Corporate Governance And Earnings Management In Latin American Markets
1. Corporate Governance and Earnings Management in Latin American markets
Jesus Alfonso Saenz Gonzalez Emma Garcia Meca
Profesor Investigador UACJ Profesora Titular UPTC
Abstract:
We use panel data to examine the relationship between the internal mechanisms of
Corporate Governance and Earnings Management measured by discretionary accruals in
companies listed on Latin American markets. Our results show how the Board dimension
creates problems of communication and coordination that reduce the oversight over the
management team, increasing earnings management. Also, we point out how in the Latin
American context the role of external directors is limited and those Boards that meet more
frequently takes a more active position in the monitoring of the insiders, showing a lower use
of manipulative practices. In addition, we find a non-linear relationship between insider
ownership and discretionary accruals, also pointing out that ownership concentration may be
a manipulative practices constrictor mechanism only when the ownership of main
shareholders is moderate. These results support the general opinion that the full application
of the Anglo-Saxon corporate governance model to a continental institutional setting is
inappropriate. In addition, the findings have important policy implications since it is, to the
best of our knowledge, the first study to analyze the relationship between the effectiveness of
the government and the earnings management behaviour. We document how when a country
implements controls aimed to reduce corruption, to strengthen the rule of law or to improve
the effectiveness of government, it leads to reduce earnings management. These data would
provide useful information for testing complementarities between low-quality financial
accounting regimes and quality control mechanisms to promote economic efficiency.
Key Words: Board of Directors; Corporate Governance; Corruption; Discretionary Accruals;
Ownership Structure; Stock Markets.
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2. 1. Introduction
In recent years, large accounting fraud uncovered in the stock markets has once again
confirmed the importance of transparency and reliability of financial information provided to
markets. It is no coincidence that this lively interest in accounting issues is accompanied by a
significant concern for good governance. The regulatory response to financial scandals has
been taking measures to protect information transparency, mitigate conflicts of interest and
ensure the independence of auditors, all in order to protect the investors interests’ and increase
the confidence of capital markets.
Thus, the strong pressure that capital markets exert on managers is an important condition
that can motivate them to engage in manipulative practices, to the point of being willing, as
shown by Graham et al. (2005), to sacrifice the value to meet investor expectations and live
up to forecasts by analysts tagged. For this reason, the accounting function should enjoy
adequate protection, and hence the corporate governance (CG) practices stand as a guarantee
of its integrity, improving the quality and transparency of financial statements1 (Johnson et
al., 2002; Garcia Osma & Gill de Albornoz, 2005; Biddle & Hilary, 2006; Biddle et al.,
2009). Thus, the establishments of internal governance processes are essential to maintain the
credibility of firms’ financial information and safeguarding against earnings manipulations
(Dechow et al., 1996). A weak governance structure may provide an opportunity for managers
to engage in behaviour that would eventually result in a lower quality of reported earnings.
This opportunistic behaviour of managers can be explained by agency theory, given the
separation between ownership and control in a firm, managers may act to maximize their own
wealth at the expense of shareholders’ wealth (Jensen y Meckling, 1976; Fama, 1980)
Thus, from the studies published by Jensen & Meckling (1976) and Fama & Jensen
(1983), it is assume that both, the role of board of directors and ownership structure, are
crucial in monitoring managerial activity, capable of reducing agency costs resulting from the
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3. alignment of ownership and management interests. Thus, several studies documented a
significant relationship between the characteristics of the board of directors and the integrity
of accounting information (Klein, 2002; Xie et al., 2003; Anderson et al., 2004; Peasnell et
al., 2005; Karamanou & Vefeas, 2005; Saleh et al., 2005; Ahmed et al., 2006; Bradbury et al.,
2006; Cheng et al., 2006; Rahman & Ali, 2006; Patelli & Prencipe, 2007; Hashim & Devi,
2008). Regarding to the ownership structure, previous studies analyzed the effect of the
internal ownership and shareholding concentration held by major shareholders on the quality
of financial results, either individually as a proxy for ownership structure or along with the
participation of managers as a distinct dimension of that structure (Wartfield et al., 1995;
Short & Keasey, 1999; Demsetz & Villalonga, 2001; Fan & Wong, 2002; Yeo et al., 2002;
Han, 2004; Lefort, 2005; Kim & Yi, 2006; Price et al., 2006). All these studies related mainly
to Anglo-Saxon countries, where outsides investors are well-protected by the legal system
(e.g. United Stated, United Kingdom) and the level of transparency is high, most listed firm’s
present widely-held ownership structures. In this setting, the main agency conflict stems from
the divergence of the interests between managers and shareholders (Jensen & Meckling,
1976).
The results documented by La Porta et al. (1998, 2000), Leuz et al. (2003), Kim & Yi
(2006) reveal that the manipulative practices are higher in economies with less developed
stock markets, with more concentrated ownership structures and weak investor protection
laws. In the Latin American context, the ownership structure of listed firms is characterised
by high levels of concentrated ownership where many firms are directly controlled by one of
the industrial or financial conglomerates that operate in the region (Khanna & Palepu, 2000;
Lefort, 2003; Lefort & Walker, 2005, 2007; Lopez & Saona, 2005; Cespedes et al., 2008), by
the use of pyramidal structures that enable controlling shareholders to separate their voting
and cash flow rights (Mendes & Mazzer, 2005), and by the notable presence of family groups
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4. among such owners (La Porta et al., 1999; Castañeda, 2000a, 2000b; Rabelo & Coutinho,
2001; Santiago et al., 2009). Moreover, the control exerted by these family owners is not
usually limited solely to their participation in the firms’ ownership since they usually play an
active role in management (La Porta et al., 1999; Castillo-Ponce, 2007). In that regard, a
lower separation between ownership and control shift the main agency conflict to the possible
expropriation of minority shareholders by controlling owners (La Porta et al., 2000; Lefort,
2005, 2007; Saona, 2009).
According to the approaches set out, this paper have the main objective to analyze the
relationship between the internal mechanisms of CG and earnings management (EM) in firms
listed on Latin American stock markets, specifically, in the markets of Argentina, Brazil,
Chile and Mexico, during the period 2006 to 2009. These countries have not been strangers to
the initiatives of practically all Western countries since the promulgation in 2000 of the
Sarbanes-Oxley in the U.S. and it seems appropriate to verify empirically the effects of CG
mechanisms such as ownership structure and board of directors on EM in these countries,
where both the predominant agency conflict and the institutional environment differ from
those in the Anglo-Saxon and Continental European markets.
In addition, according to Boyd & Hoskisson (2010) the nature of institutional country
effects in which firms are embedded shapes their governance. Thus, by using a government
index proposed by previous literature we will test if those countries that control corruption,
have a stronger rule of law and higher effectiveness of their government, reduce the EM
behaviour.
We define EM in terms of ‘absence of manipulative practices’. This is because the
intentional manipulation of earnings by managers may reduce the usefulness of earnings to
the overall users (Velury & Jenkins, 2006; Dechow et al., 2010; Matis et al., 2010). Earnings
that are persistence and predictable may not be of high quality if this results from EM
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5. (Dechow & Schrand, 2004). We use the modified version of Jones (1991) proposed by
Dechow et al. (1995) and which has been used in other studies such as Teoh et al. (1998), Xie
et al. (2003) and Francis et al. (2008) to determine the discretional accruals. Thus, we use the
absolute value of discretionary accruals [Abs (DCA) it] as a measure of the degree of EM.
This is consistent with previous studies on EM who pointed out that the study of the quality of
results does not impose any direction or sign on the expectations of EM (Wartfield et al.,
1995; Klein, 2002; Gabrielsen et al., 2002; Bowen et al., 2004, 2008; Van Tendeloo &
Vanstraelen, 2005; Wang, 2006; Chen et al., 2007; Barth et al., 2008).
This study contributes to the growing body of literature related to CG in the following
ways. First, it extends the very limited research on the relationship between CG and EM in
Latin America and provides a more comprehensive picture of this association. Second, it
provides further evidence by analyzing the empirical evidence in a Latin American context,
where the boards of directors, legal investors’ protection, the presence of reference investors’
and the threat of corporate takeover differs substantially from other regions of the world,
especially in those countries with developed markets. Third, our study extends the literature to
ethical aspects that are scarce and have not been tested yet in the relationship between internal
mechanisms of CG and EM in Latin America, such as corruption, rule of law and government
effectiveness. In this way, we include a proxy that represents the country governability level
(government index). This is because corruption is prevalent in emerging countries, affecting
the effective function of governments and economies (Gill & Kharas, 2007; Aidt, 2009). The
implementation of controls aimed to reduce the corruption, to strengthen the rule of law or to
improve the effectiveness of the government in a country could lead to reduce an
opportunistic behaviour and, consequently, could reduce the EM practices in firms.
