. About 10.2 (34.7) percent of listed firms voluntarily formed independent directorship or supervisorship before February 22, 2002 for the full (CGBPP) sample. [Insert Table 2] We discuss descriptive statistics on control variables for the CGBPP sample only, because they are generally similar to those for the full sample. The mean log of sales is 14.37, while the long-term debt of firms equals 39 percent of total assets on average. The mean lagged absolute ADA is 0.10. About 88 percent of listed firms are audited by a BIG 5 auditor. The mean of operating cash flows deflated by lagged assets is 0.089. On average, foreign institutional shareholders own a 4.8 percent stake, while management and directors hold 1.39 percent of the shares. The mean absolute value of a change in the current years income before extraordinary items divided by lagged total assets is 0.060. On average, 4.74 percent of the listed firms report a loss for the last two consecutive years for the CGBPP sample. The mean lagged ROA and ROA2 are 0.098

20

and 0.018, respectively. Table 3 presents the Pearson correlation matrix for the dependent and independent variables for the full sample in Panel A and for the CGBPP sample in Panel B. Although several hypotheses are supported by the correlations for the CGBPP sample, the formal tests are based on the multivariate regression analysis. Independence (INSR), financial expertise (IDFE), and voluntary formation of independent directorship and/or supervisorship (VOLUNTARY) are significantly and negatively correlated with absolute discretionary accruals (ADA) for the CGBPP sample, whereas the relationships for the independence and financial expertise variables are positive for the full sample (which includes the CGBPP and pre-CGBPP sample), possibly reflecting that the pre-CGBPP sample has not incorporated corporate governance features. [Insert Table 3] The discretionary accruals (DA) variable is significantly and negatively correlated with operating cash flows (CFFO) for both the full sample and the CGBPP sample, which is consistent with Dechow et al. (1995). Other correlation coefficients between variables are small and their VIFs are all between 1 and 4 in both the full sample and the CGBPP sample. Therefore, the regression models are relatively free from multicollinearity problems. 5.2 Regression Results Tests of the research hypotheses using absolute discretionary accruals (ADA) as the dependent variable are reported in Table 4.13 Results for the full sample are

13

Before formal regression analyses, we also conduct three univariate t-test and Wilcoxon z-tests (not reported) for the mean and median differences between high INBD/INSR and low INBD/INSR companies, between companies with INBD/INSR>0 and INBD/INSR=0, and between companies with voluntary formation and mandatory formation. In the first two analyses, we find that the mean (and median) values of INSR, ISFE, and VOLUNTARY are significantly higher in firms with independent directors than in firms without independent directors. We also find that mean (and median) values of 21

reported in Panel A. Hypotheses 1 and 2 predict that firms with better corporate governance mechanisms (independence and financial expertise) will engage in less earnings management. In model (1), the coefficients for INSR and IDFE are negative and marginally significant, indicating that firms with independent supervisors and independent directors having financial expertise are associated with lower levels of absolute discretionary accruals. When we replace INBD and INSR with dichotomous specifications in model (2), the coefficient for IDFE is significantly negative. When we replace IDFE and ISFE with interactions with INBD and INSR in model (3), and the dichotomous specifications with similar interaction terms in model (4), the coefficients for INBD*IDFE and INBD_DV*IDFE continue to be significantly negative. The coefficient for VOLUNTARY is significantly negative in models (2) and (4), respectively, suggesting firms that have voluntarily established independent directorship and/or supervisorship are associated with lower earnings management. [Insert Table 4] Panel B of Table 4 reports the results for the CGBPP sample. Overall, the results for the research variables are somewhat stronger for the CGBPP sample. The INSR variable increases in significance in models (1) and (3), and INSR_DV is marginally significant in model (2). For the CGBPP sample, the coefficient for IDFE in models (1) and (2), the coefficients for INBD*IDFE and INSR*IDFE in model (3) as well as the coefficients for INBD_DV*IDFE and INSR_DV*ISFE in model (4) are significantly negative.
INBD, IDFE, and VOLUNTARY are significantly higher in firms with independent supervisors than in firms without independent supervisors. For the voluntary versus mandatory formation firms, we find that the mean (and median) values of INBD, IDFE, and ISFE are significantly lower for firms with voluntary formation of independent directorship and/or supervisorship than those with mandatory formation. Firms facing the requirements of the CGBPP starting in 2002 (i.e., at least two independent directors and at least one independent supervisor) are likely to have more independent directors (and/or supervisors) on board. Since INBD (INSR) is defined as the percentage of independent directors (supervisors) on board, there is likely to be a higher percentage of independent directors or supervisors for mandatory formation firms than for voluntary formation firms. 22

These results suggest that better corporate governance characteristics are important factors in constraining earnings management after implementing the CGBPP for listed firms on the TSEC/GTSM. As an additional test, we compare the level of discretionary accruals for both the pre-CGBPP period and the post-CGBPP period, and the mean ADA is lower for the post-CGBPP period. From a multivariate regression (not reported), a period dummy variable for the post-CGBPP period is significantly negative, consistent with lower ADA following the adoption of the CGBPP. Hypothesis 3 predicts that firms with voluntary formation of independent directorship and/or supervisorship as required by the CGBPP will engage in less earnings management. The significantly negative coefficient of VOLUNTARY for all four models in Panel B of Table 4 indicates that the voluntary formation of independent directorship and/or supervisorship is associated with lower levels of absolute discretionary accruals, suggesting that firms voluntarily establishing independent directorship and/or supervisorship are associated with lower earnings management. To our knowledge, this is the first study demonstrating that independent supervisors and financial expertise of independent directors are important factors in constraining earnings management for a sample of Taiwanese listed companies, especially after the newly enacted CGBPP. For the CGBPP sample, the regression results for the test variables are consistent with and somewhat stronger than those reported for the full sample.14

