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The purpose of this paper is to investigate the relation between the value of executive
director share ownership and discretionary accruals.
Accounting Research Journal
The value of executive director share ownership and discretionary accruals
Arifur Khan Paul Mather
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To cite this document:
Arifur Khan Paul Mather, (2013),"The value of executive director share ownership and discretionary
accruals", Accounting Research J ournal, Vol. 26 Iss 1 pp. 35 - 55
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The value of executive director
share ownership and
discretionary accruals
Arifur Khan
School of Accounting, Economics and Finance, Deakin University,
Melbourne, Australia, and
Paul Mather
Department of Accounting, La Trobe University, Melbourne, Australia
Abstract
Purpose – The purpose of this paper is to investigate the relation between the value of executive
director share ownership and discretionary accruals.
Design/methodology/approach – This study uses a dataset of 1,173 ?rm-year observations drawn
from 188 Australian listed companies for the period 2000-2006. The analysis is based on multivariate
regression analysis and ordinary least square models were used to investigate the relation between the
value of managerial ownership and discretionary accruals. The issue of potential endogeneity is
addressed by using a simultaneous equation system.
Findings – A negative relation is found between value of managerial share ownership and
discretionary accruals at lower levels of value of ownership, which is consistent with the theorised
incentive alignment that as the managers commit more resources to their ?rms, stakeholders impose
less contractual constraints speci?ed in terms of accounting numbers and managers make lower
accrual adjustments. After a certain level of value of ownership is attained, a positive relations seen,
consistent with increased discretionary accrual adjustments associated with stakeholders anticipating
managerial entrenchment. Also, it is found that these results are driven by ?rms with income
increasing, as opposed to income decreasing, discretionary accruals.
Practical implications – Shares and options are forming an increasing proportion of executive
remuneration that continues to be the subject of much debate amongst regulators and in the media.
Showing that the value of share ownership may be an effective internal governance mechanism to help
align incentives adds to the debate and has policy implications.
Originality/value – The paper’s primary contribution is ?nding that the value (as opposed to
proportion) of share ownership, typically representing a sizeable proportion of managers’
undiversi?ed wealth, is a potentially direct driver of theorised incentive alignment and
entrenchment effects associated with share ownership.
Keywords Directors, Chief executives, Shares, Value of executive director share ownership,
Discretionary accruals, Incentive alignment, Entrenchment
Paper type Research paper
The current issue and full text archive of this journal is available at
www.emeraldinsight.com/1030-9616.htm
JEL classi?cation – G32, G34, M41
This paper has bene?ted from the helpful comments and suggestions of Brian Cadman,
Bala Balachandran, Janto Haman, John Hillier, Alan Ramsay, Maria Strydom and participants at
the 2010 Annual meeting of American Accounting Association in San Francisco, the 2010
Finance and Corporate Governance Conference, Melbourne and the 2009 Monash Prato PhD
Accounting and Finance Symposium, as well as research seminars at Deakin and Monash
University. The usual caveat applies.
Accounting Research Journal
Vol. 26 No. 1, 2013
pp. 35-55
qEmerald Group Publishing Limited
1030-9616
DOI 10.1108/ARJ-02-2012-0011
Director share
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1. Introduction
This paper examines the relation between the value of managerial ownership and
discretionary accruals in Australia during the period 2000-2006. The separation of
ownership and control in publicly listed ?rms is argued to result in information
asymmetries between managers (agents) and shareholders (principals) that give rise to
agency problems ( Jensen and Meckling, 1976). Increased levels of managerial share
ownership in a ?rm helps to align the interests of owners and managers and mitigate
agency problems ( Jensen and Meckling, 1976)[1]. Arguing that such incentive alignment
has contracting implications, War?eld et al. (1995), posit that corporate stakeholders
impose more restrictive contractual constraints denominated in accounting numbers as
managerial ownership and therefore, incentive alignment, declines. The presence of
accounting-based constraints in turn provides managers with incentives to use
accounting discretion to help alleviate these constraints. An alternative theoretical
argument, not considered by War?eld et al. (1995), is that increasing levels of managerial
ownership may result in managerial entrenchment (Demsetz, 1983; Fama and Jensen,
1983). The argument is that the extra voting power enables themto secure their position
in the ?rm thereby insulating them fromcertain disciplining mechanisms which in turn
creates agency problems. If stakeholders anticipate such entrenchment, increasing
levels of managerial ownership may also have contracting implications.
Strong growth in executive remuneration from the 1990s to 2007, that is often not
commensurate with corporate performance, has caused concern in the community
about the need to control such compensation (Productivity Commission, 2009).
Accordingly, executive remuneration in Australia continues to be the subject of much
debate amongst regulators and in the media. As an example, the government’s current
proposed legislation to compel ?rms to disclose the take-home pay of senior executives
and to claw back remuneration in the event of material ?nancial misstatements is
facing a backlash from the business community. The Business Council of Australia
President, Tony Shepherd, states “jumping to add further complexity and an increased
burden to the signi?cant regulatory requirements already faced by Australia’s boards”
(Hepworth, 2012).
Related to the above, long term incentives such as shares and options form an
increasing proportion of executive remuneration. An analysis of executive remuneration
in the top 300 ASX listed companies shows that the proportion of non-CEO executive
remuneration made up by long term incentives in 2005-2007 was 23 per cent compared
to 10 per cent in 2003-2004. Similarly, the proportion of CEO remuneration made up by
long term incentives in 2005-2007 was 26 per cent compared to 11 per cent in 2003-2004
(Productivity Commission, 2009). Accordingly, understanding the incentive effects
associated with managerial share ownership is an important issue that potentially
impacts a wider policy debate.
Extant research suggests that managers have incentives to manage earnings to
avoid reporting earnings decreases and losses since various contracts are based on
accounting numbers (see for example, Healy and Wahlen, 1999 for a survey of this
literature). War?eld et al. (1995) argue that ?rms with low managerial ownership are
subject to more accounting based contractual constraints providing incentives for
managers to use accrual adjustments to circumvent such constraints. As posited they
?nd that managerial ownership in the USA and the magnitude of discretionary
accruals are inversely related[2]. Yeo et al. (2002) also show an increase in discretionary
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accruals at higher levels of ownership consistent with an entrenchment effect in
Singapore. In a related study, Gabrielsen et al. (2002) using a sample of Danish ?rms
fail to ?nd any signi?cant relation between managerial share ownership and
discretionary accruals. In an Australian context Gul et al. (2003) investigate the relation
between discretionary accruals, managerial share ownership and audit fees. Consistent
with the alignment argument, they show that managerial ownership negatively affects
the positive relation between discretionary accruals and audit fees. In sum,
notwithstanding the elegant theories, the empirical evidence on the relation between
managerial share ownership and discretionary accruals is unsettled.
The prior empirical literature uses share ownership by all directors (Yeo et al., 2002)
or wider de?nitions as a proxy for managerial ownership (War?eld et al., 1995;
Gabrielsen et al., 2002; Gul et al., 2003). We argue that it is the executive directors with
operational responsibilities who are in a direct position to manage earnings. Moreover,
given the independent directors’ monitoring role and the associated reputation effects,
it is considered unlikely that they will be associated with earnings management (Fama
and Jensen, 1983). We therefore argue that the wealth of the executive directors as
opposed to the wealth of all directors is an appropriate and less “noisy” proxy to
consider the impact on discretionary accruals. Accordingly, we use ownership by
executive directors in this study[3].
The prior research measures the incentives associated with managerial ownership
in terms of control rights or the proportion of shares they own in their ?rm. A manager
who has an increasing amount of personal resources invested in their ?rm is more
likely to bear the consequences of managerial actions. Such shares often represent a
sizeable proportion of the managers’ wealth that is inherently undiversi?ed. Hence, we
argue that the value of the managerial share ownership is potentially a more direct
driver of incentive alignment and/or entrenchment than the proportion of ownership.
There can be a relative disjoint between value of managerial share ownership and
proportion of managerial share ownership and information relating to managerial
ownership of shares in two of our sample companies illustrates the distinction. In June
2006 BHP Ltd’s managerial share ownership was only 0.017 per cent whilst value of
managerial share ownership was $30 million. Conversely at the same date, in Southern
Dental Industries Limited (SDI), managerial share ownership and value of managerial
share ownership were 44 per cent and $32.6 million, respectively. Accordingly, we use
the dollar value of executive director share ownership (VESO) as our measure in this
study[4].
Our initial tests show a non-monotonic, convex relation between VESO and the
absolute value of discretionary accruals. Speci?cally, we ?nd a negative relation
between VESO and discretionary accruals at lower levels of dollar value of ownership
which is consistent with the argument that as the managers commit more resources to
their ?rms, stakeholders impose less contractual constraints denominated in
accounting numbers and managers make lower accrual adjustments. After a certain
level of dollar value of ownership is attained, we see a positive relation consistent with
increased discretionary accrual adjustments associated with stakeholders anticipating
managerial entrenchment. We also ?nd that these results are driven by ?rms with
income increasing, as opposed to income decreasing, discretionary accruals. When we
use a simultaneous equation system to address the issue of endogeneity, we do not ?nd
evidence that the VESO-discretionary accruals relation is co-deterministic. Our results
Director share
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are robust to the alternative estimates of discretionary accruals, as well as concerns for
autocorrelation, heteroskedasticity and multicollinearity.
We contribute to the literature by positing and ?nding that the value of managerial
share ownership is a more direct driver of the incentives associated with managerial
share ownership than the proportion of the stake. We also argue that it is the executive
directors with operational responsibilities who are in a direct position to manage
earnings and, in contrast to the prior literature, focus on executive director ownership.
Further analysis shows that, unlike executive director ownership, non-executive
director ownership has no relation with discretionary accruals, which may re?ect the
non-executive directors’ inability to operationally manage earnings or that they may
be immune to the theorised incentive alignment or entrenchment effects associated
with share ownership.
The paper is structured as follows: Section 2 provides a review of literature and
theoretical background. Section 3 describes the research design, while Section 4 reports
the main results. Section 5 summarises and draws conclusions.
2. Literature review and theoretical background
2.1 Literature review
Managerial share ownership, one of the internal governance mechanisms to address
agency problems, can inversely affect the magnitude of discretionary accruals due to
the incentive alignment (War?eld et al., 1995). War?eld et al. (1995) argue that because
of separation of ownership and control between owners and managers, contracts often
contain accounting-based constraints to restrict the managers from engaging in
value-reducing behaviour. The presence of accounting-based constraints in turn
provides managers with incentives to use accounting discretion to help circumvent
these constraints. They contend that when ownership is low, the increased demand for
accounting-based constraints may motivate the managers to choose the accounting
policies to mitigate the accounting-based contractual restrictions. Consistent with their
hypothesis, they ?nd a negative relationship between managerial share ownership and
the magnitude of discretionary accruals in the USA.
Gabrielsen et al. (2002) examine the same relationship for a sample of Danish ?rms,
to extend the ?ndings of War?eld et al. (1995) in a different institutional setting. They
fail to ?nd any statistically signi?cant relationship between managerial share
ownership and discretionary accruals (absolute value), and argue that their results are
likely attributable to different institutional arrangements that exist in the USA and
Denmark.