On the other hand, the analysis of the relationship between CG and EM in Latin American
markets is motivated mainly, because several studies have investigated the use of
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6. discretionary accruals in developed market such as the U.S. (DeFond & Jiambalvo, 1991;
Wartfield et al., 1995; Dechow et al., 1996; Chung et al., 2002; Klein, 2002; Rajgopal et al.,
2002; Xie et al., 2003; Bowen et al., 2004; Cornett et al., 2008), the UK (Peasnell et al., 2000,
2005) and Australia (Koh, 2003; Davidson et al., 2005; Hsu & Koh, 2005; Wan et al., 2007).
However, very little research has looked at the relationship between CG and EM in emerging
markets, such as Latin American (Lopez & Saona, 2005; Price et al., 2006; Castrillo & San
Martin, 2007; Teitel & Machuga, 2008). It is possible that in an emerging country, the
mechanisms of CG are not as effective as in a developed country because of the different
institutional environment (Gaio, 2010, Gaio & Raposo, 2011) such as a weaker market for
corporate control (Gibson, 2003; Lins, 2003), more concentrated ownership (Khanna &
Palepu, 2000; Lefort, 2003; Lefort & Walker, 2005, 2007; Lopez & Saona, 2005; Cespedes et
al., 2008), significant family ownership (Castañeda, 2000a, 2000b; Rabelo & Coutinho, 2001;
Santiago et al., 2009) and ineffective shareholder right protection (La Porta, 1998, 2000; Leuz
et al., 2003; Lefort, 2007). Additionally, boards of directors in Latin American firms are not
as independent as those in developed countries, making less effective in monitoring the
decisions taken by managers (Spencer Stuart, 2000; Santiago & Baek, 2003; Lefort, 2005;
Helland & Sukuta, 2005). Given these institutional factors, the results of our study may not be
similar to those found for developed countries.
In this case, our study fills a gap in the existing literature by examining the effectiveness
of how internal mechanisms of CG (ownership structure and board of directors) constrict
manipulative practices in Latin American firms. Also, as this study was conducted on a large
sample of firms over a reasonable time frame, we believe that our findings capture a strong
picture of the relationship between internal mechanisms of CG and EM in Latin America.
The remainder of the paper has the following organization: in section 2, the study
hypotheses are developed; in section 3, we present the design and research methodology; in
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7. section 4, we shows the statistical results; in section 5, we discusses the results, the limitations
and future lines of research and; finally, in section 6 we present the main conclusions of our
study.
2. Previous literature and development of hypotheses
2.1. Ownership structure
The ownership structure is an internal control mechanism that focuses on the aspects that
define the ownership of the company and refers to the manner in which titles or rights of
representation redistribute the capital of the firm in one or more individuals or legal entities.
In this sense, Demsetz (1983) indicates that ownership structure is just a reflection of the
existing balance between preferences that have the owners and top management team. Thus,
the monitoring power derived from the ownership structure resulting in a kind of control
exercised over the company and, particularly, over the top management team. The final
control is given by the distribution of ownership and the capability of any owner or group of
them to influence in the decisions taken.
In this way, several studies have shown that ownership structure is a natural monitoring
mechanism that exerts great control over the performance, discretionary and remuneration of
the top management (Short, 1994; Zajac & Westphal, 1994). Thus, previous studies mainly
focuses on the effect of insider ownership over the EM (Sanchez-Ballesta & Garcia-Meca,
2007; Teshima & Shuto, 2008), analyzing how the managerial ownership influence over the
informativeness of earnings (Wartfield et al., 1995; Gabrielsen et al., 2002; Yeo et al., 2002)
or, in conjunction with ownership concentration (measured by the fraction of ownership held
by major shareholders or by the proportion of ownership held by the main shareholders of the
firm), showing how that monitoring of owners improves the quality of managerial decisions
and, consequently, the firm value, since the existence of substantial block holders leads to a
closer monitoring of management, implying a lower opportunity for EM (McConnell &
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8. Servaes, 1990; Agrawal & Knoeber, 1996; Demsetz & Villalonga, 2001; De Miguel et al.,
2004; Boubraki et al., 2005; Sanchez-Ballesta & Garcia-Meca, 2007). Thus, Yeo et al. (2002)
and De Bos & Donker (2004) shows that increased ownership concentration is an effective
CG mechanism in monitoring accounting decisions taken by management.
However, Demsetz & Villalonga (2001) affirm that in order to treat ownership structure
appropriately and to account for the complexity of interest represented in a given ownership
structure, must be consider different dimensions of ownership structure, i.e. not only focus on
the insider ownership and ownership concentration. Following this suggestion, we analyze
apart of this two commonly dimensions examined by previous literature, two different
dimensions of ownership structure that previous literature also shown that could be an
effective CG mechanism in monitoring management decisions, capable to constricts
manipulative practices and, consequently, improving the earnings quality: family ownership
(Wang, 2006; Ali et al., 2007; Bona et al., 2008) and institutional ownership (Shleifer &
Vishny, 1997; Rajgopal et al., 2002; Chung et al., 2002; Balsam et al., 2002; Jiambalvo et al.,
2002; Koh, 2003; Han, 2004; Ferreira & Matos, 2008; Ruiz et al., 2009; Ferreira et al., 2010).
The next sections describe the development of the hypotheses related to the four ownership
structure variables examined in our study.
2.1.1. Internal ownership
The hypotheses about the influence that the ownership structure has on the value of the
firm, justified mainly through the Agency Theory, have been extended to other aspects of
company information, such as EM. Therefore, Agency Theory suggests that when managers
are not owners of the entity that they lead or have a low equity stake on it, their behaviour is
affected by self-interest that away goals of maximizing corporate value and, therefore, of the
interest of shareholders, which facilitates EM (Jensen & Meckling, 1976; Fama, 1980; Fama
& Jensen, 1983; Healy, 1985; Holthausen et al., 1995). In contrast, if managers have a certain
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9. proportion of their wealth materialized in shares of the company that they lead, at most
directly affect their personal wealth on the decisions taken will tend to align, to a greater
extent, their interests with other shareholders (convergence of interests’ hypothesis) and show
less discretionary behaviour (Chaganti & Damanpour, 1991; Mehran, 1995; Alonso & De
Andres, 2002; Minguez & Martin, 2003). However, excessive internal ownership may also
have an adverse effect on the company, because the higher power of the managers could lead
them to take accounting decisions that reflect personal reasons, affecting the goal of
maximizing the value of the company (Yermack, 1997; Aboody & Kaznik, 2000). In line with
this, Weisbach (1988) and Fernandez et al. (1998) point out that managers could use the
higher power contained by their shares to avoid be removal in case of inefficient behaviour. In
this way, arise the entrenchment hypothesis pointed out by Fama y Jensen (1983), which
established that high levels of internal ownership could lead to a greater EM by managers
(Cornett et al., 2008). Therefore, Yeo et al. (2002) concludes that the informativeness of
accounting results increases with low levels of internal ownership, while for high levels, the
internal ownership is not sufficient as alignment interest’s mechanism (Mork, et al., 1988;
Wartfield et al., 1995; Sanchez-Ballesta & Garcia-Meca, 2007).
In Latin American context, Santiago et al. (2009) for a sample of listed companies in
Brazil, Chile and Mexico, found that a small number of insiders owns shares of companies,
making this group unable to exert a great influence on decisions and strategies taken by the
board of directors. This suggests an agency problem, because the internal directors' interests
seem not aligned with the interests of the other shareholders (convergence of interests’
hypothesis), that could increase the likelihood of managers to use manipulative practices for
their own benefit (Koh, 2003; Bowen et al., 2004; LaFond & Roychowdhury, 2006), reducing
the quality of the information issued by companies in Latin America (Lopez & Saona, 2005).
However, Machuga & Teitel (2009) who analyzing earnings quality surrounding the
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10. implementation of Code of Best Corporate Practices for a sample of Mexican listed
companies, found that firms with a fewer internal ownership shows a greater earnings quality
compared to those firms that not have managerial ownership, i.e. shows less manipulative
practices by managers.
Therefore, the argument that insider ownership constrains the opportunistic interest of
managers suggests a negative relation between the proportion of shares held by insiders and
the absolute value of discretionary accruals. Nevertheless, the argument that high levels of
insider ownership can become ineffective in aligning insiders to take decisions that
maximizes the firms value, suggests a positive relation. Similarly, although the convergence
of interests’ hypothesis suggests a positive association between the informativeness of
earnings and insider ownership, the entrenchment hypothesis leads to a negative relationship,
suggesting that when accountings numbers are less informative in measuring the firm
performance, high managerial ownership is likely organizational response. In this way, we
address the competing views by testing the following unsigned hypothesis:
H1: The insider shareholding affects earnings management.