14

Corporate governance mechanisms are often viewed as a response to agency problems that may also give rise to earnings management. As a result, there may be two-way causation between the discretionary accrual dependent variables and the corporate governance test variables. Hausman (1978) tests indicate potential endogeneity problems with INBD and IDFE. Inferences for the corporate governance variables are substantively unchanged using a simultaneous equations approach. We also conduct a two-stage Heckman procedure for the VOLUNTARY variable to further assess potential endogeneity problems. Although potential endogeneity problems with the voluntary variable cannot be excluded (the t-statistic of the Inverse Mills ratio is -1.70 for the full sample and -3.95 for the CGBPP 23

With respect to the control variables, the coefficient for CFFO is significantly negative, suggesting that firms with strong operating cash flows are less likely to use discretionary accruals to engage in earnings management. The coefficient for A_CHNI, indicating earnings performance variability, is significantly positive and related to a higher level of absolute discretionary accruals, which is consistent with prior studies such as Bartov et al. (2000), Klein (2002) and Lee and Liao (2004). The coefficient for SIZE is significantly positive, albeit only for the full sample, indicating that larger companies have larger absolute discretionary accruals. The significantly negative (positive) coefficient for LEV for the full (CGBPP) sample may suggest that firms with higher debt ratios tend to manage earnings downward prior to the implementation of the CGBPP regulation. The coefficient for the LOSS variable is negative and significant for the full sample, while the squared ROA variable is significantly positive for both samples. The BIG 5 variable is positive and marginally significant for the full sample, which is inconsistent with the findings of Becker et al. (1998) and Francis et al. (1999) that BIG 5 auditors are associated with lower discretionary accruals. The choice of auditor and discretionary accrual choices are both made by managers. To control for this potential self-selection bias, we run a two-stage Heckman model. The results (not reported) for the governance variables are quantitatively unchanged, but the BIG 5 variable becomes negative and significant. In sum, our findings highlight the importance of independent supervisors and financial expertise of independent directors in constraining the likelihood of earnings management in Taiwan. Our results are in contrast with Lee and Liao (2004), who do not find significant results using a sample of observations from year 2001 when the
sample), results for the corporate governance variables are substantively unchanged in both samples, except for INBD_DV in the full sample and VOLUNTARY in the CGBPP sample. 24

CGBPP was not implemented. 5.3 Additional Analyses Family Ownership, Group Affiliation, and Earnings Management: Family-control is a dominant characteristic in Taiwanese listed companies, which is demonstrated in prior studies such as Claessens et al. (2000) and Yeh et al. (2001). The agency problem in such companies in an emerging economy is caused by the expropriation of minority shareholders as well as creditors by the controlling shareholders (Shleifer and Vishny 1997), which may be due to the deviation between control rights and cash flow rights, and a lack of strong legal protection of minority investors.
15

The concentrated ownership creates incentives for controlling

shareholders to manage earnings to camouflage their self-serving behaviors. Kim and Yi (2006) find that controlling shareholders tend to engage more in opportunistic earnings management in Korea as the controlling ownership disparity becomes larger, suggesting that family-controlled firms are more likely to engage in earnings management in Korea. Business group affiliation is also a dominant characteristic in Taiwanese listed companies (Claessens et al. 2000; Yeh et al. 2001). The problems associated with group affiliation within a diversified organization may be exacerbated in emerging markets because of weak disclosure requirements, ineffective governance mechanisms, and a poorly developed market for corporate control (see La Porta et al. 1997, 1998). The diversified structure of business group affiliation enables group-affiliated firms to engage in earnings management through so called propping activities (see Chung et al. 2006) and tunneling activities (see Johnson et al. 2000) to divert firm resources

15

This is consistent with the entrenchment effect reported in Classens et al. (2000). 25

to benefit themselves at the expense of minority shareholders.16 Kim and Yi (2006) examine whether business group affiliation influences the extent of earnings management in Korean companies and find that the magnitude of absolute discretionary accruals is greater for group-affiliated firms than non-affiliated firms, suggesting group-affiliated firms are more likely to engage in opportunistic earnings management when compared with non-group-affiliated firms in Korea. Consistent with Kim and Yi (2006), we examine the relation between these two dominant characteristics (i.e., family ownership and group affiliation) in Taiwanese listed firms and earnings management by adding DEV and GRP_AFF to our main regression model in equation (5), where DEV is used to proxy for the difference between control rights and cash flow rights, and GRP_AFF is used to proxy for a group-affiliated firm. 17 We use the following regression model, modified from equation (5) to test whether family-controlled firms and group-affiliated firms are more likely to engage in earnings management after controlling for the corporate governance variables and control variables reported in Table 4. ADA=+1DEV+2 GRP_AFF+3INBD+4 INSR+5 IDFE+6 ISFE +7 VOLUNTARY+8 SIZE +9 LEV+10 BIG5+11 LAGADA +12 CFFO +13 F_INSTI +14MGT +15 A_CHNI +16LOSS ++17ROA +18ROA2 (6)
16

Propping activities mean that controlling shareholders prop up their firms by using their private funds to benefit minority shareholders (Friedman et al. 2003). Propping activities often take the form of cash injections, credit provisions and/or debt guarantees. Tunneling refers to the transfer of resources out of a company to its controlling shareholders through self-dealing transactions or related party transactions (Johnson et al. 2000). Kim and Yi (2006) argue that firms with tunneling (propping) are likely to engage in income-increasing (income-decreasing) earnings management. 17 We conduct univariate t-tests and Wilcoxon signed rank tests to compare the mean and median of the ADA and corporate governance variables and other control variables across the two samples partitioned by DEV and GRP_AFF. First, we partition our sample into firms with above median DEV and firms with below median DEV, and into group-affiliated and non-group-affiliated firms based on the definition of GRP_AFF. The mean ADA for firms with above median DEV is 0.078, whereas the mean ADA for firms with below median DEV is 0.066. The difference is significant at a less than 1 percent level. Our test for median difference in ADA between the two groups (i.e., above median DEV vs. below median DEV) shows a similar result. The results are consistent with the argument that firms with a high control-ownership wedge engage more in opportunistic earnings management than those with a low wedge. However, the differences in mean and median ADA are not significant between group-affiliated firms and non-group-affiliated firms. 26