War?eld et al. (1995) posit that corporate stakeholders impose more restrictive
contractual constraints denominated in accounting numbers as managerial share
ownership and therefore, incentive alignment declines. An alternative theoretical
argument, not considered by War?eld et al. (1995), is that high level of ownership may
result in managerial entrenchment (Demsetz, 1983; Fama and Jensen, 1983). The
combination of incentive alignment and entrenchment may suggest a nonlinear
relationship between managerial share ownership and discretionary accruals.
Accordingly Yeo et al. (2002) examine the nonlinear relationship between managerial
share ownership and income increasing discretionary accruals for ?rms listed on the
Singapore stock exchange. They ?nd that at lowlevels of ownership, the level of income
increasing discretionary accruals has a negative relationship with the management
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ownership, consistent with the incentive alignment argument. However, at higher levels
of managerial ownership the relationship reverses, suggesting that the entrenchment
effect might have set in.
Gul et al. (2003) investigate the relation between discretionary accruals, managerial
share ownership and audit fees using a sample of 648 Australian ?rms for the year
1993. They ?nd a positive relation between discretionary accruals and audit fees. They
also ?nd that managerial ownership negatively affects the positive relation between
discretionary accruals and audit fees. Thus, their ?ndings are consistent with the
alignment argument.
There is also an extensive literature on executive remuneration (see for example,
Murphy (1999) for a survey of this literature). A subset of these studies has focused on
the relation between the equity incentives of the executives and earnings management.
For example, Bergstresser and Philippon (2006) show that CEOs’ equity incentives can
explain the accruals management of ?rms. Similarly, Burns and Kedia (2004) ?nd that
earnings restatements are more common at ?rms where CEOs have larger options
portfolios. Collectively, the ?ndings of previous studies suggest that executives such as
CEOs tend to manipulate reported earnings through discretionary accruals when their
compensation is closely related to the value of their share and option holdings.
2.2 Theoretical background
Managerial ownership results in a manager who owns a fraction of a ?rm’s issued
shares directly assuming the consequences of their actions, thus aligning their
incentives withother shareholders ( Jensen and Meckling, 1976). Hence, managers
owning shares in their employing ?rm are likely to strive to make better investment
decisions and thereby maximize value.
As shown in Figure 1, managerial share ownership has contractual implication as
well. It is argued that stakeholders, for example board remuneration committees and
lenders, impose more restrictive contractual constraints denominated in accounting
Figure 1.
The relation between
separation of ownership
and control and incentives
to manage earnings
Separation of
ownership and control
Stakeholders contract
with executives
Contract based on
accounting numbers
Incentives for
managing earnings
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numbers as managerial ownership and therefore, incentive alignment, declines
(War?eld et al., 1995). It is also argued that ?rms with low managerial ownership are
subject to more accounting based contractual constraints as stakeholders perceive a
lack of incentive alignment (War?eld et al., 1995). This is done to limit their managers’
opportunistic behaviour and to monitor their actions. These contractual provisions in
turn provide incentives for managers to use accrual adjustments to circumvent such
constraints. Conversely, as managerial ownership increases, it is also less likely that
the managers will engage in opportunistic behaviour hence, the demand for accounting
based contractual constraints will decline (War?eld et al., 1995).
Some of the behaviour identi?ed by Jensen and Meckling (1976) as bene?ting
managers at the expense of shareholders include perquisite-taking, shirking, and the
pursuit of non-value maximizing objectives such as empire building. As the proportion
of managers’ shares increase, it is argued that managers bear an increasing proportion
of these costs which helps align incentives. Thus, the theoretical arguments view the
aforementioned incentives associated with managerial ownership or in terms of control
rights in the managed ?rm. On the other hand we argue that such shares often represent
a sizeable proportion of the managers’ wealth that is inherently undiversi?ed. Hence, the
VESO is potentially a more direct driver of incentive alignment in the case of some
of these behaviours such as the pursuit of non-value maximising objectives[5].
The extra voting power that accrues as the ownership stake increases is theorised
to increase the potential for costs associated with entrenchment as it insulates
managers from certain disciplining mechanisms such as the managerial labour market
and the market for corporate control (Demsetz, 1983). If stakeholders anticipate such
entrenchment increasing levels of managerial ownership may have similar contracting
implications. Once again, the prior empirical literature is premisedonthe assumptionthat
such effects are likely to be associated with managerial ownership, representing the
proportion of shares or control rights in the ?rm (Yeo et al., 2002; Gabrielsen et al., 2002).
On the other hand, ceteris paribus, rational managers should prefer to hold a diversi?ed
portfolio of assets but as VESO increases they become increasingly exposed to
?rm-speci?c risk. Such high VESOis likely to make a manager more risk averse as their
decisions will have a potentially costly impact on a relatively high proportion of their
personal wealth.
Notwithstanding the limited empirical work yielding unsettled conclusions, theory
suggests that the pattern of the VESO-discretionary accruals relation is likely to be
consistent with initial incentive alignment followed by entrenchment effects. Hence we
propose the following hypothesis:
H1. There is a non-monotonic convex relation between VESO and discretionary
accruals.
3. Research design
3.1 Data
We initially identi?ed the top 300 Australian companies by market capitalisation at
30 June 1999. Consistent with the prior literature, we exclude banks, ?nancial institutions,
trusts and utility ?rms (49 ?rms) which have different disclosure requirements and/or
different corporate governance structures. We exclude another 63 ?rms due to missing
information. The ?nal sample comprises of the remaining ?rms with a total of 1,173
?rm-year observations over the seven year period 2000-2006[6], [7]. As evident in Table I,
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the sample ?rms belong to 21 Global Industrial Classi?cation Standard Sectors (GICS)
Industry Groups. We collect the required accounting information from Aspect Fin
Analysis and Connect 4 databases. The ownership and other corporate governance data
was hand collected from the corporate governance disclosures, shareholding information
and directors’ report contained in annual reports.
3.2 Measuring discretionary accruals
Our primary test to measure discretionary accruals relies on a research design used by
War?eld et al. (1995). In particular, discretionary accruals (DACC) are de?ned as current
period total accruals (ACC) less expected normal accruals (E(ACC)), standardised by
prior period total assets (ASST):
DACC
i;t
¼
ACC
i;t
2EðACCÞ
i;t
ASST
i;t21
ð1Þ
Consistent with previous research (War?eld et al., 1995; Yeo et al., 2002) we estimate total
accruals as below.
Panel A: sample selection
Number of ?rms 300
Less
Financial and utility companies 49
Companies without necessary information for
corporate governance and control variable data 63
Total 188
Panel B: analysis of sample by GICS sectors and industries
GICS sector GICS industry group
Material Chemicals 3
Construction material 5
Metal and mining 22
Paper and forest products 6
Industrial Capital goods 16
Commercial service and supplies 9
Transportation 5
Health care Health care equipment and supplies 10
Health care providers and services 6
Pharmaceutical, biotechnology and life
science
8
Telecommunication Diversi?ed telecommunication 4
Consumer staples Food and staple retailing 5
Food, beverage and tobacco 15
Consumer discretionary Automobiles and components 7
Consumer durables and apparels 6
Consumer services 11
Media 17
Retailing 10
Information technology Software and services 7
Technology hardware and equipment 6
Energy Oil and gas 10
Total 188
Table I.
Sample description
Director share
ownership
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Total accruals (ACC) ¼ DCA 2 DCL–DEP where DCA is the change in non-cash
current assets (change in current assets less change in cash), DCL is the change in
current liabilities excluding short term debt (change in current liabilities less the
change in debt included in current liabilities and minus the changes in income tax
payable) and DEP is depreciation and amortization. Expected normal accruals (E(ACC)
are estimated by using a ?ve year ?rm speci?c average of prior periods’ accounting
accruals (ACC
i,t21
, . . . , ACC
i,t25
).
As an alternative measure we use the more data intensive time series version of the
modi?ed Jones model. Under this model, the level of discretionary accruals[8] for a
particular ?rm is calculated as the difference between the ?rm’s total accruals and its
non-discretionary accruals (NDAC), as estimated with the following equation:
NDAC
t
¼ a
0
1
TA
t21
þa
1
DREV
t
2DAR
t
TA
t21
þa
2
PPE
t
TA
t21
ð2Þ
where:
NDAC
t
– non-discretionary accruals in year t.
TA
t21
– total assets in year t 2 1.
DREV
t
– change in revenue of ?rm i in year t.
DAR
t
– change in accounts receivable of ?rm i in year t.
PPE
t
– property plant and equipment for ?rm i in year t.
3.3 Model speci?cation
We use the following equation to examine the relation between VESO and discretionary
accruals using an OLS regression technique:
DACC ¼ b
0
þb
1
ðVESOÞ þb
2
ðVESOÞ
2
þb
3
ðUSUBSPÞ þb
4
ðLEVÞ þb
5
ðBINDÞ
þb
6
ðAUDÞ þb
7
ðMBÞ þb
8
ðLTACCÞ þb
9
ðLOSSÞ þb
10
ðASSTÞ
þb
11 to 17
ðGICS Sectoral dummiesÞ þb
18 to 23
ðYear dummiesÞ þ1 ð3Þ
where:
DACC – absolute value of discretionary accruals.
VESO – log of dollar value of share ownership by the executive directors.
USUBSP – unaf?liated substantial share ownership.
LEV – leverage.
BIND – board independence.
AUD – auditor dummy variable.
MB – market to book.
LTACC – lagged total accruals.
LOSS – loss dummy variable.
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ASST – ?rm size proxied by the book value of assets.
MVEQ – market value of equity.
VOL – volatility of earnings.
LIQ – liquidity.
INV – investment.
Table II summarises the de?nitions of all the variables employed in this paper. As we
anticipate a non-monotonic relation between VESO and discretionary accruals, we use a
quadratic speci?cation of the VESO variable (see for example, the treatment of MSO in
Yeo et al., 2002). The control variables used in this study include strength of unaf?liated
substantial shareholdings, leverage, level of board independence, employment of a Big 4
auditor, the market to book ratio, lagged total accruals, incurrence of loss, and size of the
?rm. We also control for the GICS industrial sector and the observation’s year[9].
We include ownership by the unaf?liated substantial shareholders to control for a
monitoring effect (Peasnell et al., 2005). Unaf?liated shareholdings are measured by
taking the percentage of share ownership by the unaf?liated substantial shareholders
(other than directors). Managers have incentives to use accounting discretion when
they are close to a debt covenant violation and leverage may capture such incentives
(Klein, 2002). We measure leverage by the ratio of book value of debt to book value of
total assets. The monitoring role of independent boards may constrain discretionary
accruals (Peasnell et al., 2005)[10]. The proportion of independent directors is a proxy
Variable De?nition Detailed explanation Expected sign
VESO Dollar value of managerial share
ownership
Log of dollar value of share ownership
by the executive directors
?