2.1.2. Ownership Concentration
The degree of ownership concentration is an important factor because it helps to overcome
the problem of the lack of incentives for monitoring. Several studies shows the importance of
concentrated ownership structures in which one or a few major shareholders exert a
highlighted level of control on listed companies (Demsetz, 1983; Shleifer & Vishny, 1986; La
Porta et al., 1998; Lefort & Walker, 2000; Han, 2004; Lefort, 2005; Sanchez-Ballesta &
Garcia-Meca, 2007; Cespedes, 2008). The basic idea lies in that large shareholders has
incentives to take responsibility and cost involved in the monitoring of managers, unlike small
shareholders who tend to adopt a passive attitude in defence of their interest.
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11. In this way, large shareholders play a key role on internal control of companies, because
the volume of participation encouraged them to monitoring and influence in the strategy of
the firm where they have invested (Fernandez et al., 1998; Yeo et al., 2002; Gabrielsen et al.,
2002). This means that a greater ownership concentration should conduct, in accordance with
the efficient monitoring hypothesis (Jensen & Meckling, 1976), to a less opportunistic
behaviour and a greater tendency to maximization the value of the firm (Fama, 1980; Fama &
Jensen, 1983), having a positive impact on the informativeness of accounting earnings, since
when increasing the participation of the controlling shareholder reduce the incentives of this
owner to expropriate the wealth of minority shareholders (McConnell & Servaes, 1990;
Agrawal & Knoeber, 1996; Demsetz & Villalonga, 2001; De Miguel et al., 2004; Boubraki et
al., 2005). In this sense, De Bos & Donker (2004) point out that increased ownership is an
effective CG mechanism in monitoring accounting decisions taken by management that
implies a higher earnings quality and a strong positive effect on earnings informativeness
(Yeo et al., 2002).
However, when the level of ownership concentration is too high it can lead to agency
problems due to the expropriation of the minority shareholders’ interests (La Porta et al..
1998, 2000, 2002, Leuz et al., 2003; Boubraki et al., 2005; Lefort, 2007). In this way, arise
the entrenchment effect formulated by Morck et al. (1988), based on the influence of the
controlling shareholder over the information provided by company to the market (Zingales,
1994; Shleifer & Vishny, 1997; Sanchez-Ballesta & Garcia-Meca, 2007), where the external
investor will put scant attention to financial data, because he expects it to remain objective, to
a greater extent, the particular interests of the majority owner rather than a true reflection of
the economic consequences of transactions made by the company (Fang & Wong, 2002).
In Latin America there are two important aspects that characterize the structures of
ownership and corporate control: first, companies shows a high degree of ownership
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12. concentration and, second, many firms are directly controlled by one of the industrial or
financial conglomerates that operate in the region (Khanna & Palepu, 2000; Lefort, 2003;
Lefort & Walker, 2005, 2007; Lopez & Saona, 2005; Cespedes et al., 2008). In their studies,
Santiago et al. (2009) and Saona (2009) for a samples of companies in Chile, Brazil and
Mexico, found that 96% of Chilean companies are affiliated to a conglomerate, followed by
72% of Brazilian companies and 57% of Mexican firms. Usually, the majority shareholder
holds the power of the conglomerates through complex structures of ownership, called
pyramids2. The problem with pyramidal structures is that they allow a phenomenon known as
tunneling3, whereby the last shareholder can divert resources among different companies of
the pyramid, of course in their own benefit, hiding the true structure of the company and
distorting the relationship between ownership and control (Shleifer & Vishny, 1997; Bertrand
& Mullainathan, 2002; Mendes & Mazzer, 2005). This type of governance structure can infer
on the quality of the financial results of companies in Latin America, increasing EM.
Therefore, the argument that a greater ownership concentration should conduct, in
accordance with the efficient monitoring hypothesis, to a less opportunistic behaviour and a
greater tendency to maximization the value on the firms’ informative quality of accounting
earnings, suggests a negative relation between the proportion of shares held by large
shareholders and the absolute value of discretionary accruals. However, the argument that
high levels of ownership concentration can lead to agency problems due to the expropriation
of the minority shareholders’ interests, in accordance with the entrenchment effect, suggests a
positive relationship. In this way, we address the competing views by testing the following
unsigned hypothesis:
H2: The ownership concentration affects earnings management.
2.1.3. Family Ownership
The Agency theory assumes that moral hazard problems are lower in companies with
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13. concentrated ownership structures, given the incentives and the greater ease with which the
big shareholders can monitor the management team. If the companies management is in hands
of the owners, as usually occurs in family firms, will tend to eliminate the agency problem
that arises from the separation of ownership and control, achieving greater alignment of
interests between shareholders and management, resulting in a higher value creation in the
company through the benefits arising from the increased monitoring (Shleifer & Vishny,
1986).
In this sense, several studies have shown how certain distinctive characteristics of family
firm have a positive impact on corporate behaviour. More specifically, in their study of a
sample of 500 US firms between 1992 and 1999, Anderson et al. (2003) reveal that family
firms achieve higher levels of performance than non-family firms. This result would be
justified by certain characteristics associated with family nature of the firm, such as it long-
investment horizons and its reputation concerns. In this sense, compared with other types of
owners, families are interested in remaining in the firm over a long period time, so they are
more prone to make investments that maximize value in the long term (Anderson & Reeb,
2003; Jaggi et al., 2009). Thus, a family owner would tend to have incentives to follow
market rules when making decisions, since the firm is not considered a resource to be
consumed during the owner’s lifetime but rather an asset to be transferred to his/her heirs in
the future (Dyer, 2003). Therefore, the firm’s survival becomes a “family matter” in this type
of enterprise. Furthermore, Anderson et al. (2003) suggest that the long-term ties typical of
the family owner mean that external agents, such a supplier or lenders, develop their business
with the controlling family over a long period of time. This leads to those external agents
perceiving a “family reputation” that has economic consequences that last not only for
owners’ lifetime, but throughout the lives of his/her heirs.
On the same lines, Wang (2006) and Ali et al. (2007) states that long-term orientation and
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14. reputation concerns means that family firms do not act opportunistically in reporting earnings,
such those actions that are more in line with a short-term orientation. These authors uses these
arguments to offer possible explanations for the result obtained in his study using a sample of
U.S. firms and concludes that family firms provide better earnings quality than non-family
firms, leading to reduced managerial discretion that results in better performance of the
companies (Anderson et al., 2004).
At this point, it could be concluded that compared with non-family firms, controlling
family firms would tend to maximize the firm’s wealth in the long term. Thus, there would be
fewer incentives to obtain private benefits at the expense of minority shareholders, which in
turn could result in a higher earnings quality (Bona et al., 2008). However, Wang (2006) and
Ali et al. (2007) also point out that one of the main limitations that have their studies is the
difficulty to extend their results to other settings where there is a lower protection of minority
shareholders, and consequently, more concentrated ownership structures such as Latin
American context. This is because the presence of concentrated ownership structures and the
presence of family groups may trigger other problems of CG. In this sense, when there are
large shareholders on firms it is more likely to arise conflicts of interests between these parties
and the minority shareholders. In family firms, given their greater information asymmetries,
the likelihood of expropriation of corporate resources is high, including the likelihood of
entrenchment of unskilled family management team (Mcvey et al., 2005; Sacristan & Gomez,
2007).
According with this argument, Castrillo & San Martin (2007) for a sample of Mexican
companies, studying the relationship between ownership structure and the board of directors
with managerial discretion, finding that family ownership and the level of corporate leverage
explain the degree of discretion that managers have to manipulate accounting numbers in
Mexico. They also point out that the high concentration of family ownership is a mechanism
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15. usually used to align the interest of the company in benefit of the majority shareholder, in
detriment of minority shareholders. Other studies conducted on Latin American context such
as Castañeda (2000a, 2000b) and Rabelo & Coutinho (2001) shows that a high family
participation exerts a decisive influence on the control of companies, where the owners
usually issued non-voting shares and develop pyramidal ownership structures to obtain funds
without dispersing their capacity to control the companies. According to previous arguments,
it could be argued that the greater concentration of voting rights could entail greater
incentives for controlling shareholders to obtain private benefits, i.e. increasing EM (Bona et
al., 2008).