Consistent with LaPorta et al. (2002, 1157), we define control rights as the fraction of the firms voting rights owned by its controlling shareholder. The cash flow rights are defined as the sum of percentages of equity shares owned by the controlling shareholders and by affiliated firms. We include DEV, the difference between control rights and cash flow rights, to capture the control-ownership wedge. We obtain the ownership data from the TEJ Corporate Governance Module, which has information on control right percentage (item #29) and cash flow right percentage (item #30) for most firms listed on TSEC and GTSM. 18 We also use the TEJ definition to classify firms into group-affiliated and non-group-affiliated firms. That is, we use a threshold of at least three listed firms in either TSEC or GTSM as the criteria for defining group membership. We use GRP_AFF to capture the difference in the magnitude of earnings management between group-affiliated firms and

non-group-affiliated firms. [Insert Table 5] Column (1) of Table 5 presents the results of the OLS regression of absolute discretionary accruals on the control-ownership wedge (DEV) after controlling for continuous corporate governance variables and other control variables in equation (6).19 The coefficient for DEV is marginally positive, suggesting that as the deviation between control rights and cash flow rights becomes larger, corporate insiders have stronger incentives to expropriate wealth at the expense of minority shareholders.
According to the TEJ definition, the control rights are measured as the combination of a shareholders direct (i.e., through shares registered in the shareholders name) and indirect (i.e., through shares held by entities that the shareholder controls) voting rights in the firm, which is calculated on the basis of LaPorta et al. (2002). Our definition of family-controlled firms further excludes firms controlled by a political party (KMT, the oldest political party in Taiwan), such as China Television Co. (TEJ code 9928), state-owned firms like Chunghwa Telecom (TEJ code 2412), or quasi-state-owned firms like China Airlines (TEJ code 2610). 19 Columns (1) and (3) of Table 5 and Table 6 include 1,796 firm-year observations, whereas Column (2) in these tables includes 2,024 firm-year observations. This is due to missing data for cash flow rights used in calculating DEV, the deviation between control rights and cash flow rights. 27
18

Column (2) of Table 5 presents the results of the OLS regression of absolute discretionary accruals on group affiliation (GRP_AFF) after controlling for continuous corporate governance variables and other control variables. The coefficient for GRP_AFF is positive, but is not significant. Column (3) of Table 5 presents the full-model regression which includes both variables DEV and GRP_AFF, along with the continuous corporate governance variables and other control variables. The result shows that the control-ownership wedge (DEV) has a marginally significant positive impact on managerial opportunism in financial reporting, which is consistent with Kim and Yi (2006) in that controlling shareholders tend to engage more in opportunistic earnings management. With respect to the corporate governance variables, the coefficient for INSR is significantly negative, which is consistent with the results in Panel A of Table 4. The results for other control variables are qualitatively similar to those reported in Table 4. [Insert Table 6] Table 6 presents the results of the OLS regression of absolute discretionary accruals on DEV, GRP_AFF, and both DEV and GRP_AFF using dichotomous corporate governance variables. The results for DEV and GRP_AFF are similar to those reported in Table 5. The coefficient for INBD_DV*IDFE is significantly negative, which is also consistent with the results in Panel A of Table 4. The results for other control variables are also qualitatively similar to those reported in Table 4. In sum, the results of our full-model regression in Tables 5 and 6 reveal that family-controlled firms listed on the TSEC and GTSM tend to engage more in opportunistic earnings management, which is consistent with findings reported by Kem and Yi (2006) for other emerging markets such as Korea.

28

Alternative Measure of Earnings Management: We also use real transactions measured by abnormal non-core earnings per share (AABNCEPS) to proxy for earnings management. The following two models are used to run regressions similar to (except for the dependent variable) those reported in Table 4: Model A1: AABNCEPS =+1INBD+2 INSR+3 IDFE+4 ISFE+5 VOLUNTARY +6 SIZE +7 LEV +8 BIG5+9 LAGADA +10 CFFO +11 F_INSTI +12 MGT +13 A_CHNI +14 LOSS +15 ROA +16 ROA2 Model A2: AABNCEPS = +1INBD_DV +2 INSR_DV +3 INBD_DV * IDFE +4 INSR_DV * ISFE +5 VOLUNTARY +6 SIZE +7 LEV +8 BIG5+9 LAGADA +10 CFFO +11 F_INSTI +12MGT +13 A_CHNI +14 LOSS +15 ROA +16 ROA2
where: AABNCEPS NCEPSt

(7)

(8)

= Absolute value of Abnormal Non-core earnings per share; = Non-core earnings per share in year t. = (Net Income recurring earnings) / Weighted outstanding shares. Abnormal Non-core earnings per share = NCEPSt (NCEPSt-1NCEPSt-2NCEPSt-3)/3. Recurring earnings (TEJ definition) = Net income excluding extraordinary income gain from disposal of assets and investments.