USUBSP Unaf?liated substantial share
ownership
Percentage of ordinary shares owned
by the unaf?liated (excluding the
directors) substantial shareholders
–
LEV Leverage Ratio of book value of debt and book
value of total assets
þ
BIND Board independence The number of independent directors
scaled by the size of the board
–
AUD Auditor dummy variable A dummy variable 1 if the ?rm is
audited by a Big 4 auditor and
otherwise 0
–
MB Market to book ratio Market value of equity divided by the
book value of shareholders’ equity
?
LTACC Lagged total accruals Prior year total accruals scaled by the
prior year total assets
–
LOSS Loss dummy variable A dummy variable 1 if the ?rm has
negative earnings and otherwise 0
þ
ASST Size Natural log of book value of assets ?
MVEQ Market value of equity Natural log of market value of equity ^
LIQ Liquidity Net operating cash ?ow scaled by the
book value of assets
þ
INV Investment Capital expenditure scaled by the book
value of assets
þ
Table II.
De?nition of variables
Director share
ownership
43
D
o
w
n
l
o
a
d
e
d
b
y
P
O
N
D
I
C
H
E
R
R
Y
U
N
I
V
E
R
S
I
T
Y
A
t
2
1
:
1
7
2
4
J
a
n
u
a
r
y
2
0
1
6
(
P
T
)
for board independence. Previous research suggests that large audit ?rms (Big 4) are
considered to be more effective monitors of the ?nancial reporting process compared to
smaller ?rms (Francis and Krishnan, 1999). Therefore, a dummy variable is used to
control for the effect of auditor type on the level of discretionary accruals. Following
previous studies we take market to book ratio as one of our control variables and
measured as market value of equity divided by the book value of shareholders’ equity
(Klein, 2002). Accruals are mean reverting, with the majority of the mean reversion
occurring within a year (Dechow et al., 1995). A high level of lagged total accruals will
probably reduce managers’ ability to manage current period reported earnings upward
and vice versa. Therefore, we control for the total accruals of the previous period (Koh,
2003). Firms with negative earnings are associated with greater discretionary accruals
(Wang, 2006). Hence we use a dummy variable when a ?rm has negative earnings in a
particular year. Finally we follow previous studies and control for ?rm size by taking a
natural log of book value of assets (Klein, 2002; Wang, 2006).
4. Results
4.1 Descriptive statistics
Panel A of Table III reports the descriptive statistics of some key variables. It shows
that the average DACC using War?eld et al. (1995) (modi?ed Jones) is 0.065 (0.058), the
average managerial ownership is 6.29 per cent and that unaf?liated substantial
shareholders, on average, hold 37.15 per cent of total shares outstanding[11]. The
average VESO (logged value) is 5.134[12].
Panel B of Table III presents the Pearson correlation matrix[13]. DACC using both
War?eld et al. (1995) and modi?ed Jones is negatively and signi?cantly correlated with
VESO. VESOis negativelyand signi?cantly correlated with BIND(board independence)
suggesting that ?rms with high VESO are less likely to have independent boards.
VESOis positively and signi?cantly correlated with market value of equity. Firmsize is
negatively correlated with MSO (managerial ownership), suggesting that executive
directors’ equity interests decrease as ?rm size (measured by LASST) increases. The
positive correlation between ?rm size (LASST) and leverage (LEV) suggests that large
?rms have high leverage and larger ?rms are also more likely to have Big 4 auditors.
A negative correlation between VESO and the auditor variable indicates that directors
have greater equity interests in ?rms audited by non-Big 4 ?rms which is likely to be
driven by ?rm size.
4.2 Managerial share ownership and discretionary accruals
Table IV presents the results of the OLS regression estimation. The ?rst regression
result relates to VESOand discretionary accruals (Panel A). We ?nd signi?cant p-values
for the coef?cients of VESO (0.022) and VESO
2
(0.027). The signs of VESO and VESO
2
are negative and positive, respectively. In other words, we ?nd a negative relation
between VESO and discretionary accruals up to a certain point followed by a positive
relation. It implies a non-monotonic, convex relation between VESO and the absolute
value of discretionary accruals. The negative relation between VESO and discretionary
accruals up to a certain point is consistent with the hypothesis that as VESO increases,
the board and/or stakeholders imposes less contractual restrictions denominated in
accounting numbers and managers have less of a need to make accrual adjustments to
alleviate these restrictions. However, at a higher level of VESOthe results are consistent
ARJ
26,1
44
D
o
w
n
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a
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1
7
2
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a
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a
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2
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1
6
(
P
T
)
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e
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a
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1
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3
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(
%
)
6
.
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(
%
)
3
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(
c
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)
Table III.
Descriptive statistics
Director share
ownership
45
D
o
w
n
l
o
a
d
e
d
b
y
P
O
N
D
I
C
H
E
R
R
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N
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A
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1
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1
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(
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;
V
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–
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;
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B
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P
–
p
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a
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f
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;
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A
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–
d
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Table III.
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with the hypothesis that stakeholders anticipate the managers to be entrenched and
impose more contractual constraints which in turn motivate the managers to make more
accrual adjustments. The estimated point at which the negative VESOand discretionary
accruals relation turns positive is where VESO is AUD 6.8 million. We ?nd that 198
?rm-year observations have VESO (in AUD) in excess of the estimated turning point,
which corresponds to 17 per cent of the total number of observations.
DACC DACC
þ ve
DACC
2ve
Panel A
VESO 20.041 (0.022) 20.039 (0.025) 20.021 (0.944)
VESO
2
0.003 (0.027) 0.002 (0.029) 0.001 (0.879)
LEV 0.005 (0.466) 0.006 (0.507) 20.007 (0.631)
USUBSP 20.001 (0.909) 20.009 (0.489) 0.011 (0.285)
BIND 20.005 (0.032) 20.006 (0.038) 20.007 (0.557)
AUD 0.001 (0.896) 0.006 (0.478) 20.006 (0.425)
MB 0.001 (0.631) 0.001 (0.362) 20.001 (0.385)
LTACC 20.022 (0.214) 20.059 (0.019) 0.032 (0.173)
LOSS 0.025 (0.001) 0.041 (0.001) 0.013 (0.110)
ASST 20.013 (0.000) 20.020 (0.000) 20.003 (0.403)
Intercept 0.258 (0.000) 0.364 (0.000) 0.077 (0.224)
Adjusted R
2
0.044 0.085 0.033
n 1,173 736 437
Panel B
VESO 20.188 (0.075) 20.183 (0.082) 20.174 (0.286)
VESO
2
0.014 (0.036) 0.013 (0.075) 0.016 (0.329)
LEV 0.012 (0.895) 0.006 (0.347) 20.001 (0.959)
USUBSP 0.004 (0.974) 20.001 (0.963) 20.017 (0.192)
BIND 20.378 (0.008) 20.007 (0.022) 20.016 (0.219)
AUD 20.105 (0.217) 20.007 (0.398) 0.007 (0.390)
MB 0.007 (0.426) 0.001 (0.531) 0.002 (0.028)
LTACC 20.801 (0.011) 20.073 (0.003) 20.069 (0.063)
LOSS 0.179 (0.115) 0.034 (0.008) 20.001 (0.924)
ASST 20.117 (0.004) 20.015 (0.000) 0.011 (0.012)
Intercept 2.130 (0.005) 0.263 (0.000) 20.226 (0.007)
Adjusted R
2
0.046 0.075 0.040
n 811 519 292
Notes: This table reports the regression results relating to VESO and discretionary accruals; different
notations used in the table are de?ned as follows: DACC – in Panel A absolute value of discretionary
accruals estimated according to War?eld et al. (1995) model and in Panel B absolute value of
discretionary accruals estimated according to modi?ed Jones model; DACC
þve
– absolute value of
income increasing discretionary accruals; DACC
2ve
– absolute value of income decreasing
discretionary accruals; VESO – logged value of market value of equity multiplied by the percentage of
share ownership by the executive directors; ESO – percentage of ordinary shares owned by the
executive directors of the board; USUBSP – percentage of ordinary shares owned by the unaf?liated
(excluding the directors) substantial shareholders; LEV – leverage, calculated as the ratio of book
value of debt and book value of total assets; BIND – board independence calculated as the number of
independent directors scaled by the size of the board; AUD – dummy variable 1 if the ?rm is audited
by Big 4 auditors; MB – market to book ratio; LTACC – lagged total accruals; LOSS – loss dummy
variable; ASST – natural log of book value of assets; year and industry dummies are not reported; the
reported results are heteroskedasticity and autocorrelation consistent; ?gures in the parentheses are
p-values
Table IV.
Relation between VESO
and discretionary
accruals (War?eld et al.,
modi?ed Jones models)
Director share
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The fact that the coef?cients of some other control variables are statistically
signi?cant suggests that discretionary accruals are also in?uenced by other factors.
Speci?cally, discretionary accruals are positively related to loss (LOSS) and negatively
related to board independence (BIND) and ?rm size (ASST). All other control variables
are insigni?cant. A positive signi?cant coef?cient for loss (LOSS) is consistent with the
?ndings of Wang (2006) and implies that ?rms with negative earnings are associated
with greater discretionary accruals. The negative, signi?cant coef?cient for board
independence (BIND) is consistent with prior literature suggesting that independent
director monitoringconstrains the use of discretionaryaccruals (Peasnell et al., 2005). The
negative, signi?cant coef?cient for ?rmsize (ASST) is also consistent with Wang (2006).
We also document a number of insigni?cant coef?cients including unaf?liated
shareholdings (USUBSP), Big 4 auditor and leverage (LEV). The insigni?cant coef?cient
for substantial shareholders (USUBSP) implies passive monitoring by Australian
block holders (Dignam and Galanis, 2004). An insigni?cant coef?cient for the auditor
(AUD) variable suggests that Big 4 auditors do not have any signi?cant relation
with discretionary accruals in our dataset. This is also consistent with Peasnell et al.
(2005).
The sample ?rm-years are divided into two sub-samples according to the sign of
discretionary accruals, and we repeat the regression analysis for each sub-sample. The
results are presented in the second and third regression estimation results in Table IV,
Panel A. Observations with positive (negative) discretionary accruals are consistent
with income-increasing (income-decreasing) accrual adjustments and DACC
þve
(DACC
2ve
) indicates the absolute value for positive (negative) discretionary accruals,
respectively. For the DACC
þve
regression, all coef?cients for the VESO variables are
statistically signi?cant with the expected signs, that is, consistent with the main
regression. For the DACC
2ve
regression, all coef?cients of the VESO variables have
the expected signs, but, they are not statistically signi?cant. Taken together, this
suggests that VESO is signi?cantly associated with income-increasing but not
income-decreasing accrual adjustments. The difference in relations is consistent with
the contracting argument posited in this paper.
One of the most commonly used models to estimate discretionary accruals is the
modi?ed Jones model and we use the time series version of the model to measure
discretionary accruals. The time series version requires extensive data which was
unavailable for some of the sample companies. Therefore, our sample ?rms reduce to 141
with a total of 811 ?rm-year observations. We present the results in Panel B of Table IV.