In this respect, some studies have provided evidence on the expropriation actions carried
out by family groups. DeAngelo & DeAngelo (2000) shows how the controlling family of a
large North American firm cut dividends to minority shareholders while paying itself a special
dividend. Similarly, drawing on data based on a entire population of Spanish newspapers
Gomez-Mejia et al. (2001) analyze the role that family relations play in agency contracts and
provide evidence of the entrenchment of the chairman of the board when he/she has a family
ties with the controlling shareholders. In those circumstances, controlling shareholders would
have incentives to manipulate the accounting information in order to avoid the cost associated
with the detection of this kind of behaviour (Fan & Wong, 2002; Haw et al., 2004; Francis et
al., 2005; Santana et al., 2007). In this way, Fan & Wong (2002) states that, when an owner
effectively controls a firm, she/he also controls the production of the firms’ accounting
information and reporting policies.
Therefore, the argument that a greater family ownership should conduct to a positive
impact on corporate behaviour, justified by certain characteristics associated with family
nature of the firm such as it long-term investment horizons and its reputation concerns,
leading to reduced managerial discretion that results in a better performance of the firms,
15
16. suggests a negative relation between the proportion of shares held by family owners and the
absolute value of discretionary accruals. However, the argument that high levels of family
ownership can lead to agency problems due to the expropriation of the minority shareholders’
interests, suggests a positive relationship. In this way, we address the competing views by
testing the following unsigned hypothesis:
H3: The family ownership affects earnings management.
2.1.4. Institutional Ownership
The literature review carried out related to the influence of institutional ownership on EM,
reveals the existence of two conflicting views regarding the general role of institutional
investors in the companies. On one hand, Porter (1992) and Bhide (1993) argue the
fragmented ownership that usually have these institutional investors and the frequency of
trading investments, does not actively engage in CG of companies that are part of their
portfolios. Furthermore, Bushee (1998) and El-Gazzar (1998) argue that institutional investors
plays an active role in controlling managerial discretion and improve the efficiency of
information in capital markets, being sophisticated investors with advantages to acquire and
process information (Balsam et al., 2002; Jiambalvo et al., 2002; Koh, 2003; Han, 2004;
Ferreira & Matos, 2008; Ruiz et al., 2009; Ferreira et al., 2010), limiting the opportunism and
promoting the reduction of agency costs (Shleifer & Vishny, 1997; Rajgopal et al., 2002;
Chung et al., 2002). In this way, Koh (2003) and Hsu & Koh (2005) proposed that the role of
institutional investors in firms can be approximated considering the level of participation of
the institutional shareholders in them, i.e., that institutional ownership may act as a
governance mechanism that affects the EM based on the level of their participation. In
concrete, low levels of investor participation is assimilated to temporary or short-term view,
whereas when the level of participation increases, the institutional investor is assimilate as an
investor more engaged with the company, and hence, involved in the resolution of conflicts
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17. that may arise therein.
In Latin America context, Lefort (2005) pointed out that institutional investor have an
important role in CG of companies. The early reform of the pension funds in Chile, followed
later by Argentina, Colombia, Peru and Mexico, gave to institutional investors an important
role as providers of capital and prompted several changes to the laws of capital markets in the
region, helped to substantially improve the protection of minority shareholders (Iglesias,
2000), given the nature of funds administered and their political influence. In this way,
Walker & Lefort (2001) shows that the participation of institutional investors create a more
dynamic legal framework in capital markets using good CG practices that improves
transparency of accounting information, reducing the cost of capital in firms.
Therefore, the argument that a higher institutional ownership should conduct to a positive
impact on corporate behaviour, because the managers would be discouraged to make EM due
to the pressure from institutional investors to focus in long term, suggests a negative relation
between the proportion of shares held by institutional owners and the absolute value of
discretionary accruals. However, the argument that low levels of institutional ownership could
lead to managers to manipulate accountings numbers, due to the short-term vision and the
preference for short-term gains, suggests a positive relationship. In this way, we address the
competing views by testing the following unsigned hypothesis:
H4: The institutional investors affect earnings management.
2.2. Board of Directors
The board of directors is the governance body in which shareholders delegate the
responsibility to oversee, compensate and substitute managers, as well as to approve major
strategic projects, and therefore plays a key role in the overall oversight of the company and
the monitoring of top management, in particular (Jensen & Meckling, 1976; Jensen, 1993;
17
18. John & Senbet, 1998; Daily et al., 2003; Chatterjee et al., 2003). In this way, the board of
directors is an essential element of CG and is considered the main internal mechanism to
reduce agency conflicts, either between managers and shareholders or between majority and
minority shareholders (LaFond & Roychowdhury, 2006; De Andrade et al., 2009).
The CG literature shows different characteristics that may influence in the effectiveness
with which the boards monitor the performance of managers in firms (John & Senbet, 1998;
Rahman & Ali, 2006). In this sense, this influence depends on the ability of control that exert
the board over the top management (Brick et al., 2005), which can be affected by aspects such
a number and type of directors (Karamanou & Vafeas, 2005), the ownership structure of the
firm (Kim & Yi, 2006), the quality of CG system (Gibson, 2003), the activism of institutional
investors (Koh, 2003), the CEO duality or concentration of power (Saleh et al., 2005; Hashim
& Devi, 2008), the existence of specific committee (Klein, 2002; Goodwin & Kent, 2006), the
presence of a hostile takeover market or the existence of a competitive labour market (Brick et
al., 2006; De Andrade et al., 2009). Although, according to Fernandez et al. (1997), most of
the previous CG literature discusses two mainly characteristics or variables that influence the
monitoring capabilities of boards: its independence and size. In this way, a part of these two
characteristic, we analyze its activity and the CEO duality or concentration o power. The next
sections describe the development of the hypotheses related to the four board characteristics
examined in our study.
2.2.1. Board Size
Studies such as Davila & Watkins (2009) in Mexico and Ferraz et al. (2011) in Brazil,
found that if the size of Board is very small the monitoring of the management team is smaller
too, so they tend to a greater discretion to receive a higher remuneration, a greater chance of
EM and a more likely to information asymmetry (Fernandez et al., 1998; Azofra et al., 2005;
Brick, et al., 2006). Thus, a larger size of board assumes a better supervision of the
18
19. management team and a higher quality of corporate decisions (Pearce & Zahra, 1992). In this
sense, Chin et al. (2006) for a sample of 313 firms from Hong Kong, found a negative
relationship between the size of the board and EM, concluding that a larger board fewer are
the manipulative practices made by the management of companies.
However, excessive size can be an obstacle for quick and efficient making decisions, due
to problems of coordination and communication. In this sense, Santiago & Brown (2009) in a
sample of 97 companies in Brazil, Chile and Mexico, found a positive relationship between
the size of the board and EM. This indicates that the low separation between ownership and
control that exists in Latin American companies assumes that a larger size of the board the
levels of monitoring over the management team decreases, so it increases the risk of
expropriation by controlling shareholders and the propensity to the discretion of the board
members to establish a higher level of remuneration and manipulate the results of companies
for their own benefit (Jensen, 1993; Yermack, 1996; Fernandez et al., 1997; Eisenberg et al.,
1998; Sanders & Carpenter, 1998; Core et al., 1999; Thomsen, 2008). In line with this, Xie et
al. (2003) for a sample of 110 U.S. companies, shows a positive relationship between size of
the board and EM, concluding that a larger size of board greater are the manipulative
practices made by the management of companies. Finally, Bradbury et al. (2006) in a sample
of companies in Malaysia and Singapore found no relationship that links the size of the board
with the EM. Since we do not can say that there is a conclusive position about the effects that
board size might have on the quality of results in companies, we formulate the following
unsigned hypothesis:
H5: The board size affects earnings management.
2.2.2. Board Independence
Because previous CG literature shows that independence is often considered as a
substitute for transparency and disclosure of annual reports, recommending that a number of
19
20. external members in board of directors are greater than the owners, for there to be more
oversight of management and to maximize the value of the organization (Zattoni & Cuomo,
2010; Ferraz et al., 2011). This suggests that the degree of board independence is directly
related to the quality of information that firms issues (Cheng & Courtenay, 2006). Also, CG
literature affirmed that a greater degree of board independence provides more control over the
development of company activities and a better defence of the issue of information as a
mechanism to carry out processes of accountability to different groups of business interest,
because the external directors are not linked to the management of the entity (Willekens et al.,
2005; Karamanou & Vafeas, 2005; Cheng & Courtenay, 2006). Thereby, seeks fairness in the
strategic decisions taken by the board and effective monitoring of the decisions and activities
of managers, thus ensuring transparency of information and proper image on the outside of
organizations (Chen & Jaggi, 2000; Patelli & Prencipe, 2007). Furthermore, several studies
provide empirical evidence relating to the role of external directors on the constriction of EM,
documenting that a higher proportion of external directors, greater and better will be the
quality of financial information that is issued by firms, reducing the chances of EM (Klein,
2002; Xie et al., 2003; Peasnell, 2005; Davidson et al., 2005; Garcia-Osma & Gill de
Albornoz, 2005, 2007; Bradbury et al., 2006; Jaggi et al., 2009).