The results (not reported) for the full sample and the CGBPP sample indicate that the coefficients for IDFE and ISFE (INBD_DV*IDFE and INSR_DV*ISFE) are significantly negative, suggesting that firms with independent directors and supervisors having financial expertise are associated with lower earnings management measured by abnormal non-core earnings per share. These results are more consistent than those in Table 4, which use absolute discretionary accruals to measure earnings management. The coefficients for VOLUNTARY are also significantly negative in both models, which is also consistent with the results in Table 4. In summary, the regression results using real transactions to measure earnings management are qualitatively similar to those using absolute discretionary accruals to capture earnings
29

management. 5.4 Sensitivity Analyses In sensitivity analyses, we first include the two variables DEV and GRP_APP in model A1 in equation (7) to further investigate whether firms with high control-ownership wedge and group-affiliated firms are more likely to use real transactions (i.e., AABNCEPS) to manage earnings. The coefficient for DEV (GRP_AFF) is positive (negative) but insignificant, which differs from the results using absolute discretionary accruals to measure earnings management. For the corporate governance variables, we find that the coefficients for IDFE and VOLUNTARY are significantly negative. However, the coefficient for INBD is positive and significant, which might be due to the use of real transactions as a measure of earnings management. When we repeat the above analyses using model A2 (i.e., dichotomous corporate governance variables) in equation (8), the results for DEV and GRP_AFF as well as the corporate governance variables are qualitatively similar to those using model A1. We also replace GRP_AFF with GRP_AFF1, in which group affiliation is measured by a threshold of at least two rather than three listed firms as defined in GRP_AFF. First, we rerun our regression analyses in Tables 5 and 6 by adding DEV and GRP_AFF1. The coefficient for DEV is significantly positive, which is consistent with results reported in Tables 5 and 6. However, the coefficient for GRP_AFF1 is negative and significant, which differs from the results reported in Tables 5 and 6, suggesting that the results are sensitive to the definition of group affiliation. For the corporate governance variables, the results are qualitatively similar to those using the GRP_AFF variable. We then rerun our regression analyses for models A1 and A2. The coefficients for DEV and GRP_AFF1 are insignificantly positive and negative,
30

respectively, similar to the results reported using GRP_AFF. These findings suggest that family-controlled firms and group-affiliated firms are not using real transactions to manage their earnings. 6. Summary and Conclusions This study examines whether corporate governance characteristics mandated by the CGBPP for companies listed on the TSEC and GTSM are associated with earnings management. In particular, we investigate whether the regulatory requirements, first stipulated by the CGBPP, of establishing independent directorship and supervisorship as well as the financial expertise of independent directors and supervisors are associated with a lower magnitude of absolute discretionary accruals. We further examine whether firms that have voluntarily formed independent directorship and/or supervisorship are more likely to be associated with lower absolute discretionary accruals than firms with mandatory formation of independent directorship and/or supervisorship. Our findings generally support the requirements of the CGBPP in that the independence of supervisors and financial expertise of independent directors are associated with reduced earnings management. We also find that the voluntary formation of independent directorship and/or supervisorship is negatively associated with earnings management. This is consistent with the signaling hypothesis that firms will send a credible signal of their corporate governance practices by voluntarily hiring independent directors and/or supervisors prior to the implementation of the CGBPP regulations. Since family-control and business group affiliation are among the dominant characteristics in Taiwanese listed companies, we further examine whether family-controlled firms and group-affiliated firms are more likely to engage in
31

opportunistic earnings management. Using the deviation between control rights and cash flow rights to measure the control-ownership wedge and using the threshold of at least three listed firms in either TSEC or GTSM to define group affiliation membership, we find that family-controlled firms are more likely to engage in opportunistic earnings management in this emerging market, which is consistent with the results reported for Korea by Kim and Yi (2006). When we further use real transactions, measured by abnormal non-core earnings per share, to capture earnings management, the findings are qualitatively similar to the results using absolute discretionary accruals. This study is subject to a number of limitations. First, our results demonstrate an association, instead of causation, between corporate governance characteristics and earnings management. Second, we use the popular cross-sectional modified Jones model to estimate discretionary accruals. We incorporate lagged ROA as an additional factor to control for firm performance. However, our results may still be subject to potential measurement error concerns. Third, our study does not examine the quality of accruals. Therefore, accruals measures used by Ball and Shivakumar (2005) and Dechow and Dichev (2002) might be an alternative avenue that can be used for future research. We only include the corporate governance characteristics (i.e., independence and financial expertise) required by the CGBPP, and the voluntary formation of independent directorship and supervisorship to test our hypotheses. Future research could incorporate other characteristics, such as the number of board meetings and board size, to examine their relations to earnings management. Finally, the current study only provides evidence of a relation between corporate governance characteristics and financial reporting quality through publicly disclosed information,

32

but we have very little understanding of the process through which independent directors and supervisors influence financial reporting quality. Future research might find a way to examine these processes.

33

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37

Table 1 Sample Selection Panel A: Sample Selection Criteria

Number of Firm-Year Observations Year Year Year Year Total 2000 2001 2002 2003 531 584 638 669 2,422 300 831 -54 0 -412 365 Year 2000 333 917 -63 -8 -417 429 Year 2001 384 1,022 -68 -37 -289 628 Year 2002 423 1,092 -68 -58 -151 815 Year 2003 1,440 3,862 -253 -103 -1,269 2,237 Total

Full Sample
Companies listed in Taiwan Stock Exchange Corporation Companies listed in GreTai Securities Market Companies in Market Observation Post System of TSEC/GTSM Excludefinancial service and insurance industries Excludeincomplete data about independent directors and supervisors Excludeincomplete financial data

The CGBPP Sample

Number of companies establishing independent directorship and/or supervisorship by the end of the year

245

409

654

Note: The CGBPP sample comprises TSEC/GTSM firms establishing independent directorship and/or supervisorship during years 2002 and 2003.