The ?rst regression shows a signi?cant coef?cient for VESO ( p ¼ 0.075) and a
signi?cant coef?cient for VESO
2
( p ¼ 0.036). The signs of VESOand VESO
2
are negative
and positive, respectively, which implies a non-monotonic relation between VESO and
discretionary accruals, consistent withthe earlier ?ndings. We also ?nd that discretionary
accruals are related to several control variables (LOSS, BIND, and ASST) that were
signi?cant in the earlier analysis using the War?eld et al. model. Additionally,
discretionary accruals are negatively related to lagged total accruals (LTACC). The
negative, signi?cant coef?cient for lagged total accruals (LTACC) implies that a highlevel
of lagged total accruals will probably reduce managers’ ability to manage discretionary
accruals upward and vice versa (Koh, 2003).
Once again, the sample is divided into two sub-samples according to the sign of
the discretionary accruals, and we repeat the regression analysis for each sub-sample.
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The results are reported in the second and third regressions in Table IV, Panel B
For the DACC
þve
regression we ?nd that all the coef?cients of VESO variables are
statistically signi?cant, consistent with the results for DACC as a whole. However, the
coef?cients for the VESO variables in the DACC
2ve
regression are not signi?cant.
The results of control variables in these two sub-samples do not show any qualitative
difference from results presented in the ?rst regression. Thus, we once gain ?nd that
VESO is associated with income-increasing but not income-decreasing accruals.
4.3 Robustness checks
Endogeneity of VESO. A theoretical possibility not considered by the prior studies is
that the levels of VESO may be endogenously determined as part of the ?rm’s broader
operating and ?nancing arrangements (Demsetz, 1983)[14]. The arguments supporting
incentive alignment and/or managerial entrenchment essentially take the view that
elements of corporate governance such as managerial ownership as well as value of
managerial ownership may develop independently and may be unrelated to the ?rm’s
broader operating and ?nancing arrangements. An alternative view is that some or all
of the corporate governance characteristics, including VESO, may be endogenously
determined as part of the ?rm’s broader operating and ?nancing arrangements
(Demsetz, 1983). In this view, ?rms with greater dif?culty in monitoring management
performance due to factors such as longer operating cycles, more uncertain future cash
?ows, and higher propensity to make losses (Dechow and Dichev, 2002) may be more
likely to adopt particular corporate governance arrangements (for example, higher
managerial ownership). Increases in accruals and the propensity for discretion in such
accruals may be more likely to arise from greater timing and matching problems in
?rms that have longer business cycles and/or more volatile business fundamentals. In
turn, these characteristics may also be related to VESO because higher VESO is likely
to make for more ef?cient contracting, due to information asymmetries and the
increased dif?culty in monitoring management performance (Demsetz, 1983).
Accordingly, we use a simultaneous equations system (3 SLS) to address the
endogeneity of VESO.
We introduce the following equation in addition to our original equation to address
the potential endogeneity of VESO:
VESO ¼ d
0
þd
1
ðDACCÞ þd
2
ðMVEQÞ þd
3
ðLEVÞ þd
4
ðVOLÞ þd
5
ðLIQÞ
þd
6
ðINVÞ þd
7 to 12
ðIndustry dummiesÞ þd
13 to 18
ðYear dummiesÞ þ1
ð4Þ
The control variables usedinthis equationare leverage, volatility, market value of equity,
investment and liquidity. Holderness et al. (1999) report that the market value of equity
negatively in?uences the proportion of total managerial ownership because of
managerial wealth constraints. On the other hand, market value of equity is positively
associatedwithVESO. Riskmeasuredbyvolatilityof earnings is included to examine the
possibility that high ?rm speci?c uncertainty affects the level of managerial ownership
(Cho, 1998). The use of leverage may lessen the need for external ?nancing thereby
resulting in an increase in managerial ownership (Cho, 1998) as well as an increase in
VESOor leverage and VESOmay be perceived as an alternative monitoring mechanism
(War?eldet al., 1995). Cho also argues that managers may prefer to have a higher stake in
highly liquid ?rms due to the ease of discretionary spending. Himmelberg et al. (1999)
argue that ?rms with high investment spending may have high managerial ownership to
Director share
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alleviate the monitoring problems caused by discretionary managerial investment,
which may result in a positive relation between managerial ownership and investments.
Table V presents the results of our simultaneous equations system. Panel A reports
the results using our primary measure of discretionary accruals and Panel B reports
the results using the modi?ed Jones model. In Panel A we document signi?cant
p-values for VESO (0.061) and VESO2 (0.043) in the DACC regression. The signs of
those two variables are consistent with our previous ?ndings. Once again it implies a
non-monotonic relation between VESO and discretionary accruals. In the VESO
regression, the coef?cient of DACC shows a positive but insigni?cant p-value implying
that DACCdoes not affect VESO. In Panel Bwe measure discretionary accruals by using
the modi?ed Jones model. In the DACC regression the ?ndings in relation to VESO
variables are consistent with our original ?ndings. Once again, our VESO regression
does not suggest an insigni?cant relation between DACC and VESO[15].
Panel A (War?eld et al. model) Panel B (modi?ed Jones model)
DACC VESO DACC VESO
VESO 20.074 (0.061) 21.124 (0.087)
VESO
2
0.006 (0.043) 0.097 (0.079)
USUBSP 20.016 (0.397) 20.039 (0.223)
LEV 0.002 (0.971) 20.147 (0.053) 20.209 (0.694) 0.234 (0.524)
BIND 20.034 (0.252) 20.489 (0.414)
AUD 20.005 (0.643) 20.297 (0.152)
MB 0.001 (0.053) 0.018 (0.064)
LTACC 20.014 (0.056) 20.099 (0.028)
LOSS 0.043 (0.000) 0.059 (0.033)
ASST 0.006 (0.512) 20.339 (0.159)
MVEQ 0.002 (0.000) 0.001 (0.028)
VOL 22.659 (0.000) 21.193 (0.018)
LIQ 0.456 (0.134) 1.009 (0.060)
INV 0.149 (0.756) 1.996 (0.043)
DACC 0.295 (0.475) 0.098 (0.164)
Intercept 0.187 (0.213) 5.729 (0.000) 6.481 (0.025) 5.406 (0.000)
Adjusted R
2
0.059 0.628 0.056 0.642
n 1,173 811
Notes: This table reports the regression results relating to VESO and discretionary accruals;
different notations used in the table are de?ned as follows: DACC – absolute value of discretionary
accruals estimated according to War?eld et al. (1995) model/modi?ed Jones model; VESO – logged value
of market value of equity multiplied by the percentage of share ownership by the executive directors;
ESO – percentage of ordinary shares owned by the executive directors of the board; USUBSP –
percentage of ordinary shares owned by the unaf?liated (excluding the directors) substantial
shareholders; LEV – leverage, calculated as the ratio of book value of debt and book value of total assets;
BIND – board independence calculated as the number of independent directors scaled by the size of the
board; AUD – dummy variable 1 if the ?rm is audited by Big 4 auditors; MB – market to book ratio;
LTACC – lagged total accruals; LOSS – loss dummy variable; ASST – natural log of book value of
assets; MVEQ – natural log of market value of common equity; VOL – volatility of earnings calculated
as a SD of earnings of preceding ?ve years scaled by book value of assets; LIQ – liquidity, calculated as
the ratio of net operatingcash?ows and bookvalue of assets; INV – investment, calculatedas the ratio of
capital expenditure to book value of assets; year and industry dummies are not reported; the reported
results are heteroskedasticity and autocorrelation consistent; ?gures in the parentheses are p-values
Table V.
Relation between VESO
and discretionary
accruals: simultaneous
equation systems
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Reconciliation of managerial ownership and value of managerial ownership. Since VESO
has two variable components (value and proportion), it may be argued that the level of
control dominates the value and vice versa. This concern is addressed by forming
portfolios of managerial ownership based on the proportion of ownership and examining
the relation between VESO and discretionary accruals within these portfolios.
Accordingly we create four portfolios of managerial ownership – the ?rst portfolio
with the least managerial ownership (based on proportion) and the fourth portfolio with
the greatest managerial ownership. The results are reported in Table VI. In the ?rst three
portfolios we document a signi?cant non-monotonic, convex relation between VESO and
discretionary accruals. Whilst we ?nd a similar non-monotonic, convex relation in the
last portfolio, the results are not signi?cant. Overall these results suggest that it is the
value, rather than the proportion of managerial ownership that is associated with
discretionary accruals.
Additional analysis. First, we also followthe prior literature and we replace VESOand
VESO
2
withexecutive director share ownership(ESO) andthe square of executive director
ownership (ESO
2
) in all the analyses of the full sample reported in Tables IV-VI. In
untabulated results, we ?nd signi?cant p-values for the coef?cients ESOand ESO
2
but the
signs of ESO and ESO
2
are positive and negative, respectively. In other words, we ?nd a
positive relation between managerial ownershipand discretionary accruals upto a certain
point followed by a negative relation. Implied is a non-monotonic, concave relation
between managerial ownership and the absolute value of discretionary accruals. This is
inconsistent with the theory outlined in Section 2 of this paper (and any of the results
reported in the admittedly fairly limited prior literature). A possible explanation for the
initial positive relation is that increased ownership arises from the increased volatility in
accounting earnings re?ected in higher accruals. However, the system of simultaneous
equations used to test for endogeneity did not indicate that accruals and managerial
ownership (ESO) were co-determined. Overall, this suggests that VESO may be more
appropriate to identify the incentives associated with managerial ownership.
Second, we use an alternative approach to control for industry differences.
Consistent with the Australian economy, around 17 per cent of our sample are resource
Variable Portfolio 1 Portfolio 2 Portfolio 3 Portfolio 4
VESO 20.057 (0.071) 20.139 (0.039) 20.102 (0.029) 20.100 (0.262)
VESO
2
0.003 (0.079) 0.010 (0.080) 0.006 (0.040) 0.007 (0.217)
Intercept 0.251 (0.032) 0.506 (0.009) 0.450 (0.179) 0.259 (0.432)
Adjusted R
2
0.035 0.034 0.037 0.017
Notes: This table reports the regression results relating to VESO and discretionary accruals to test
whether the proportion of ownership dominates value in VESO-DACC relation; we split the sample
into quartiles based on proportion of ownership and create four portfolios of managerial ownership;
the ?rst portfolio includes those ?rm-year observations that have least managerial ownership and the
last portfolio includes ?rm-year observations with greatest managerial ownership; different notations
used in the table are de?ned as follows: DACC – absolute value of discretionary accruals estimated
according to War?eld et al. (1995) model/modi?ed Jones model; VESO ¼ logged value of market
value of equity multiplied by the percentage of share ownership by the executive directors; the
reported results are heteroskedasticity and autocorrelation consistent; ?gures in the parentheses are
p-values
Table VI.
Relation between VESO
and discretionary
accruals: simultaneous
equation systems
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(metal and mining and energy) companies. Accordingly, we also use a resource dummy
in all regressions and document a signi?cantly positive coef?cient for this variable. It
suggests that the resource companies are more likely to manage earnings than the
non-resource companies but otherwise our results remain unchanged.