However, Park & Shin (2004) argues that transparency of information and effectiveness in
containing manipulative practices may be seriously compromised by the type of CG and,
particularly, by the high ownership concentration that could neutralize performance of the
external directors. In this way, the Securities and Exchange Commission (SEC) of the United
States noted that in Latin America, given the widespread use of pyramidal structures and the
high degree of participation that have the controlling shareholders in the daily activities of
Latin American firms, generally the boards of directors are mainly integrated by internal
directors, who tends to be associated with the majority shareholders and/or control groups,
20
21. making boards less effective in monitoring the decisions taken by managers opposed to those
boards that have a majority of external directors4 (Santiago & Baek, 2003; Lefort, 2005;
Helland & Sykuta, 2005). In this sense, external directors have a very limited participation
that facilitates the EM and managerial discretion (Silveira et al., 2003; Schiehll & Santos,
2004).
Nevertheless, most recent studies such as Price et al. (2006, 2007), Teitel & Machuga
(2008), Chong et al. (2009), Davila & Watkins (2009) and Ferraz et al. (2011) shows that
legal framework in capital markets (such a Code of Best Corporate Practices) forced Latin
American firms to include more external directors, allowing to improve the way that firms
disclosed their financial information, showing a greater transparency in their reports and
decreasing the chances of EM. By the above, we formulate the following hypothesis in the
sense that it could be expecting a possible negative association between the degree of board
independence and EM:
H6: The boards independence affects negatively on earnings management.
2.2.3. Board Activity
Another characteristic related to the board of directors is its activity, measured by the
number of meetings, since its size and independence are necessary but not sufficient. Thus,
Adams (2003) and Garcia Lara et al. (2009) suggest that the number of meetings is a good
proxy for the directors’ monitoring effort. As Menon & Williams (1994) notes, boards that do
not meet, or meet only a few numbers of times, are unlikely to be effective monitors. In this
way, Eguidazu (1999) argues that it is also essential that the boards being active and
understand its task as a continuous process, and empirically Vafeas (1999) has demonstrated
the existence of a direct relationship between the board activity and the profitability of the
firm. In consequence, is possible that boards with more engaged on their duties take a more
active stance in order to safeguard the quality of accounting information, so hopefully, in
21
22. principle, a negative relationship between the board's activity and EM (Monterrey & Sanchez,
2008). An opposing view is that board meetings are not necessarily useful because routine
task absorb much of limited time that directors and CEO’s spend together to set the agenda
for board meetings (Lorca et al., 2011). By the above, we formulate the following hypothesis
in the sense that it could be expecting a possible negative association between the boards
activity and EM:
H7: A greater number of board meetings influences negatively on earnings management.
2.2.4. CEO Duality
It is understood that there is concentration of power in a company when the same person
takes charge of chief executive and president of the board. This assumption of power
increases, from the perspective of the Theory of Agency, the risk that the chief executive can
develop strategies that promote their personal interests (Jensen & Meckling, 1976; Jensen,
1986) encouraging the management team to adopt decisions for their own benefit without
considering the interests of owners and even develop actions against them (Cole et al., 2001;
Jensen & Zajac, 2004), which could create information asymmetries and conflicts of interest,
thus leading to inefficiency in CG (Fama & Jensen, 1983; Jensen, 1993). Furthermore, the
existence of duplicity of functions arises the illogical that the manager is controlled by
himself, i.e., has a greater power to influence members of the board of directors, which alters
the functioning of the company and the handling of the ownership structure of companies
(Cyert, 2002; Dahya & Travlos, 2002; Brick et al., 2006; Faleye, 2007; Ganga & Vera, 2008).
Also, CEO duality may damage the transparency of information of the company, raising the
possibility of the development and disclosure of fraudulent financial statements (Forker,
1992; Pi & Timme, 1993; Hashim & Devi, 2008).
Some empirical studies developed in Latin America, shows that in practice is not fulfilled
with the separation of roles between the president and CEO, despite the recommendations of
22
23. the Codes of Good Governance, given the high concentration of ownership and control held
by families that produces an effect of entrenchment by the chairman of board of directors
when it maintains family ties with the major shareholders. In this sense, in Mexico, Castañeda
(2000b) found that in 85% of Mexican companies listed on the Stock Exchange in New York,
the majority owners presides the board of directors and also exerted the role of CEO.
However, Husted & Serrano (2002) argues that while in Mexican firms, the family retained
both functions, a group of them showed that the majority owner delegated the role of general
manager to a family member, which responds to succession process and the need to provide a
resource management of the business trust (Hoshino, 2004; Ruiz-Porras & Steinwascher,
2007).
Also, Leal & Carvalhal (2005) in Brazil, through the application of surveys on a sample of
400 listed companies, documented that 36% of companies have concentrated power in the
same person. In Argentina, Chisari & Ferro (2009) for a sample of 100 listed firms, found that
75% of the corporations the chairman and CEO are the same person. This situation is not very
different in Chile, Lefort and Walker (2005) obtained similar results in a sample of 120 listed
companies, pointing out that only in 21% of corporations Chairman of the board is
independent, that is, not have duplication of functions between President-CEO, a situation
that is widespread throughout Latin America. By the above, we formulate the following
hypothesis in the sense that it could be expecting a possible positive association between the
CEO duality and EM:
H8: The existence of concentration of power (CEO duality) increases earnings
management.
2.3. Government Index
While corruption is prevalent in emerging countries, there is increasing focus on the
degree of its predictability to affect the effective functioning of governments and economies
23
24. (Gill & Kharas, 2007; Aidt, 2009). Voliotis (2011) looked at different forms of organisational
corruption at the European Union; Galang´s (2011) study reviewed the corruption literature in
leading management journals while Dela Rama (2011) looks at how the CG of family-owned
business groups, deals with different forms of corruption in Asia. However, literature
regarding ethical aspects on Latin American countries is scarce and the effects on discretional
behaviour have not been tested yet.
Thus, we use the Government Index (GOV_Index) taken from the research project
“Worldwide Governance Indicators” (WGI)6 proposed by Kaufmann et al. (2010) and
published by the world Bank7 between the periods 2006-2009. In this way, we integrated this
index using three mainly indicators that previous literature have shown as more important
factors to measure the way in which the governability of a country helps to reduce or even
increase the opportunistic behaviour in firms: Control of corruption, rule of law and
government effectiveness (Aidt, 2009; Voliotis, 2011; Galang, 2011). In this sense, low levels
of governability (a low index value) imply, generally, behaviours that affect the trust placed in
public officials and, therefore, undermine the basis of government trust (Shleifer & Vishny,
1993). The presence of corruption, the lack of confidence and respect of the agents in the
quality of contract enforcement, property rights, courts, as well as the ineffectiveness of
governments about the implementation and formulation of policies, increase the risk of the
entrepreneur, because people from outside value chain may have opportunistic behaviour and
take advantage of their profits, situation that is feasible due to the relatively high levels of
asymmetry information that characterize the economic activity (Anokhin & Schulze, 2008). In
addition, the corruption, the inefficiency of governments and a weak rule of law as well as
other weaknesses in the country infrastructure, increase transaction and agency costs, limiting
the income of the firms (Manzetti & Wilson, 2007) and, in consequence, increase the
opportunistic behaviour of firms. By contrast, control of corruption, a strong rule of law and a
24
25. effectiveness of government (a high index value) increase the chance that entrepreneurs
capture a larger portion of the revenues that they generate by increasing the reliability of cash
flows (Rose-Ackerman, 2001) and, consequently, reduce the opportunistic behaviour in firms.
Furthermore, in recent years Latin American countries have been made reforms to their legal
frameworks, modifying laws and established harder punishments to those persons who are
demonstrated a corruption practice. By the above, we formulate the following hypothesis in
the sense that it could be expecting a possible negative association between the government
index and EM:
H9: A country with higher levels of governability shows a lower opportunistic behaviour,
i.e. the firm’s shows lower levels on earnings management practices.