38

Table 1 (continued) Panel B: Sample firms by year and by TEJ codes distribution (1) Full Sample
TSEC Industry (Code)
Foods (12) Plastics (13) Textiles (14) Electric & Machinery (15) Appliance & Cable (16) Chemicals (17) Steel & Iron (20) Rubber (21) Electronics (23,24,30) Constructions (25) Transportations (26) Tourism (27) Wholesale & Retail (29) Others (89,98,99) Total

GTSM

Total
Number percent

Yr '00 Yr '01 Yr '02 Yr '03 Yr '00 Yr '01 Yr '02 Yr '03 10 14 21 14 1 16 9 0 158 15 11 0 0 22 291 11 16 22 13 1 16 7 0 180 14 12 0 1 23 316 14 15 30 20 1 19 11 0 229 18 12 1 2 27 399 16 17 31 23 3 25 13 1 250 18 14 1 4 26 442 1 2 3 3 0 5 2 0 44 6 1 0 0 7 74 2 2 3 5 0 6 2 0 79 6 1 0 0 7 113 2 2 3 13 1 12 2 1 169 6 3 0 2 13 229 4 2 4 19 1 24 5 1 279 7 4 2 3 18 373

60 2.68% 70 3.13% 117 5.23% 110 4.92% 8 0.36% 123 5.50% 51 2.28% 3 0.13% 1,388 62.05% 90 4.02% 58 2.59% 4 0.18% 12 0.54% 143 6.39% 2,237 100%

(2) The CGBPP Sample

TSEC Industry (Code) Foods (12) Plastics (13) Textiles (14) Electric & Machinery (15) Appliance & Cable (16) Chemicals (17) Steel & Iron (20) Rubber (21) Electronics (23,24,30) Constructions (25) Transportations (26) Tourism (27) Wholesale & Retail (29) Others (89,98,99) Total Yr '02 1 3 7 8 1 5 3 0 97 4 0 1 0 3 133 Yr '03 2 5 8 12 1 9 3 1 131 4 0 1 0 3 180 GTSM Yr '02 0 0 0 4 1 6 0 1 89 1 1 0 2 7 112 Yr '03 1 0 1 9 1 16 2 1 178 2 1 2 2 13 229 Total Number 4 8 16 33 4 36 8 3 495 11 2 4 4 26 654 percent 0.61% 1.22% 2.45% 5.05% 0.61% 5.50% 1.22% 0.46% 75.69% 1.68% 0.31% 0.61% 0.61% 3.98% 100%

39

Table 2 Descriptive Statistics for Dependent and Independent Variables Panel A: Full Sample Variable ADA DA INBD INSR INBD_DV INSR_DV IDFE ISFE VOLUNTARY SIZE LEV LAGDA LAGADA BIG5 CFFO F_INSTI MGT A_CHNI LOSS ROA ROA2 N 2,237 2,237 2,237 2,237 2,237 2,237 2,237 2,237 2,237 2,237 2,237 2,024 2,024 2,237 2,237 2,237 2,237 2,237 2,237 2,237 2,237 Mean 0.0736 -0.0011 0.1549 0.1087 0.2678 0.2727 0.1547 0.1627 0.1015 14.8364 0.3306 -0.0032 0.0805 0.8538 0.0732 4.4388 0.8635 0.0279 0.1073 0.0653 0.0134 Standard deviation 0.0793 0.1081 0.2928 0.1897 0.4429 0.4454 0.3617 0.3692 0.3020 1.3677 0.2520 0.1276 0.0991 0.3534 0.1498 8.8021 1.9250 0.0917 0.3095 0.0956 0.0252 Lower quartile 0.0226 -0.0583 0.0000 0.0000 0.0000 0.0000 0.0000 0.0000 0.0000 13.8654 0.1864 -0.0621 0.0234 1.0000 0.0087 0.0000 0.0000 -0.0080 0.0000 0.0183 0.0013 Median 0.0516 -0.0079 0.0000 0.0000 0.0000 0.0000 0.0000 0.0000 0.0000 14.6750 0.3765 -0.0086 0.0522 1.0000 0.0681 0.4100 0.0800 0.0174 0.0000 0.0605 0.0052 Upper quartile 0.0959 0.0426 0.2500 0.3333 1.0000 1.0000 0.0000 0.0000 0.0000 15.6152 0.5349 0.0427 0.1036 1.0000 0.1314 4.8469 0.7600 0.0545 0.0000 0.1158 0.0151

Panel B: The CGBPP Sample Variable ADA DA INBD INSR INBD_DV INSR_DV IDFE ISFE VOLUNTARY SIZE LEV LAGDA LAGADA BIG5 CFFO F_INSTI MGT A_CHNI LOSS ROA ROA2 N 654 654 654 654 654 654 654 654 654 654 654 654 654 654 654 654 654 654 654 654 654 Mean 0.0848 0.0021 0.5297 0.3717 0.9159 0.9327 0.5291 0.5566 0.3471 14.3671 0.3896 -0.0037 0.1022 0.8853 0.0894 4.8026 1.3880 0.0595 0.0474 0.0976 0.0176 Standard deviation 0.0763 0.1141 0.3078 0.1591 0.2777 0.2507 0.4995 0.4972 0.4764 1.2283 0.1509 0.1591 0.1219 0.3189 0.1332 9.8405 2.2897 0.0664 0.2127 0.0902 0.0251
40

Lower quartile 0.0294 -0.0659 0.3333 0.3333 1.0000 1.0000 0.0000 0.0000 0.0000 13.5333 0.2723 -0.0790 0.0329 1.0000 0.0170 0.0000 0.0100 0.0162 0.0000 0.0438 0.0028

Median 0.0640 -0.0043 0.5000 0.3333 1.0000 1.0000 1.0000 1.0000 0.0000 14.2227 0.3824 -0.0128 0.0728 1.0000 0.0821 0.6500 0.3900 0.0393 0.0000 0.0893 0.0085

Upper quartile 0.1172 0.0632 0.7500 0.3333 1.0000 1.0000 1.0000 1.0000 1.0000 14.9991 0.5006 0.0621 0.1249 1.0000 0.1548 4.8200 1.8000 0.0781 0.0000 0.1463 0.0221