Third, Himmelberg et al. (1999), in a managerial ownership-performance context,
argue that managerial ownership may also be endogenously determined by unobserved
?rm heterogeneity. Therefore, we repeat all the analyses using a random effect model
and fail to ?nd any qualitative difference to our main ?ndings.
Fourth, we then split our sample into two different sub-samples based on time
periods – from 2000 to 2004, 2005 to 2006 and replicated the original analysis. The
purpose of splitting the sample is to test any impact of the major corporate regulatory
changes (for example, the introduction of ASX corporate governance guidelines in
2003) that took place during our study period. The results for these sub-samples are
qualitatively similar to the original results.
Fifth, we also examine the impact of the dollar value of ownership by all directors,
that is, executive and non-executive directors, on discretionary accruals by repeating
all regressions using this alternative de?nition and ?nd no qualitative differences
in results. However, when we repeat the analyses using dollar value of ownership
by non-executive directors, we ?nd no relation between discretionary accruals and
dollar value of ownership by non-executive directors. Our results may re?ect the
non-executive directors lack of operational responsibilities and hence the inability to
manage earnings. Alternatively, it is also possible that they may be immune to the
theorised incentive alignment or entrenchment effects associated with share
ownership.
5. Conclusion
We examine the relation between the value of managerial share ownership and
discretionary accruals in Australian ?rms. We argue that VESO is a direct driver of
incentive alignment and/or managerial entrenchment and our results strongly support
this contention. These results show a non-monotonic, convex relation between VESO
and discretionary accruals consistent with incentive alignment up to a certain level of
VESO, followed by entrenchment effects. We also ?nd that these results are driven by
?rms with income increasing, as opposed to income decreasing, discretionary accruals.
Our results are robust to alternative measures of discretionary accruals as well as in
regard to autocorrelation, heteroskedasticity, multicollinearity and potential issues of
endogeneity.
Executive remuneration in Australia continues to be the subject of much societal
debate and long term incentives such as equity in their ?rms form an increasing
proportion of executive remuneration. Accordingly, understanding the incentive effects
associated with managerial share ownership is an important issue that potentially
impacts a wider policy debate. More speci?cally, our research shows regulators and
other stakeholders that the value, rather than proportion, of managerial share ownership
may be an effective internal governance mechanism to align incentives. Moreover, the
lack of a relation between discretionary accruals and the dollar value of ownership by
non-executive directors may re?ect the non-executive directors’ inability to manage
earnings or that they may be immune to the theorised incentive alignment or
entrenchment effects associated with share ownership.
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We acknowledge that, ideally, VESO should be examined in the context of each
manager’s personal wealth but the information on the latter is not publicly available.
Whilst introducing the concept of VESO into the literature is novel, we are cognisant of
the fact that the results may be speci?c to an institutional context hence replication of
this work in other jurisdictions is desirable. Additionally, the recognition of employee
stock option plans in Australian ?nancial statements was made mandatory with the
introduction of “AASB 2: share-based payment” in 2005. A useful extension of this
research would be to consider the impact of managerial stock option plans in the
relation examined. Finally, our study looks at top 300 ASX listed companies. It is
possible that the documented relation between VESO and discretionary accruals may
not hold in smaller ?rms.
Notes
1. Aprincipal-agent relationshipis establishedwhere one or more parties (the principal(s)) engage
another party (the agent) to perform some duties on their behalf which involves delegating
some decision-making authority to the agent ( Jensen and Meckling, 1976). Although an agent
is expected to act in the best interest of the principal, being a “rational economic person”,
the utility maximizing agent may have different goals and risk preferences and thereby seeks
to undertake actions that maximize his/her own interest ( Jensen and Meckling, 1976). Such
divergence of interests creates a potential con?ict in a the relationship.
2. The sample size of War?eld et al. (1995) is 4,778 ?rm-year observations over the period
1988-1990.
3. However, we also use share ownership by all directors in additional analysis.
4. Ideally this would be measured as a proportion of a manager’s personal wealth but, in the
absence of publicly available information about the personal wealth of managers, we use the
absolute value of managerial ownership as a proxy.
5. There can be a relative disjoint between VMSO and MSO. The correlation coef?cient of these
two measures in our sample is 0.517.
6. We also do the same analysis after trimming the top and bottom 1 per cent observations
based on the key variables, that is, VESO and DACC. Our results are not qualitatively
different from those reported in the paper.
7. The year 2006 was chosen as the terminating year to ensure that our analysis is not
compromised by the period of ?nancial crisis which had its genesis in 2007-2008.
8. Various discretionary accruals models of earnings management suffer from estimation
errors and are always subject to criticism (Dechow et al., 1995). A major limitation of this
research is that existing techniques for measuring discretionary accruals lack power as the
exisiting models have poor ability to isolate such accruals. Furthermore, tests using these
techniques are misspeci?ed due to correlated omitted variables in samples with extreme
?nancial performance, a situation that is not uncommon in tests for earnings management.
Alternative techniques have been proposed for identifying discretionary accruals (Dechow
and Dichev, 2002), but offer minimal improvements over previous models.
9. We apply White’s (1980) heteroskedasticity consistent standard errors for all regression
analyses performed in this study. Furthermore, we apply the ?rm clustering technique for all
the analyses because multiple observations from the same ?rm (but from different years) are
included in our dataset.
10. One of the measures of board monitoring that has been widely used in the previous literature
is board independence (Vicknair et al., 1993; Peasnell et al., 2005). The governance literature
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emphasises the role of independent directors in resolving agency problems between
managers and shareholders through the creation of appropriate employment contracts and
the subsequent monitoring of managerial behaviour. Whilst a number of control variables
could have been used, in the interest of having a relatively parsimonious model, board
independence has been used as a suitable proxy for corporate governance.
11. In the context of Australia, Koh (2003) and Davidson et al. (2005) reported the average DACC
to be 0.077 and 0.156, respectively.
12. The average VESO is AUD 2.1 million and is heavily skewed. Therefore, we use log of dollar
value of ownership.
13. To test the problem of multicollinearity we run the auxiliary regressions and check the R
2
values and tolerance factors from these regressions. The R
2
values and tolerance factors do
not suggest the presence of any serious multicollinearity problem.
14. There is empirical support for this proposition in the related area of the managerial
ownership-performance relation (Demsetz and Villalonga, 2001).
15. We also use an alternative regression technique to examine the relation between VESO and
level of discretionary accruals. In particular, we use an IV regression (2 SLS) and predict
VESO using the average age of executive directors as well as the other independent
variables. We ?nd that average age of executive directors signi?cantly in?uences VESO.
The ?rst-stage ?tted values for VESO are then used in the second-stage OLS regression. Our
unreported results are consistent with the ?ndings in Table IV.
References
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Financial Economics, Vol. 80 No. 3, pp. 511-529.
Burns, N. and Kedia, S. (2004), “Do executive stock options generate incentives for earnings
management? Evidence from accounting restatements”, unpublished working paper,
Harvard Business School, Boston, MA.
Cho, M.-H. (1998), “Ownership structure, investment and the corporate value: an empirical
analysis”, Journal of Financial Economics, Vol. 47 No. 1, pp. 103-121.
Davidson, R., Goodwin-Stewart, J. and Kent, P. (2005), “Internal governance structures and
earnings management”, Accounting and Finance, Vol. 45 No. 2, pp. 241-267.
Dechow, P.M. and Dichev, I.D. (2002), “The quality of accruals and earnings: the role of accrual
estimation errors”, The Accounting Review, Vol. 77, pp. 35-59.
Dechow, P.M., Sloan, R.G. and Sweeney, A.P. (1995), “Detecting earnings management”,
The Accounting Review, Vol. 70 No. 2, pp. 193-225.
Demsetz, H. (1983), “The structure of ownership and theory of the ?rm”, Journal of Law
& Economics, Vol. 26, pp. 375-390.
Demsetz, H. and Villalonga, B. (2001), “Ownership structure and corporate performance”, Journal
of Corporate Finance, Vol. 7 No. 3, pp. 209-233.
Dignam, A. and Galanis, M. (2004), “Australia inside-out: the corporate governance
system of the Australian listed market”, Melbourne University Law Review, Vol. 28,
pp. 623-653.
Fama, E. and Jensen, M. (1983), “Separation of ownership and control”, Journal of Law
& Economics, Vol. 26, pp. 327-349.
Francis, J.R. and Krishnan, J. (1999), “Accounting accruals and auditor reporting conservatism”,
Contemporary Accounting Research, Vol. 16, pp. 135-165.
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Gabrielsen, G., Gramlich, J.D. and Plenborg, T. (2002), “Managerial ownership, information
content of earnings and discretionary accruals in a non-US setting”, Journal of Business
Finance & Accounting, Vol. 29, pp. 967-988.
Gul, F., Chen, C.J. and Tsui, J. (2003), “Discretionary accounting accruals, managers’ incentives
and audit fees”, Contemporary Accounting Research, Vol. 20 No. 3, pp. 441-464.
Healy, P.M. and Wahlen, J.M. (1999), “A review of the earnings management literature and its
implications for standard setting”, Accounting Horizons, Vol. 13, pp. 365-383.
Hepworth, A. (2012), “Bosses blast planned executive pay law”, Business Australian,
27 November.
Himmelberg, C.P., Hubbard, R.G. and Palia, D. (1999), “Understanding the determinants of
managerial ownership and the link between ownership and performance”, Journal of
Financial Economics, Vol. 53, pp. 353-384.
Holderness, C.G., Kroszner, R.S. and Sheehan, D.P. (1999), “Were good old days that good?
Changes in managerial stock ownership since the great depression”, Journal of Finance,
Vol. 54, pp. 435-469.
Jensen, M. and Meckling, W. (1976), “Theory of ?rm: managerial behaviour, agency costs and
ownership structure”, Journal of Financial Economics, Vol. 3, pp. 305-360.
Klein, A. (2002), “Audit committee, board of director characteristics, and earnings management”,
Journal of Accounting and Economics, Vol. 33, pp. 375-400.
Koh, P.-S. (2003), “On the association between institutional ownership and aggressive corporate
earnings management in Australia”, The British Accounting Review, Vol. 35, pp. 105-128.
Murphy, K.J. (1999), “Executive compensation”, in Ashenfelter, O. and Card, D. (Eds), Handbook
of Labor Economics, 3rd ed., North Holland, Amsterdam, pp. 2485-2563.
Peasnell, K., Pope, P. and Young, S. (2005), “Board monitoring and earnings management: do
outside directors in?uence abnormal accruals?”, Journal of Business Finance &Accounting,
Vol. 32, pp. 1311-1336.
Vicknair, D., Hickman, K. and Carnes, K.C. (1993), “A note on audit committee independence:
evidence from the NYSE on ‘grey’ area directors”, Accounting Horizons, Vol. 7 No. 1,
pp. 53-57.
Wang, D. (2006), “Founding family ownership and earnings quality”, Journal of Accounting
Research, Vol. 44, pp. 619-656.