3. Design and Research Methodology
3.1. Sample and Data
The sample is obtained from companies listed on the Mexican Stock Exchange (Bolsa
Mexicana de Valores), Santiago Stock Exchange (Bolsa de Comercio de Santiago), Stock
Market of Buenos Aires (Mercado de Valores de Buenos Aires) and the Sao Paulo Stock
Exchange (Bolsa de Valores de Sao Paulo) during the period 2006 to 2009. Financial
institutions are excluded, as is common in this type of studies because their particular
accounting practices. The accounting data on financial statements obtained through
Economatica database, while data on CG and ownership structure are obtained directly from
annual reports submitted by companies to the different regulatory agencies8 and which are
available in their Web site. In this way, we get information for 435 firms and a total of 1,740
observations by the period from 2006 to 2009. The composition of the sample allows the
combination of time series and cross sections with an adequate opportunity to take advantage
in the creation of a panel data, especially in the control of unobserved heterogeneity, i.e. the
individual characteristics of each entity that are not observable but affects the variables under
25
26. study (Arellano & Bover, 1991; Arellano, 1993; Himmelberg et al., 1999; Palia, 2001; Brick
et al., 2005). Additionally, since at present is widely accepted the idea of using unbalanced
panels with total observations is discarded the option of analyzing balanced panels with fewer
companies, because it may be conditioned by the survival bias (Baltagi & Chang, 1994).
3.2. Models and Variables Definition
Because the intention of investigating the influence that CG mechanisms have on EM,
measured by discretionary accruals, we regress the absolute value of discretionary accruals
[Abs (DCA)it] on the variables of ownership structure, board of directors and control used in
previous literature, according to the following model:
Abs(DAC)it= Β0 + β1 (Int_OW ) + β2 (OW _Con) + β3 (Fam_OW ) + β4 (Inst_OW ) +
β5 (Board_SIZE) + β6 (Board_I D) + β7 (Board_ACT) + β8 (CEO_Dual) +
β9 (GOV_Index) + β10 (Control) + ηi + λt + υit
The unobserved heterogeneity is controlled in the two models through individual effects
of companies (ηi). Also, we included dummy variables to control the temporal effects (λit)
and the error term (υit). As a proxy for internal property (Int_OWN) we use the proportion of
shares ≥ 1% owned by members of board of directors and managers of the firms; the
ownership concentration (OWN_Con) is measured by the proportion of shares owned by the
major shareholder of the company, because many firms in Latin America are directly
controlled by one of the industrial or financial conglomerates that operate in the region
(Lefort & Walker, 2005, 2007; Lopez & Saona, 2005; Cespedes et al., 2008); the family
ownership (Fam_OWN) is measured by the proportion of shares held by family members, i.e.
the percentage of capital that is directly or indirectly in their hands ≥ 5% and; the institutional
ownership (Inst_OWN) through the proportion of shares held by institutional investors.
Moreover, the board size (Board_SIZE) is measured by the total number of directors that
26
27. integrate the board of directors; the board independence (Board_IND) is measured by the
proportion of external directors inside the board (external directors / total directors) and with a
dummy variable (Board_IND50) that takes the value of one when the board comprises with a
majority of external directors; the board activity (Board_ACT) is measured by the number of
meetings held during the year; the President-CEO duality (CEO_Dual) is measured through a
dummy variable that considers the value of 1 if there is duality of roles between the chairman
and CEO of the firm and, 0 otherwise. Finally, the government index (Gov_Index) that
measure the governability level of the country (control of corruption, rule of law and
government effectiveness).
On the other hand, we control the effect of various factors through the inclusion of
variables to our model, which have been used in previous studies and have been associated
with EM and CG. Thus, the variable quality and reputation of the external auditor (Big_4)
measured by a dummy variable that takes the value 1 if the company is audited by one of the
big four audit firms, 0 otherwise. In this way, several studies indicate that quality of
accounting information will be linked to the prestige and quality of the external auditor
(DeFond & Jiambalvo, 1991, 1994, DeFond, 1992; Teoh & Wong, 1993; Dechow et al.,
1996; Lennox, 1999a, 1999b; Jara & Lopez, 2007), because most reputable auditors limit the
possibility of EM (Becker et al., 1998; Francis et al., 1999; Kim et al., 2003; Van Tendeloo &
Vanstraelen, 2005) and therefore, the financial statements audited by these firms have greater
credibility (DeFond & Subramayan, 1998; Teoh et al., 1998).
Another control variable is the firm size (Log_ASSET) measured by the natural logarithm
of total assets at the end of year (Sanchez & Sierra, 2001; Navarro & Martinez, 2004),
controlling with it the effects of company size on accounting choice. Authors generally
expect, and often proves, a negative relationship between firm size and EM, given that in
larger companies are expected to have more sophisticated control systems, skilled advisers,
27
28. more negotiating power with the external auditor and are subject to increased monitoring by
investors and analysts, so accounting fraud is less probable than in smaller firms, where the
managers of these companies have more opportunities to manipulate the information (Beasley
et al., 1999; Bartov et al., 2000; Reynolds & Francis, 2000; Sanchez & Sierra, 2001; Klein,
2002; Richardson et al., 2002; Lee & Choi, 2002; Navarro & Martinez, 2004; Garcia Osma &
Gill de Albornoz, 2005; Cahan & Zhang, 2006; Goodwin & Kent, 2006; Prior et al., 2008).
Moreover, we includes the indebtedness level variable (Debt), calculated as the ratio of total
debt and total assets. Thus, a high indebtedness is associated with the risk of excessive
leverage (Press & Weintrop, 1990), which motivates the EM to conceal inconvenient
information and display a greater capacity to generate resources (DeFond & Jiambalvo, 1994;
Sweeney, 1994; DeAngelo et al., 1994; Dechow et al., 1995; Krishnan et al., 1996; Frankel et
al., 2002; Balsam et al., 2003).
Additionally, following the study of Francis & Wang (2004) we include two control
variables on firm performance. The first is the growth variable (GROWTH), measured in
terms of the relation of the difference in sales and sales of the previous period for firm i in
year t, which indicates that firms with high growth rates are more likely to use discretionary
accruals (McNichols, 2000). The second is the variable (ROA), calculated by the ratio
between earnings before extraordinaire, interest and taxes of year t and the total net assets at
beginning of year t, and positively related to the use of discretionary accruals. This suggests
that managers are motivated to manipulate the results upward, i.e., increase the benefits
obtained with the intention to make the company more attractive (Kothari et al., 2005;
Machuga & Teitel, 2007).
Also, because a poor financial situation of the company could increase agency costs and
encourage the management to manipulate the accounting numbers (Nurul et al., 2010; Sierra
et al., 2010) we includes the control variable loss (Loss) which is measured through a dummy
28
29. variable that takes value of 1 if the company has had losses in the last two years and, 0
otherwise. Finally, we consider the sector of activity variables (IND) and year (YEAR), being
these important factors of measurement, because in sectors and specific years could have a
better results to identifying discretionary accruals (McNichols et al., 1988; Roychowdhury,
2006).
4. Analysis and Results
4.1. Descriptive Analysis
Table 1 displays the descriptive statistics and t values of discretionary accruals for
estimated [Abs (DAC) it], showing that mean values of discretionary accruals are, in all cases,
statistically different from zero. This does not allow us to reject the null hypothesis and,
therefore, provides evidence that Latin American companies manipulate their results, either
by increasing the benefit to denote a better and higher profitability of the company or, on the
contrary, reducing the benefit as fiscal strategy aims to pay fewer taxes and contributions.
TABLE 1:
Descriptive Statics of Discretionary Accruals [Abs (DAC)it]
Estimations by Year
Year N Mean Median Std. Dev. T Adjusted R2
DAC-2006 435 0.224 0.119 0.441 0.619 0.536
DAC-2007 435 0.278 0.112 0.704 -1.070 0.285
DAC-2008 435 0.198 0.122 0.293 1.567 0.118
DAC-2009 435 0.249 0.142 0.420 -0.243 0.808
Global 1,740 0.237 0.121 0.489 1.459 0.447
For its part, Table 2 shows the mean, median, standard deviation and the associated t-
Value of the estimated coefficients of the absolute value of discretionary accruals [Abs
(DAC)it] per country. In it, can be seen that the model significantly explained variations in the
coefficients of discretionary accruals, as its explanatory power shows Adjusted R2 values
(significance level) above 40% for all the countries.
29
30. TABLE 2:
Descriptive Statics of Discretionary Accruals [Abs (DAC)it]
Estimations by Country
Country N Mean Median Std. Dev. T Adjusted R2
Argentina 308 0.247 0.137 0.425 0.412 0.744
Brazil 480 0.293 0.152 0.481 1.749 0.476
Chile 532 0.236 0.101 0.651 1.852 0.542
Mexico 420 0.167 0.110 0.198 1.493 0.408
Global 1,740 0.237 0.121 0.489 1.459 0.447
Table 3 shows the main descriptive statistics of quantitative and dichotomous variables.