ADA DA INBD INSR INBD_DV INSR_DV IDFE ISFE VOLUNTARY SIZE LEV LAGADA LAGDA BIG5 CFFO F_INSTI MGT A_CHNI LOSS ROA ROA2

= = = = = = = = = = = = = = = = = = = = =

absolute value of discretionary accruals calculated by using the modified Jones model after controlling for firm performance. discretionary accruals calculated by using the modified Jones model after controlling for firm performance. percentage of independent directors on the board. percentage of independent supervisors on the supervisory board. indicator variable coded 1 if there is at least one independent director on the board, and 0 otherwise. indicator variable coded 1 if there is at least one independent supervisor on the board, and 0 otherwise. indicator variable coded 1 if at least one independent director is a financial expert, and 0 otherwise. indicator variable coded 1 if at least one independent supervisor is a financial expert, and 0 otherwise. indicator variable coded 1 if a firm voluntarily formed independent directorship or supervisorship before February 22, 2002, and 0 otherwise. Ln(sales). ratio of total debt to total assets. absolute value of discretionary accruals in year t-1 divided by ending total assets in year t-2. discretionary accruals in year t-1 divided by ending total assets in year t-2. indicator variable coded 1 if the auditor is a Big 5 audit firm, and 0 otherwise. operating cash flows deflated by lagged total assets. percentage of outstanding common shares held by foreign institutional shareholders. percentage of outstanding common shares held by management. the absolute value of change in the current years income before extraordinary items divided by lagged total assets. indicator variable coded 1 if the firm has experienced a net loss for two or more consecutive years, and 0 otherwise. rate of return on lagged total assets. square of rate of return on lagged total assets.

41

Table 3 Correlation Matrix for Dependent and Independent Variables Panel A: Full Sample (n=2,237) #
VOLUNDA INBD INSR IDFE ISFE TARY ADA 0.289*** 0.068*** 0.051** 0.035* 0.042** 0.007 0.005 DA 0.059*** 0.017 0.026 -0.011 -0.040* -0.025 INBD 0.765*** 0.674*** 0.591*** 0.270*** -0.210*** INSR 0.612*** 0.658*** 0.466*** -0.200*** IDFE 0.538*** 0.163*** -0.159*** ISFE 0.209*** -0.179*** VOLUNTRAY -0.037* SIZE LEV LAGDA LAGADA BIG5 CFFO F_INSTI MGT A_CHNI LOSS ROA -0.074*** 0.024 -0.686*** -0.743*** -0.555*** -0.572*** -0.436*** 0.310*** 0.053** 0.112*** 0.028 0.006 0.041* -0.011 -0.027 0.031 0.044** 0.208*** 0.085*** 0.160*** 0.139*** 0.102*** 0.106*** 0.023 -0.041* -0.143*** 0.263*** 0.044** -0.021 0.044** 0.064*** 0.047** 0.042** 0.034 0.101*** -0.035* -0.013 0.025 -0.172*** -0.621*** 0.046** 0.063*** 0.057*** 0.081*** -0.010 0.000 -0.170*** -0.115*** -0.026 0.043** 0.006 -0.036* -0.012 0.030 0.021 0.020 0.059*** 0.323*** -0.026 0.052** 0.039* 0.114*** 0.076*** 0.009 0.034 0.213*** 0.162*** 0.151*** 0.160*** 0.023 -0.113*** -0.132*** 0.016 0.004 -0.019 0.010 -0.070*** 0.151*** 0.045** 0.161*** 0.196*** 0.156*** 0.172*** 0.073*** -0.083*** -0.196*** -0.090*** 0.155*** 0.041* 0.433*** 0.021 0.068*** -0.081*** -0.060*** -0.131*** -0.123*** -0.096*** -0.098*** -0.026 -0.054** 0.233*** -0.056** -0.053** -0.024 -0.103*** -0.079*** -0.052** 0.110*** 0.130*** 0.129*** 0.225*** 0.196*** 0.179*** 0.182*** -0.027 0.015 -0.346*** 0.010 0.152*** 0.031 0.462*** 0.094*** 0.079*** 0.501*** -0.347*** 0.165*** -0.019 0.104*** 0.094*** 0.104*** 0.105*** -0.058*** -0.080*** -0.177*** -0.044** 0.194*** 0.035* 0.514*** 0.023 0.036* 0.516*** -0.085*** 0.543*** SIZE LEV LAGDA LAGADA BIG5 CFFO F_INSTI MGT A_CHNI LOSS ROA ROA2

*, **, and *** denote significance at the 0.10, 0.05, and 0.01 levels, respectively. # The sample size for variables LAGDA and LAGADA is based on 2,024 firm-year observations. Variables are defined in Table 2.

42

Table 3 (continued) Panel B: CGBPP Sample (n=654)

VOLUNDA ADA DA INBD INSR IDFE ISFE VOLUNTRAY SIZE LEV LAGDA LAGADA BIG5 CFFO F_INSTI MGT A_CHNI LOSS ROA INBD INSR IDFE ISFE TARY 0.163*** -0.025 -0.129*** -0.065* 0.133*** -0.001 0.032 0.122*** 0.297*** 0.056 -0.053 -0.059 0.065* 0.143*** 0.151*** -0.092** -0.102*** -0.330*** 0.001 -0.290*** -0.241*** 0.044 -0.017 -0.102*** -0.013 -0.034 -0.077* 0.189*** 0.129*** 0.079** 0.027 -0.022 -0.045 -0.056 0.028 0.409*** 0.012 0.099** 0.073* 0.026 0.080** -0.019 -0.042 -0.029 0.010 0.195*** 0.075* 0.089** 0.014 0.003 0.007 -0.093** 0.064 0.101*** 0.289*** 0.026 -0.003 -0.011 0.059* 0.026 0.007 0.010 0.109*** -0.066* -0.001 -0.002 -0.113*** -0.663*** 0.039 0.004 0.030 0.096** -0.113*** -0.035 -0.341*** -0.097** -0.021 -0.007 0.000 -0.068* -0.100** 0.023 0.007 0.005 0.087** 0.156*** -0.064 0.079** 0.086** 0.110*** 0.060 -0.028 0.073* 0.189*** 0.021 0.071* 0.086** -0.125*** -0.059 0.035 0.034 -0.051 -0.113*** -0.065* -0.097** 0.180*** 0.040 -0.094** -0.006 0.031 0.071* -0.128*** -0.062 -0.105*** -0.034 0.171*** 0.040 0.290*** 0.002 -0.001 -0.009 -0.094** -0.136*** -0.073* -0.049 -0.047 0.125*** 0.008 0.068* -0.071* -0.051 -0.010 -0.047 -0.016 -0.046 0.125*** 0.072* 0.206*** 0.158*** 0.009 0.091** 0.090** -0.322*** 0.016 -0.306*** -0.014 0.053 0.122*** 0.522*** -0.001 0.010 0.360*** -0.255*** 0.128*** 0.094** 0.049 -0.009 0.080** 0.080** -0.251*** -0.093** -0.330*** 0.008 0.160*** -0.031 0.473*** 0.001 -0.015 0.613*** -0.084** 0.727*** SIZE LEV LAGDA LAGADA BIG5 CFFO F_INSTI MGT A_CHNI LOSS ROA ROA2