War?eld, T.D., Wild, J.J. and Wild, K.L. (1995), “Managerial ownership, accounting choices, and
informativeness of earnings”, Journal of Accounting and Economics, Vol. 20, pp. 61-91.
Yeo, H.H., Tan, M.S., Ho, K.W. and Chen, S. (2002), “Corporate ownership structure and
informativeness of earnings”, Journal of Business Finance & Accounting, Vol. 29,
pp. 1024-1046.
Further reading
ASX Corporate Governance Council (2003), Principles of Good Corporate Governance and Best
Practice Recommendations, ASX Corporate Governance Council.
Corresponding author
Paul Mather can be contacted at: [email protected]
To purchase reprints of this article please e-mail: [email protected]
Or visit our web site for further details: www.emeraldinsight.com/reprints
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doc_782253336.pdf
The purpose of this paper is to investigate the relation between the value of executive
director share ownership and discretionary accruals.
Accounting Research Journal
The value of executive director share ownership and discretionary accruals
Arifur Khan Paul Mather
Article information:
To cite this document:
Arifur Khan Paul Mather, (2013),"The value of executive director share ownership and discretionary
accruals", Accounting Research J ournal, Vol. 26 Iss 1 pp. 35 - 55
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The value of executive director
share ownership and
discretionary accruals
Arifur Khan
School of Accounting, Economics and Finance, Deakin University,
Melbourne, Australia, and
Paul Mather
Department of Accounting, La Trobe University, Melbourne, Australia
Abstract
Purpose – The purpose of this paper is to investigate the relation between the value of executive
director share ownership and discretionary accruals.
Design/methodology/approach – This study uses a dataset of 1,173 ?rm-year observations drawn
from 188 Australian listed companies for the period 2000-2006. The analysis is based on multivariate
regression analysis and ordinary least square models were used to investigate the relation between the
value of managerial ownership and discretionary accruals. The issue of potential endogeneity is
addressed by using a simultaneous equation system.
Findings – A negative relation is found between value of managerial share ownership and
discretionary accruals at lower levels of value of ownership, which is consistent with the theorised
incentive alignment that as the managers commit more resources to their ?rms, stakeholders impose
less contractual constraints speci?ed in terms of accounting numbers and managers make lower
accrual adjustments. After a certain level of value of ownership is attained, a positive relations seen,
consistent with increased discretionary accrual adjustments associated with stakeholders anticipating
managerial entrenchment. Also, it is found that these results are driven by ?rms with income
increasing, as opposed to income decreasing, discretionary accruals.
Practical implications – Shares and options are forming an increasing proportion of executive
remuneration that continues to be the subject of much debate amongst regulators and in the media.
Showing that the value of share ownership may be an effective internal governance mechanism to help
align incentives adds to the debate and has policy implications.
Originality/value – The paper’s primary contribution is ?nding that the value (as opposed to
proportion) of share ownership, typically representing a sizeable proportion of managers’
undiversi?ed wealth, is a potentially direct driver of theorised incentive alignment and
entrenchment effects associated with share ownership.
Keywords Directors, Chief executives, Shares, Value of executive director share ownership,
Discretionary accruals, Incentive alignment, Entrenchment
Paper type Research paper
The current issue and full text archive of this journal is available at
www.emeraldinsight.com/1030-9616.htm
JEL classi?cation – G32, G34, M41
This paper has bene?ted from the helpful comments and suggestions of Brian Cadman,
Bala Balachandran, Janto Haman, John Hillier, Alan Ramsay, Maria Strydom and participants at
the 2010 Annual meeting of American Accounting Association in San Francisco, the 2010
Finance and Corporate Governance Conference, Melbourne and the 2009 Monash Prato PhD
Accounting and Finance Symposium, as well as research seminars at Deakin and Monash
University. The usual caveat applies.
Accounting Research Journal
Vol. 26 No. 1, 2013
pp. 35-55
qEmerald Group Publishing Limited
1030-9616
DOI 10.1108/ARJ-02-2012-0011
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1. Introduction
This paper examines the relation between the value of managerial ownership and
discretionary accruals in Australia during the period 2000-2006. The separation of
ownership and control in publicly listed ?rms is argued to result in information
asymmetries between managers (agents) and shareholders (principals) that give rise to
agency problems ( Jensen and Meckling, 1976). Increased levels of managerial share
ownership in a ?rm helps to align the interests of owners and managers and mitigate
agency problems ( Jensen and Meckling, 1976)[1]. Arguing that such incentive alignment
has contracting implications, War?eld et al. (1995), posit that corporate stakeholders
impose more restrictive contractual constraints denominated in accounting numbers as
managerial ownership and therefore, incentive alignment, declines. The presence of
accounting-based constraints in turn provides managers with incentives to use
accounting discretion to help alleviate these constraints. An alternative theoretical
argument, not considered by War?eld et al. (1995), is that increasing levels of managerial
ownership may result in managerial entrenchment (Demsetz, 1983; Fama and Jensen,
1983). The argument is that the extra voting power enables themto secure their position
in the ?rm thereby insulating them fromcertain disciplining mechanisms which in turn
creates agency problems. If stakeholders anticipate such entrenchment, increasing
levels of managerial ownership may also have contracting implications.
Strong growth in executive remuneration from the 1990s to 2007, that is often not
commensurate with corporate performance, has caused concern in the community
about the need to control such compensation (Productivity Commission, 2009).
Accordingly, executive remuneration in Australia continues to be the subject of much
debate amongst regulators and in the media. As an example, the government’s current
proposed legislation to compel ?rms to disclose the take-home pay of senior executives
and to claw back remuneration in the event of material ?nancial misstatements is
facing a backlash from the business community. The Business Council of Australia
President, Tony Shepherd, states “jumping to add further complexity and an increased
burden to the signi?cant regulatory requirements already faced by Australia’s boards”
(Hepworth, 2012).
Related to the above, long term incentives such as shares and options form an
increasing proportion of executive remuneration. An analysis of executive remuneration
in the top 300 ASX listed companies shows that the proportion of non-CEO executive
remuneration made up by long term incentives in 2005-2007 was 23 per cent compared
to 10 per cent in 2003-2004. Similarly, the proportion of CEO remuneration made up by
long term incentives in 2005-2007 was 26 per cent compared to 11 per cent in 2003-2004
(Productivity Commission, 2009). Accordingly, understanding the incentive effects
associated with managerial share ownership is an important issue that potentially
impacts a wider policy debate.
Extant research suggests that managers have incentives to manage earnings to
avoid reporting earnings decreases and losses since various contracts are based on
accounting numbers (see for example, Healy and Wahlen, 1999 for a survey of this
literature). War?eld et al. (1995) argue that ?rms with low managerial ownership are
subject to more accounting based contractual constraints providing incentives for
managers to use accrual adjustments to circumvent such constraints. As posited they
?nd that managerial ownership in the USA and the magnitude of discretionary
accruals are inversely related[2]. Yeo et al. (2002) also show an increase in discretionary
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accruals at higher levels of ownership consistent with an entrenchment effect in
Singapore. In a related study, Gabrielsen et al. (2002) using a sample of Danish ?rms
fail to ?nd any signi?cant relation between managerial share ownership and
discretionary accruals. In an Australian context Gul et al. (2003) investigate the relation
between discretionary accruals, managerial share ownership and audit fees. Consistent
with the alignment argument, they show that managerial ownership negatively affects
the positive relation between discretionary accruals and audit fees. In sum,
notwithstanding the elegant theories, the empirical evidence on the relation between
managerial share ownership and discretionary accruals is unsettled.
The prior empirical literature uses share ownership by all directors (Yeo et al., 2002)
or wider de?nitions as a proxy for managerial ownership (War?eld et al., 1995;
Gabrielsen et al., 2002; Gul et al., 2003). We argue that it is the executive directors with
operational responsibilities who are in a direct position to manage earnings. Moreover,
given the independent directors’ monitoring role and the associated reputation effects,
it is considered unlikely that they will be associated with earnings management (Fama
and Jensen, 1983). We therefore argue that the wealth of the executive directors as
opposed to the wealth of all directors is an appropriate and less “noisy” proxy to
consider the impact on discretionary accruals. Accordingly, we use ownership by
executive directors in this study[3].
The prior research measures the incentives associated with managerial ownership
in terms of control rights or the proportion of shares they own in their ?rm. A manager
who has an increasing amount of personal resources invested in their ?rm is more
likely to bear the consequences of managerial actions. Such shares often represent a
sizeable proportion of the managers’ wealth that is inherently undiversi?ed. Hence, we
argue that the value of the managerial share ownership is potentially a more direct
driver of incentive alignment and/or entrenchment than the proportion of ownership.
There can be a relative disjoint between value of managerial share ownership and
proportion of managerial share ownership and information relating to managerial
ownership of shares in two of our sample companies illustrates the distinction. In June
2006 BHP Ltd’s managerial share ownership was only 0.017 per cent whilst value of
managerial share ownership was $30 million. Conversely at the same date, in Southern
Dental Industries Limited (SDI), managerial share ownership and value of managerial
share ownership were 44 per cent and $32.6 million, respectively. Accordingly, we use
the dollar value of executive director share ownership (VESO) as our measure in this
study[4].
Our initial tests show a non-monotonic, convex relation between VESO and the
absolute value of discretionary accruals. Speci?cally, we ?nd a negative relation
between VESO and discretionary accruals at lower levels of dollar value of ownership
which is consistent with the argument that as the managers commit more resources to
their ?rms, stakeholders impose less contractual constraints denominated in
accounting numbers and managers make lower accrual adjustments. After a certain
level of dollar value of ownership is attained, we see a positive relation consistent with
increased discretionary accrual adjustments associated with stakeholders anticipating
managerial entrenchment. We also ?nd that these results are driven by ?rms with
income increasing, as opposed to income decreasing, discretionary accruals. When we
use a simultaneous equation system to address the issue of endogeneity, we do not ?nd
evidence that the VESO-discretionary accruals relation is co-deterministic. Our results
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are robust to the alternative estimates of discretionary accruals, as well as concerns for
autocorrelation, heteroskedasticity and multicollinearity.
We contribute to the literature by positing and ?nding that the value of managerial
share ownership is a more direct driver of the incentives associated with managerial
share ownership than the proportion of the stake. We also argue that it is the executive
directors with operational responsibilities who are in a direct position to manage
earnings and, in contrast to the prior literature, focus on executive director ownership.
Further analysis shows that, unlike executive director ownership, non-executive
director ownership has no relation with discretionary accruals, which may re?ect the
non-executive directors’ inability to operationally manage earnings or that they may
be immune to the theorised incentive alignment or entrenchment effects associated
with share ownership.
The paper is structured as follows: Section 2 provides a review of literature and
theoretical background. Section 3 describes the research design, while Section 4 reports
the main results. Section 5 summarises and draws conclusions.