Thus, with respect the board characteristics variables it can be seen that in the four countries
analyzed, generally, companies boards meets on average 5 times a year. It can also be seen
that boards are composed with a mean of 11 members, of whom 38.5% are external directors,
a fact that clearly indicates that the composition of this organ of government is a majority of
internal members, thus demonstrating control and domain that have families on this governing
body (Santiago & Brown, 2009; Santiago et al., 2009). Our result contradicts the
recommendations highlighted in previous studies that recommend an integration of boards by
a majority of external directors (Hermelin & Weisbach, 2003; Sanchez & Guilarte, 2006,
2008; Zattoni & Cuomo, 2010); and is in line with results of previous studies conducted in
Latin America which document, likewise, a composition of boards by a majority of internal
directors (Silveira et al., 2003; Schiehll & Santos, 2004; Lefort, 2005, Ferraz et al., 2011).
Regarding the ownership structure, Table 3 shows that Mexican companies reveal to have
a higher family engagement with the 37.1%, followed by Argentinean (35%), Chilean
(26.2%) and Brazilian (24%) companies. The ownership concentration (major shareholder)
reflects an average of 29.4% of the social capital of firms. In this way, Chilean companies are
those that revealed have a higher shareholding concentration with 32.2%, followed by
Brazilian (29.3%), Mexican (28.6%) and Argentinean (27.5%) firms. Moreover, regarding to
the internal ownership (top management), it can be seen that manager and directors holds, on
average, 6.1% of the social capital of companies. Thus, Brazilian firms are those that revealed
30
31. have a higher internal ownership with 7.3%, followed by Argentinean (7.1%), Chilean (6%)
and Mexican (4.5%) companies. Finally, the institutional ownership indicates an average
value of 22.8% of social capital held by institutional investors. Thus, Brazilian companies are
those that have revealed a higher participation of institutional investors with 23.9%, followed
by the Chilean (23.8%), Argentinean (21%) and Mexican (20.6%) firms.
TABLE 3:
Descriptive Statistics of Quantitative and Dichotomous Variables
Observations by Country
Variable Statistics Argentina Brazil Chile Mexico Global
a) Quantitative Variables 1
N 308 480 532 420 1.740
Int_OWN Mean 0.071 0.073 0.060 0.045 0.061
Std. Dev. 0.046 0.048 0.047 0.038 0.046
Mean 0.275 0.293 0.322 0.286 0.294
OWN_Con
Std. Dev. 0.106 0.102 0.118 0.101 0.107
Fam_OWN Mean 0.350 0.240 0.262 0.371 0.305
Std. Dev. 0.163 0.177 0.181 0.181 0.179
Inst_OWN Mean 0.210 0.239 0.238 0.206 0.228
Std. Dev. 0.145 0.136 0.135 0.135 0.137
Mean 11.49 11.38 11.54 11.47 11.47
Board_SIZE
Std. Dev. 3.82 3.69 3.60 3.66 3.67
Mean 0.400 0.394 0.366 0.375 0.385
Board_IND
Std. Dev 0.730 0.891 0.077 0.862 0.083
Mean 5.42 5.37 5.33 5.15 5.31
Board_ACT
Std. Dev. 2.49 2.50 2.47 2.38 2.46
Mean 41.13 51.12 88.05 48.78 49.73
GOV_Index
Std. Dev. 3.25 2.51 0.68 2.06 18.78
Mean 13.32 13.39 18.39 16.09 15.58
Log_ASSET
Std. Dev. 1.91 1.75 2.32 1.70 2.93
Mean 0.396 0.504 0.280 0.227 0.350
Debt
Std. Dev. 1.371 0.691 0.924 0.158 0.862
Mean 4.47 4.58 9.18 6.96 6.56
ROA
Std. Dev. 1.84 1.67 2.36 1.70 2.79
Mean 0.236 0.531 0.103 0.124 0.249
GROWTH
Std. Dev. 0.617 2.221 0.299 0.484 1.241
b) Dichotomous Variables 2
Variable Statistics Argentina Brazil Chile Mexico Global
N 308 480 532 420 1.740
Board_IND50 0 148 48.1% 240 50.0% 316 59.4% 224 53.3% 928 53.3%
1 160 51.9% 240 50.0% 216 40.6% 196 46.7% 812 46.7%
0 99 32.1% 193 40.2% 209 39.3% 172 40.9% 673 38.7%
CEO_Dual
1 209 67.9% 287 59.8% 323 60.7% 248 59.1% 1,067 61.3%
0 144 46.8% 199 41.5% 180 33.8% 120 28.6% 643 36.9%
Big_4
1 164 53.2% 281 58.5% 352 66.2% 300 71.4% 1,097 63.1%
31
32. TABLE 3:
Descriptive Statistics of Quantitative and Dichotomous Variables
Observations by Country
Variable Statistics Argentina Brazil Chile Mexico Global
0 234 76.0% 373 77.7% 436 81.9% 319 75.9% 1,362 78.3%
Loss
1 74 24.0% 107 22.3% 96 18.1% 101 24.1% 378 21.7%
(1) Quantitative Variables: Int_OWN = Internal ownership, measured by the proportion of shares owned by managers and members of
Boards (≥ 1%); OWN_Con = Ownership Concentration, measured by the ratio of shares held by the major shareholder of the company
(≥ 5%); Fam_OWN = Family Ownership, measured by the proportion of shares held by family members (≥ 5%), as a percentage of
capital that is directly or indirectly in his possession; Inst_OWN= Institutional Ownership, measured by the proportion of shares held by
institutional investors; Board_SIZE= Size of boards of directors, measured by the total number of members of Boards; Board_IND=
independence of the Board, measured by the proportion of independent members (independent directors / total directors); Board_ACT=
Activity of Boards, measured by the number of meetings; GOV_Index= The degree of law enforcement of each country analyzed, taken
from the research project “Worldwide Governance Indicators” (WGI) proposed by Kaufmann et al., (2010); Log_ASSET= Firm size,
measured by the natural logarithm of total assets of the companies; Debt= Level of indebtedness, measured by the quotient resulting
from gross debt to total assets, ROA= Economic Return, measured by the ratio of the relationship between the result before special
items, interest and taxes of year t and the total net assets at the beginning of year t; GROWTH= Growth of the Companies, calculated in
terms of the ratio of the difference in sales and sales of the previous period of firm i in year t.
(2) Dichotomous Variables: Boad_IND50= Measured through a dummy variable that takes value of 1 if boards has a majority of
independent directors and, 0 otherwise; CEO_Dual= Measured through a dummy variable that considers the value of 1 if there is
duality of roles between the chairman and CEO of the companies and, 0 otherwise; Big_4= Measured by a dummy variable that takes
the value 1 if the firms are audited by one of the big four firms, 0 otherwise; Loss= Measured through a dummy variable that takes
value of 1 if the companies have had losses in the last two years and, 0 otherwise.
4.2. Regression Results
After analyzing the variables descriptively, it is necessary to apply tests to help measure
the linear relationship between the dependent variable “absolute value of discretionary
accruals [Abs (DAC)it]” and the independent and control variables of the firms. The
explanatory development is based mainly, on determining the level of influence that CG
mechanisms has on discretionary accruals. In order to determine which model is better suited
to our data, either the fixed effects based on groups estimator or random effects based on
generalized least squares (GLS) we perform the Hausman test (1978), which determines
whether the differences are systematic and significant between the two models. In all cases,
the result of this test does not reject the null hypothesis of no systematic differences between
the regressors’ and unobserved heterogeneity, therefore assuming the random effects as the
most appropriate for our analysis.
Thus, in Table 4 the model 1 shows the results obtained from the linear regression of the
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33. panel data, the absolute value of discretionary accruals [Abs (ADD) it] on the variables of
ownership structure, board of directors and control. With regard to the internal ownership, is
observed that the stake held by managers and directors in Latin American firms have a
significant negative relationship at level of 1% with the absolute value of discretionary
accruals, suggesting that the low insider’s ownership reduce the EM practices, i.e. reduce the
use of discretionary accruals (convergence of interest’s hypothesis). Our result is in line with
those results obtained by Machuga & Teitel (2009) with a sample of Mexican firms, who
shows that firms with a fewer internal ownership shows a greater earnings quality compared
to those firms that do not have managerial ownership, i.e. shows less manipulative practices
by managers, because the implementation of good CG practices contained in Codes of Best
Practices. In similar terms, other studies such as Morck et al. (1988) in Canada, Wartfield et
al. (1995) in the U.S., Yeo et al. (2002) in Singapore and Sanchez-Ballesta & Garcia-Meca
(2007) in Spain, also point out that the informativeness of accounting results increases with
low levels of internal ownership, while for a high levels, the internal ownership is not
sufficient as alignment interest’s mechanism.