*, **, and *** denote significance at the 0.10, 0.05, and 0.01 levels, respectively. Variables are defined in Table 2.

43

Table 4 Regression of Absolute Discretionary Accruals on Corporate Governance Variables Panel A: Full Sample (n=2,024)
Model Variables Intercept INBD INSR INBD_DV INSR_DV IDFE ISFE
INBD * IDFE INSR * ISFE

Predicted Sign

1 Coefficient (t-statistic) 0.037 (1.86) 0.002 (0.27) -0.027* (-1.56)

2 Coefficient (t-statistic) 0.033 (1.63)

-0.008* (-1.38) -0.001 (-0.09)

0.012 (1.38) -0.002 (-0.26) -0.015** (-2.20) -0.005 (-0.82)

3 Coefficient (t-statistic) 0.038 (1.89) 0.011 (1.05) -0.019 (-1.05)

4 Coefficient (t-statistic) 0.033 (1.63)

0.012 (1.36) -0.002 (-0.18)

-0.014** (-2.18) -0.006 (-1.00) -0.005 -0.010** -0.007 -0.010** VOLUNTARY (-0.84) (-1.64) (-1.18) (-1.68) 0.003** 0.003** 0.003** 0.003** SIZE ? (2.18) (2.02) (2.12) (2.01) -0.047*** -0.032*** -0.045*** -0.032*** LEV ? (-3.89) (-2.40) (-3.81) (-2.40) 0.008* 0.007* 0.008* 0.007* BIG5 (1.87) (1.80) (1.86) (1.80) 0.095*** 0.093*** 0.096*** 0.093*** LAGADA (3.70) (3.52) (3.81) (3.53) -0.204*** -0.202*** -0.204*** -0.202*** CFFO ? (-4.67) (-4.61) (-4.66) (-4.61) -0.000 -0.000 -0.000 -0.000 F_INSTI (-0.64) (-0.59) (-0.63) (-0.60) -0.000 -0.001 -0.000 -0.001 MGT (-0.52) (-0.66) (-0.42) (-0.66) 0.119*** 0.114*** 0.119*** 0.114*** A_CHNI (3.59) (3.39) (3.60) (3.40) -0.017*** -0.018*** -0.018*** -0.018*** LOSS ? (-3.54) (-3.59) (-3.56) (-3.59) 0.007 0.009 0.006 0.009 ROA ? (0.20) (0.28) (0.18) (0.28) 0.764*** 0.762*** 0.763*** 0.762*** ROA2 ? (6.44) (6.36) (6.44) (6.37) Adj. R-square 0.162 0.162 0.164 0.162 F-value 25.42*** 25.36*** 25.78*** 25.39*** *, **, and *** denote significance at the 0.10, 0.05, and 0.01 levels, respectively, one-tailed test where appropriate. We report asymptotic t-statistics in parentheses based on White (1980) standard errors. Variables are defined in Table 2.

INBD_DV * IDFE INSR_DV * ISFE

-0.020** (-2.15) -0.019 (-1.27)

44

Table 4 (continued) Regression of Absolute Discretionary Accruals on Corporate Governance Variables Panel B: CGBPP Sample (n=654)
Model Variables Intercept INBD INSR INBD_DV INSR_DV IDFE ISFE
INBD * IDFE INSR * ISFE

Predicted Sign

1 Coefficient (t-statistic) 0.079 (2.24) -0.009 (-0.89) -0.055*** (-2.95)

2 Coefficient (t-statistic) 0.073 (1.95)

-0.011** (-1.87) -0.007 (-1.06)

-0.002 (-0.23) -0.018* (-1.31) -0.013** (-1.94) -0.007 (-1.13)

3 Coefficient (t-statistic) 0.076 (2.19) -0.001 (0.11) -0.046** (-2.27)

4 Coefficient (t-statistic) 0.073 (1.97)

-0.002 (-0.24) -0.017 (-1.26)

-0.013** (-1.93) -0.008* (-1.30) -0.014** -0.016** -0.014** -0.016** VOLUNTARY (-2.02) (-2.27) (-1.98) (-2.29) -0.000 0.000 -0.000 0.000 SIZE ? (0.03) (0.05) (-0.12) (0.03) 0.058** 0.059** 0.059** 0.058** LEV ? (2.08) (2.13) (2.10) (2.14) 0.009 0.007 0.008 0.007 BIG5 (0.97) (0.84) (0.95) (0.84) 0.080** 0.077** 0.082** 0.077** LAGADA (2.12) (1.86) (2.24) (1.86) -0.111** -0.109** -0.111** -0.108** CFFO ? (-2.14) (-2.09) (-2.15) (-2.09) 0.000 0.000 0.000 0.000 F_INSTI (0.22) (0.23) (0.18) (0.22) -0.001 -0.001 -0.001 -0.001 MGT (-0.69) (-0.89) (-0.58) (-0.88) 0.156** 0.162** 0.155** 0.162** A_CHNI (2.28) (2.34) (2.27) (2.34) -0.008 -0.007 -0.007 -0.007 LOSS ? (-0.74) (-0.63) (-0.66) (-0.62) 0.044 0.040 0.043 0.040 ROA ? (0.76) (0.67) (0.74) (0.67) 0.310* 0.308* 0.310* 0.310* ROA2 ? (1.52) (1.48) (1.51) (1.49) Adj. R-square 0.114 0.102 0.116 0.103 F-value 6.26*** 5.64*** 6.36*** 5.66*** *, **, and *** denote significance at the 0.10, 0.05, and 0.01 levels, respectively, one-tailed test where appropriate. We report asymptotic t-statistics in parentheses based on White (1980) standard errors. Variables are defined in Table 2.