2. Literature review and theoretical background
2.1 Literature review
Managerial share ownership, one of the internal governance mechanisms to address
agency problems, can inversely affect the magnitude of discretionary accruals due to
the incentive alignment (War?eld et al., 1995). War?eld et al. (1995) argue that because
of separation of ownership and control between owners and managers, contracts often
contain accounting-based constraints to restrict the managers from engaging in
value-reducing behaviour. The presence of accounting-based constraints in turn
provides managers with incentives to use accounting discretion to help circumvent
these constraints. They contend that when ownership is low, the increased demand for
accounting-based constraints may motivate the managers to choose the accounting
policies to mitigate the accounting-based contractual restrictions. Consistent with their
hypothesis, they ?nd a negative relationship between managerial share ownership and
the magnitude of discretionary accruals in the USA.
Gabrielsen et al. (2002) examine the same relationship for a sample of Danish ?rms,
to extend the ?ndings of War?eld et al. (1995) in a different institutional setting. They
fail to ?nd any statistically signi?cant relationship between managerial share
ownership and discretionary accruals (absolute value), and argue that their results are
likely attributable to different institutional arrangements that exist in the USA and
Denmark.
War?eld et al. (1995) posit that corporate stakeholders impose more restrictive
contractual constraints denominated in accounting numbers as managerial share
ownership and therefore, incentive alignment declines. An alternative theoretical
argument, not considered by War?eld et al. (1995), is that high level of ownership may
result in managerial entrenchment (Demsetz, 1983; Fama and Jensen, 1983). The
combination of incentive alignment and entrenchment may suggest a nonlinear
relationship between managerial share ownership and discretionary accruals.
Accordingly Yeo et al. (2002) examine the nonlinear relationship between managerial
share ownership and income increasing discretionary accruals for ?rms listed on the
Singapore stock exchange. They ?nd that at lowlevels of ownership, the level of income
increasing discretionary accruals has a negative relationship with the management
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ownership, consistent with the incentive alignment argument. However, at higher levels
of managerial ownership the relationship reverses, suggesting that the entrenchment
effect might have set in.
Gul et al. (2003) investigate the relation between discretionary accruals, managerial
share ownership and audit fees using a sample of 648 Australian ?rms for the year
1993. They ?nd a positive relation between discretionary accruals and audit fees. They
also ?nd that managerial ownership negatively affects the positive relation between
discretionary accruals and audit fees. Thus, their ?ndings are consistent with the
alignment argument.
There is also an extensive literature on executive remuneration (see for example,
Murphy (1999) for a survey of this literature). A subset of these studies has focused on
the relation between the equity incentives of the executives and earnings management.
For example, Bergstresser and Philippon (2006) show that CEOs’ equity incentives can
explain the accruals management of ?rms. Similarly, Burns and Kedia (2004) ?nd that
earnings restatements are more common at ?rms where CEOs have larger options
portfolios. Collectively, the ?ndings of previous studies suggest that executives such as
CEOs tend to manipulate reported earnings through discretionary accruals when their
compensation is closely related to the value of their share and option holdings.
2.2 Theoretical background
Managerial ownership results in a manager who owns a fraction of a ?rm’s issued
shares directly assuming the consequences of their actions, thus aligning their
incentives withother shareholders ( Jensen and Meckling, 1976). Hence, managers
owning shares in their employing ?rm are likely to strive to make better investment
decisions and thereby maximize value.
As shown in Figure 1, managerial share ownership has contractual implication as
well. It is argued that stakeholders, for example board remuneration committees and
lenders, impose more restrictive contractual constraints denominated in accounting
Figure 1.
The relation between
separation of ownership
and control and incentives
to manage earnings
Separation of
ownership and control
Stakeholders contract
with executives
Contract based on
accounting numbers
Incentives for
managing earnings
Director share
ownership
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numbers as managerial ownership and therefore, incentive alignment, declines
(War?eld et al., 1995). It is also argued that ?rms with low managerial ownership are
subject to more accounting based contractual constraints as stakeholders perceive a
lack of incentive alignment (War?eld et al., 1995). This is done to limit their managers’
opportunistic behaviour and to monitor their actions. These contractual provisions in
turn provide incentives for managers to use accrual adjustments to circumvent such
constraints. Conversely, as managerial ownership increases, it is also less likely that
the managers will engage in opportunistic behaviour hence, the demand for accounting
based contractual constraints will decline (War?eld et al., 1995).
Some of the behaviour identi?ed by Jensen and Meckling (1976) as bene?ting
managers at the expense of shareholders include perquisite-taking, shirking, and the
pursuit of non-value maximizing objectives such as empire building. As the proportion
of managers’ shares increase, it is argued that managers bear an increasing proportion
of these costs which helps align incentives. Thus, the theoretical arguments view the
aforementioned incentives associated with managerial ownership or in terms of control
rights in the managed ?rm. On the other hand we argue that such shares often represent
a sizeable proportion of the managers’ wealth that is inherently undiversi?ed. Hence, the
VESO is potentially a more direct driver of incentive alignment in the case of some
of these behaviours such as the pursuit of non-value maximising objectives[5].
The extra voting power that accrues as the ownership stake increases is theorised
to increase the potential for costs associated with entrenchment as it insulates
managers from certain disciplining mechanisms such as the managerial labour market
and the market for corporate control (Demsetz, 1983). If stakeholders anticipate such
entrenchment increasing levels of managerial ownership may have similar contracting
implications. Once again, the prior empirical literature is premisedonthe assumptionthat
such effects are likely to be associated with managerial ownership, representing the
proportion of shares or control rights in the ?rm (Yeo et al., 2002; Gabrielsen et al., 2002).
On the other hand, ceteris paribus, rational managers should prefer to hold a diversi?ed
portfolio of assets but as VESO increases they become increasingly exposed to
?rm-speci?c risk. Such high VESOis likely to make a manager more risk averse as their
decisions will have a potentially costly impact on a relatively high proportion of their
personal wealth.
Notwithstanding the limited empirical work yielding unsettled conclusions, theory
suggests that the pattern of the VESO-discretionary accruals relation is likely to be
consistent with initial incentive alignment followed by entrenchment effects. Hence we
propose the following hypothesis:
H1. There is a non-monotonic convex relation between VESO and discretionary
accruals.
3. Research design
3.1 Data
We initially identi?ed the top 300 Australian companies by market capitalisation at
30 June 1999. Consistent with the prior literature, we exclude banks, ?nancial institutions,
trusts and utility ?rms (49 ?rms) which have different disclosure requirements and/or
different corporate governance structures. We exclude another 63 ?rms due to missing
information. The ?nal sample comprises of the remaining ?rms with a total of 1,173
?rm-year observations over the seven year period 2000-2006[6], [7]. As evident in Table I,
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the sample ?rms belong to 21 Global Industrial Classi?cation Standard Sectors (GICS)
Industry Groups. We collect the required accounting information from Aspect Fin
Analysis and Connect 4 databases. The ownership and other corporate governance data
was hand collected from the corporate governance disclosures, shareholding information
and directors’ report contained in annual reports.
3.2 Measuring discretionary accruals
Our primary test to measure discretionary accruals relies on a research design used by
War?eld et al. (1995). In particular, discretionary accruals (DACC) are de?ned as current
period total accruals (ACC) less expected normal accruals (E(ACC)), standardised by
prior period total assets (ASST):
DACC
i;t
¼
ACC
i;t
2EðACCÞ
i;t
ASST
i;t21
ð1Þ
Consistent with previous research (War?eld et al., 1995; Yeo et al., 2002) we estimate total
accruals as below.
Panel A: sample selection
Number of ?rms 300
Less
Financial and utility companies 49
Companies without necessary information for
corporate governance and control variable data 63
Total 188
Panel B: analysis of sample by GICS sectors and industries
GICS sector GICS industry group
Material Chemicals 3
Construction material 5
Metal and mining 22
Paper and forest products 6
Industrial Capital goods 16
Commercial service and supplies 9
Transportation 5
Health care Health care equipment and supplies 10
Health care providers and services 6
Pharmaceutical, biotechnology and life
science
8
Telecommunication Diversi?ed telecommunication 4
Consumer staples Food and staple retailing 5
Food, beverage and tobacco 15
Consumer discretionary Automobiles and components 7
Consumer durables and apparels 6
Consumer services 11
Media 17
Retailing 10
Information technology Software and services 7
Technology hardware and equipment 6
Energy Oil and gas 10
Total 188
Table I.
Sample description
Director share
ownership
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Total accruals (ACC) ¼ DCA 2 DCL–DEP where DCA is the change in non-cash
current assets (change in current assets less change in cash), DCL is the change in
current liabilities excluding short term debt (change in current liabilities less the
change in debt included in current liabilities and minus the changes in income tax
payable) and DEP is depreciation and amortization. Expected normal accruals (E(ACC)
are estimated by using a ?ve year ?rm speci?c average of prior periods’ accounting
accruals (ACC
i,t21
, . . . , ACC
i,t25
).
As an alternative measure we use the more data intensive time series version of the
modi?ed Jones model. Under this model, the level of discretionary accruals[8] for a
particular ?rm is calculated as the difference between the ?rm’s total accruals and its
non-discretionary accruals (NDAC), as estimated with the following equation:
NDAC
t
¼ a
0
1
TA
t21
þa
1
DREV
t
2DAR
t
TA
t21
þa
2
PPE
t
TA
t21
ð2Þ
where:
NDAC
t
– non-discretionary accruals in year t.
TA
t21
– total assets in year t 2 1.
DREV
t
– change in revenue of ?rm i in year t.
DAR
t
– change in accounts receivable of ?rm i in year t.
PPE
t
– property plant and equipment for ?rm i in year t.
3.3 Model speci?cation
We use the following equation to examine the relation between VESO and discretionary
accruals using an OLS regression technique:
DACC ¼ b
0
þb
1
ðVESOÞ þb
2
ðVESOÞ
2
þb
3
ðUSUBSPÞ þb
4
ðLEVÞ þb
5
ðBINDÞ
þb
6
ðAUDÞ þb
7
ðMBÞ þb
8
ðLTACCÞ þb
9
ðLOSSÞ þb
10
ðASSTÞ
þb
11 to 17
ðGICS Sectoral dummiesÞ þb
18 to 23
ðYear dummiesÞ þ1 ð3Þ
where:
DACC – absolute value of discretionary accruals.
VESO – log of dollar value of share ownership by the executive directors.
USUBSP – unaf?liated substantial share ownership.
LEV – leverage.
BIND – board independence.
AUD – auditor dummy variable.
MB – market to book.
LTACC – lagged total accruals.
LOSS – loss dummy variable.
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ASST – ?rm size proxied by the book value of assets.
MVEQ – market value of equity.
VOL – volatility of earnings.
LIQ – liquidity.
INV – investment.
Table II summarises the de?nitions of all the variables employed in this paper. As we
anticipate a non-monotonic relation between VESO and discretionary accruals, we use a
quadratic speci?cation of the VESO variable (see for example, the treatment of MSO in
Yeo et al., 2002). The control variables used in this study include strength of unaf?liated
substantial shareholdings, leverage, level of board independence, employment of a Big 4
auditor, the market to book ratio, lagged total accruals, incurrence of loss, and size of the
?rm. We also control for the GICS industrial sector and the observation’s year[9].