In relation to the ownership concentration, shows a significant negative relationship at
level of 1% with the absolute value of discretionary accruals, suggesting that when the main
shareholders have a high percentage of ownership or when a conglomerate directly controls
the firm, the absolute value of discretionary accruals is reduced, due to the efficient
monitoring hypothesis indicated by the Agency theory (Jensen & Meckling, 1976; Fama,
1980; Fama & Jensen, 1983). Thus, Fernandez et al. (1998), Yeo et al. (2002), Gabrielsen et
al. (2002) and De Bos & Donker (2004) results are also consistent with the monitoring role of
external block holders, and their strong positive effects on earnings informativeness.
Moreover, respect to the board size, this indicates a positive relationship significant at
level of 5%, showing our result that the greater board size the level of monitoring over the
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34. management team decreases due to the existence of problems of communication and
coordination that increases the use of discretionary accruals, in line with previous studies as
Xie et al. (2003), Thomsen (2008) and Santiago & Brown (2009).
Also, respect to the board independence, it shows a weak negative relationship significant
at level of 10%. Our result contrasts with the prominent role that literature, theoretical and
empirical, assigned to this attribute of the board to safeguard the quality and transparency of
results but, for the case of Latin American countries analyzed, does not seem to be so
effective. In this regard, Price et al. (2006, 2007), Teitel & Machuga (2008), Chong et al.
(2009) and Davila & Watkins (2009) in Mexico; Silveira et al. (2003), Schiehll & Santos
(2004) and Ferraz et al. (2011) in Brazil; Majluf et al. (1998), Iglesias (1999), Lefort &
Walker (2000, 2005) in Chile; suggests that this is due to boards are mainly composed of
major shareholders and managers of the companies, having external directors a very limited
participation which facilitates the EM and the managerial discretion. It is probably that this
evidence is derived, as stated by Yermack (2004)9, by the presence of grey directors, lack of
rotation of the directors or the two causes simultaneously.
Regarding the grey directors, they are those that maintain some kind of family or
professional relationship (present or past) with the company or its top management, the fact
that in the annual reports of CG are designated as external and almost in no way disclose any
possible conflicts of interest, could severely limit the board independence. Regards the
second, its slow or almost non-existent rotation makes them permanent external, and thus the
report of the First Latin American Corporate Governance Survey, conducted by Price
Waterhouse Cooper (PWC) in 2010 (published in 2011) indicates that on average only
12,35% of companies listed on Latin American stock markets put time limits for external
directors. In short, according to Monterrey & Sanchez (2008), both groups might fall into the
category that Eguidazu (1999) calls “the label”, in which independence is an appearance and
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35. not an attitude, because the absence of sufficient distance from the management of the
company could concentrate in fact the power inside the board, thereby facilitating EM (Garcia
Osma & Gill de Albornoz, 2005).
In addition, the model 1 shows that board activity results to have a negative relationship
significant at level of 5% showing that the greater number of meetings held by the boards
decreases the use of discretionary accruals, i.e., the higher board activity reduces the EM. We
do not find any statistically significant relationship between family ownership (Fam_OWN),
institutional ownership (Inst_OWN), CEO duality (CEO_Dual) and the absolute value of
discretional accruals.
On the other hand, there is a significant negative relationship at level of 1% between
Government Index (GOV_Index) and discretionary accruals, suggesting that when a country
implements controls aimed to reduce the corruption, to strengthen the rule of law or to
improve the effectiveness of government seems to influence on EM negatively, i.e., it shows
an increase on the quality and transparency of the financial information issued by companies,
showing a reduction of discretionary accruals (La Porta et al., 1998, 2002, 2006; Leuz et al.,
2003; Bushman et al., 2004; Ball & Shivakumar, 2005).
Finally, in the remaining control variables it can be seen that they maintain their level of
significance and expected sign: A significant negative relationship at level of 5% between
firm size and discretionary accruals, because the largest companies are subjected to a greater
monitoring than smaller firms (Garcia & Gill, 2005; Cahan & Zhang, 2006; Goodwin & Kent,
2006; Prior et al., 2008); a significant positive relationship at level of 1% between
discretionary accruals and level of debt, due to the companies with more leverage used
manipulative practices to exhibit a greater capacity to generate resources (Krishnan et al.,
1996; Frankel et al., 2002; Balsam et al., 2003); a significant positive relationship at level of
1% between economic profitability and discretionary accruals, suggesting that managers are
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36. motivated to manipulate the results obtained with the intention to make the company more
attractive (Kothari et al., 2005; Machuga & Teitel, 2007); a significant positive relationship at
level of 1% between growth and discretionary accruals, indicating that companies that
observed a high growth are more likely to use a discretionary accruals adjustments
(McNichols, 2000), because they experiment better opportunities to attract investment
(Young, 1999).
Additionally, in column 11 of Table 4 we use a different proxy for board independence,
replacing the proportion of external directors on boards (Board_IND) by a dummy variable
that takes the value of 1 if board has a majority of external directors, and 0 otherwise
(Board_IND50). The conclusions are the same than model 1, i.e., the board independence also
shows a weak negative relationship significant at level of 10% with the dependent variable
[Abs (ADD) it].
36
38. TABLE 4:
Discretionary Accrual Regressions on Corporate Governance and Control Variables
Random Effects Estimation (GLS)
Model 1: Abs(ADD)it= β0 + β1(Int_OW ) + β2(OW _Con) + β3(Fam_OW ) + β4(Inst_OW ) + β5(Board_SIZE) + β6(Board_I D) + β7(Board_ACT) +
β8(CEO_Dual) + β9(Big_4) + β10(Log_ASSET) + β11(Debt) + β12(ROA) + β13(GROWTH) + β14(Loss) + β15(GOV_Index) +ηi +λt +υit
Expected Model 1 Model 2
Variable
Sign (1) (2) (3) (4) (5) (6) (7) (8) (9) (10) (11)
0.031*** 0.031*** 0.031*** 0.031*** 0.031*** 0.031*** 0.031*** 0.030*** 0.031*** 0.029*** 0.029***
GROWTH +
(3.49) (3.48) (3.48) (3.52) (3.49) (3.50) (3.50) (3.43) (3.50) (3.27) (3.28)
0.001 0.003 0.005 0.005 0.005 0.005 0.005 0.008 0.004 0.006 0.006
Loss +
(0.04) (0.10) (0.19) (0.19) (0.18) (0.18) (0.19) (0.29) (0.13) (0.22) (0.20)
Significance 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.000
Adjusted R2 0.2729 0.2726 0.2719 0.2719 0.2717 0.2727 0.2720 0.2726 0.2716 0.2777 0.2770
Number of Observations 1.740 1.740 1.740 1.740 1.740 1.740 1.740 1.740 1.740 1.740 1.740
(***) Significant at level 1%; (**) Significant at level 5%; (*) Significant at level 10%.
Note 1. The model includes industry sectors and time controls, but they are not reported.
Note 2. Z statistics in parentheses.
Quantitative Variables: Int_OWN = Internal ownership, measured by the proportion of shares owned by managers and members of Boards (≥ 1%); OWN_Con = Ownership
Concentration, measured by the ratio of shares held by the major shareholder of the company (≥ 5%); Fam_OWN = Family Ownership, measured by the proportion of shares held by
family members (≥ 5%), as a percentage of capital that is directly or indirectly in his possession; Inst_OWN= Institutional Ownership, measured by the proportion of shares held by
institutional investors; Board_SIZE= Size of boards of directors, measured by the total number of members of Boards; Board_IND= independence of the Board, measured by the
proportion of independent members (independent directors / total directors); Board_ACT= Activity of Boards, measured by the number of meetings; Log_ASSET= Firm size, measured by
the natural logarithm of total assets of the companies; Debt= Level of indebtedness, measured by the quotient resulting from gross debt to total assets, ROA= Economic Return, measured
by the ratio of the relationship between the result before special items, interest and taxes of year t and the total net assets at the beginning of year t; GROWTH= Growth of the Companies,
calculated in terms of the ratio of the difference in sales and sales of the previous period of firm i in year t; GOV_Index= The degree of law enforcement of each country analyzed, taken
from the research project “Worldwide Governance Indicators” (WGI) proposed by Kaufmann et al., (2010).
Dichotomous Variables: Boad_IND50= Measured through a dummy variable that takes value of 1 if boards has a majority of independent directors and, 0 otherwise; CEO_Dual=
Measured through a dummy variable that considers the value of 1 if there is duality of roles between the chairman and CEO of the companies and, 0 otherwise; Big_4= Measured by a
dummy variable that takes the value 1 if the firms are audited by one of the big four firms, 0 otherwise; Loss= Measured through a dummy variable that takes value of 1 if the companies
have had losses in the last two years and, 0 otherwise.
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