INBD_DV * IDFE INSR_DV * ISFE

-0.018** (-1.93) -0.023** (-1.65)

45

Table 5 Additional Analyses for the Regression of Absolute Discretionary Accruals on Family Ownership, and Group Affiliation after controlling for Continuous Corporate Governance Variables and other Control Variables
(3) Full model Predicted Coefficient Variables Sign (t-statistic) 0.032 Intercept (1.41) -0.002 INBD (-0.20) -0.030** INSR (-1.70) -0.006 IDFE (-0.85) 0.002 ISFE (0.36) -0.002 VOLUNTARY (-0.33) 0.001* DEV (1.64) 0.001 -0.004 GRP_AFF (0.19) (-0.80) 0.002* 0.003** 0.003** SIZE ? (1.60) (2.00) (1.78) -0.041*** -0.047*** -0.042*** LEV ? (-3.22) (-3.90) (-3.29) 0.009 0.008 0.009 BIG5 (1.97) (1.87) (1.95) 0.133*** 0.095*** 0.133*** LAGADA (5.14) (3.70) (5.13) -0.204*** -0.204*** -0.203*** CFFO ? (-4.21) (-4.66) (-4.18) 0.000 -0.000 0.000 F_INSTI (0.01) (-0.64) (0.06) 0.000 -0.000 -0.000 MGT (-0.07) (0.00) (-0.50) 0.115*** 0.119*** 0.116*** A_CHNI (3.16) (3.59) (3.19) -0.017*** -0.017*** -0.017*** LOSS ? (-3.18) (-3.54) (-3.17) 0.002 0.007 -0.002 ROA ? (0.05) (0.22) (-0.05) 0.803*** 0.765*** 0.801*** ? ROA2 (6.39) (6.43) (6.39) Adj. R-square 0.164 0.161 0.164 F-value 21.70*** 23.92*** 20.52*** Sample firms 1,796 2,024 1,796 *, **, and *** denote significance at the 0.10, 0.05, and 0.01 levels, respectively, one-tailed test where appropriate. We report asymptotic t-statistics in parentheses based on White (1980) standard errors. Variables are defined in Table 2, except for DEV indicating the deviation between control rights and cash flow rights, and GRP_AFF a dummy variable for group-affiliated firms. Model (1) DEV included Coefficient (t-statistic) 0.038 (1.73) -0.002 (-0.21) -0.029** (-1.67) -0.006 (-0.87) 0.003 (0.39) -0.002 (-0.30) 0.001* (1.51) (2) GRP_AFF included Coefficient (t-statistic) 0.039 (1.82) 0.002 (0.27) -0.027* (-1.56) -0.009* (-1.38) -0.001 (-0.09) -0.005 (-0.83)

46

Table 6 Additional Analyses for the Regression of Absolute Discretionary Accruals on Family Ownership, and Group Affiliation after controlling for Dichotomous Corporate Governance Variables and other Control Variables
(3) Full model Predicted Coefficient Variables Sign (t-statistic) 0.030 Intercept (1.30) 0.008 INBD_DV (0.92) -0.006 INSR_DV (-0.69) -0.011* INBD_DV * IDFE (-1.49) -0.002 INSR_DV * ISFE (-0.28) -0.006 VOLUNTARY (-0.97) 0.001* DEV (1.58) 0.001 -0.004 GRP_AFF (0.29) (-0.70) 0.002* 0.003** 0.003** SIZE ? (1.50) (1.81) (1.65) -0.031** -0.031*** -0.031** LEV ? (-2.17) (-2.40) (-2.24) 0.009 0.007 0.008 BIG5 (1.92) (1.80) (1.90) 0.132*** 0.093*** 0.132*** LAGADA (5.14) (3.53) (5.14) -0.202*** -0.202*** -0.201*** CFFO ? (-4.16) (-4.61) (-4.13) 0.000 -0.000 0.000 F_INSTI (0.08) (-0.60) (0.12) -0.000 -0.000 -0.000 MGT (-0.22) (-0.16) (-0.63) 0.112*** 0.114*** 0.113*** ACHANGENI (3.07) (3.40) (3.10) -0.017*** -0.018*** -0.017*** LOSS ? (-3.23) (-3.59) (-3.22) 0.002 0.010 -0.001 ROA ? (0.06) (0.30) (-0.03) 0.797*** 0.762*** 0.794*** ? ROA2 (6.30) (6.36) (6.30) Adj. R-square 0.163 0.161 0.162 F-value 21.50*** 23.89*** 20.32*** Sample firms 1,796 2,024 1,796 *, **, and *** denote significance at the 0.10, 0.05, and 0.01 levels, respectively, one-tailed test where appropriate. We report asymptotic t-statistics in parentheses based on White (1980) standard errors. Variables are defined in Table 2, except for DEV indicating the deviation between control rights and cash flow rights, and GRP_AFF a dummy variable for group-affiliated firms. Model (1) DEV included Coefficient (t-statistic) 0.035 (1.58) 0.008 (0.94) -0.006 (-0.69) -0.011** (-1.51) -0.002 (-0.25) -0.006 (-0.94) 0.001* (1.47) (2) GRP_AFF included Coefficient (t-statistic) 0.035 (1.64) 0.012 (1.37) -0.002 (-0.18) -0.015** (-2.19) -0.006 (-1.00) -0.010** (-1.67)

47