We include ownership by the unaf?liated substantial shareholders to control for a
monitoring effect (Peasnell et al., 2005). Unaf?liated shareholdings are measured by
taking the percentage of share ownership by the unaf?liated substantial shareholders
(other than directors). Managers have incentives to use accounting discretion when
they are close to a debt covenant violation and leverage may capture such incentives
(Klein, 2002). We measure leverage by the ratio of book value of debt to book value of
total assets. The monitoring role of independent boards may constrain discretionary
accruals (Peasnell et al., 2005)[10]. The proportion of independent directors is a proxy
Variable De?nition Detailed explanation Expected sign
VESO Dollar value of managerial share
ownership
Log of dollar value of share ownership
by the executive directors
?
USUBSP Unaf?liated substantial share
ownership
Percentage of ordinary shares owned
by the unaf?liated (excluding the
directors) substantial shareholders
–
LEV Leverage Ratio of book value of debt and book
value of total assets
þ
BIND Board independence The number of independent directors
scaled by the size of the board
–
AUD Auditor dummy variable A dummy variable 1 if the ?rm is
audited by a Big 4 auditor and
otherwise 0
–
MB Market to book ratio Market value of equity divided by the
book value of shareholders’ equity
?
LTACC Lagged total accruals Prior year total accruals scaled by the
prior year total assets
–
LOSS Loss dummy variable A dummy variable 1 if the ?rm has
negative earnings and otherwise 0
þ
ASST Size Natural log of book value of assets ?
MVEQ Market value of equity Natural log of market value of equity ^
LIQ Liquidity Net operating cash ?ow scaled by the
book value of assets
þ
INV Investment Capital expenditure scaled by the book
value of assets
þ
Table II.
De?nition of variables
Director share
ownership
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for board independence. Previous research suggests that large audit ?rms (Big 4) are
considered to be more effective monitors of the ?nancial reporting process compared to
smaller ?rms (Francis and Krishnan, 1999). Therefore, a dummy variable is used to
control for the effect of auditor type on the level of discretionary accruals. Following
previous studies we take market to book ratio as one of our control variables and
measured as market value of equity divided by the book value of shareholders’ equity
(Klein, 2002). Accruals are mean reverting, with the majority of the mean reversion
occurring within a year (Dechow et al., 1995). A high level of lagged total accruals will
probably reduce managers’ ability to manage current period reported earnings upward
and vice versa. Therefore, we control for the total accruals of the previous period (Koh,
2003). Firms with negative earnings are associated with greater discretionary accruals
(Wang, 2006). Hence we use a dummy variable when a ?rm has negative earnings in a
particular year. Finally we follow previous studies and control for ?rm size by taking a
natural log of book value of assets (Klein, 2002; Wang, 2006).
4. Results
4.1 Descriptive statistics
Panel A of Table III reports the descriptive statistics of some key variables. It shows
that the average DACC using War?eld et al. (1995) (modi?ed Jones) is 0.065 (0.058), the
average managerial ownership is 6.29 per cent and that unaf?liated substantial
shareholders, on average, hold 37.15 per cent of total shares outstanding[11]. The
average VESO (logged value) is 5.134[12].
Panel B of Table III presents the Pearson correlation matrix[13]. DACC using both
War?eld et al. (1995) and modi?ed Jones is negatively and signi?cantly correlated with
VESO. VESOis negativelyand signi?cantly correlated with BIND(board independence)
suggesting that ?rms with high VESO are less likely to have independent boards.
VESOis positively and signi?cantly correlated with market value of equity. Firmsize is
negatively correlated with MSO (managerial ownership), suggesting that executive
directors’ equity interests decrease as ?rm size (measured by LASST) increases. The
positive correlation between ?rm size (LASST) and leverage (LEV) suggests that large
?rms have high leverage and larger ?rms are also more likely to have Big 4 auditors.
A negative correlation between VESO and the auditor variable indicates that directors
have greater equity interests in ?rms audited by non-Big 4 ?rms which is likely to be
driven by ?rm size.
4.2 Managerial share ownership and discretionary accruals
Table IV presents the results of the OLS regression estimation. The ?rst regression
result relates to VESOand discretionary accruals (Panel A). We ?nd signi?cant p-values
for the coef?cients of VESO (0.022) and VESO
2
(0.027). The signs of VESO and VESO
2
are negative and positive, respectively. In other words, we ?nd a negative relation
between VESO and discretionary accruals up to a certain point followed by a positive
relation. It implies a non-monotonic, convex relation between VESO and the absolute
value of discretionary accruals. The negative relation between VESO and discretionary
accruals up to a certain point is consistent with the hypothesis that as VESO increases,
the board and/or stakeholders imposes less contractual restrictions denominated in
accounting numbers and managers have less of a need to make accrual adjustments to
alleviate these restrictions. However, at a higher level of VESOthe results are consistent
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(
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2
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0
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6
0
.
1
5
0
*
(
c
o
n
t
i
n
u
e
d
)
Table III.
Descriptive statistics
Director share
ownership
45
D
o
w
n
l
o
a
d
e
d
b
y
P
O
N
D
I
C
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R
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T
Y
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t
2
1
:
1
7
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4
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a
n
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a
r
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6
(
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T
)
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;
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d
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p
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;
d
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f
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n
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d
a
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f
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l
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s
:
E
S
O
–
p
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r
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n
t
a
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e
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f
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r
d
i
n
a
r
y
s
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a
r
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s
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w
n
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d
b
y
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h
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x
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c
u
t
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v
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d
i
r
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c
t
o
r
s
o
f
t
h
e
b
o
a
r
d
;
V
E
S
O
–
l
o
g
g
e
d
v
a
l
u
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o
f
m
a
r
k
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t
v
a
l
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f
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q
u
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y
m
u
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t
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p
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d
b
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t
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e
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x
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c
u
t
i
v
e
d
i
r
e
c
t
o
r
s
;
U
S
U
B
S
P
–
p
e
r
c
e
n
t
a
g
e
o
f
o
r
d
i
n
a
r
y
s
h
a
r
e
s
o
w
n
e
d
b
y
t
h
e
u
n
a
f
?
l
i
a
t
e
d
(
e
x
c
l
u
d
i
n
g
t
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d
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r
e
c
t
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s
)
s
u
b
s
t
a
n
t
i
a
l
s
h
a
r
e
h
o
l
d
e
r
s
;
D
A
C
C
W
–
d
i
s
c
r
e
t
i
o
n
a
r
y
a
c
c
r
u
a
l
s
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t
i
m
a
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d
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d
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W
a
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.
m
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l
;
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–
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m
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d
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J
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m
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l
;
B
I
N
D
–
b
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r
d
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n
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b
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a
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;
L
E
V
–
l
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v
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r
a
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,
c
a
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d
a
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v
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f
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a
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t
s
;
A
S
S
T
–
l
o
g
o
f
b
o
o
k
v
a
l
u
e
o
f
a
s
s
e
t
s
;
M
B
–
m
a
r
k
e
t
t
o
b
o
o
k
r
a
t
i
o
;
A
U
D
–
a
d
u
m
m
y
v
a
r
i
a
b
l
e
1
i
f
t
h
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?
r
m
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s
a
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d
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t
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d
b
y
B
i
g
4
a
u
d
i
t
o
r
s
;
a
d
u
m
m
y
v
a
r
i
a
b
l
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1
i
f
t
h
e
?
r
m
h
a
s
n
e
g
a
t
i
v
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e
a
r
n
i
n
g
s
;
L
T
A
C
C
–
p
r
i
o
r
y
e
a
r
t
o
t
a
l
a
c
c
r
u
a
l
s
;
M
V
E
Q
–
l
o
g
o
f
m
a
r
k
e
t
v
a
l
u
e
o
f
e
q
u
i
t
y
;
L
I
Q
–
n
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t
o
p
e
r
a
t
i
n
g
c
a
s
h
?
o
w
s
c
a
l
e
d
b
y
t
h
e
b
o
o
k
v
a
l
u
e
o
f
a
s
s
e
t
s
;
V
O
L
–
S
D
o
f
e
a
r
n
i
n
g
s
o
f
p
r
e
v
i
o
u
s
?
v
e
y
e
a
r
s
s
c
a
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e
d
b
y
t
h
e
b
o
o
k
v
a
l
u
e
o
f
a
s
s
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t
s
;
I
N
V
–
c
a
p
i
t
a
l
e
x
p
e
n
d
i
t
u
r
e
s
c
a
l
e
d
b
y
t
h
e
b
o
o
k
v
a
l
u
e
o
f
a
s
s
e
t
s
Table III.
ARJ
26,1
46
D
o
w
n
l
o
a
d
e
d
b
y
P
O
N
D
I
C
H
E
R
R
Y
U
N
I
V
E
R
S
I
T
Y
A
t
2
1
:
1
7
2
4
J
a
n
u
a
r
y
2
0
1
6
(
P
T
)
with the hypothesis that stakeholders anticipate the managers to be entrenched and
impose more contractual constraints which in turn motivate the managers to make more
accrual adjustments. The estimated point at which the negative VESOand discretionary
accruals relation turns positive is where VESO is AUD 6.8 million. We ?nd that 198
?rm-year observations have VESO (in AUD) in excess of the estimated turning point,
which corresponds to 17 per cent of the total number of observations.
DACC DACC
þ ve
DACC
2ve
Panel A
VESO 20.041 (0.022) 20.039 (0.025) 20.021 (0.944)
VESO
2
0.003 (0.027) 0.002 (0.029) 0.001 (0.879)
LEV 0.005 (0.466) 0.006 (0.507) 20.007 (0.631)
USUBSP 20.001 (0.909) 20.009 (0.489) 0.011 (0.285)
BIND 20.005 (0.032) 20.006 (0.038) 20.007 (0.557)
AUD 0.001 (0.896) 0.006 (0.478) 20.006 (0.425)
MB 0.001 (0.631) 0.001 (0.362) 20.001 (0.385)
LTACC 20.022 (0.214) 20.059 (0.019) 0.032 (0.173)
LOSS 0.025 (0.001) 0.041 (0.001) 0.013 (0.110)
ASST 20.013 (0.000) 20.020 (0.000) 20.003 (0.403)
Intercept 0.258 (0.000) 0.364 (0.000) 0.077 (0.224)
Adjusted R
2
0.044 0.085 0.033
n 1,173 736 437
Panel B
VESO 20.188 (0.075) 20.183 (0.082) 20.174 (0.286)
VESO
2
0.014 (0.036) 0.013 (0.075) 0.016 (0.329)
LEV 0.012 (0.895) 0.006 (0.347) 20.001 (0.959)
USUBSP 0.004 (0.974) 20.001 (0.963) 20.017 (0.192)
BIND 20.378 (0.008) 20.007 (0.022) 20.016 (0.219)
AUD 20.105 (0.217) 20.007 (0.398) 0.007 (0.390)
MB 0.007 (0.426) 0.001 (0.531) 0.002 (0.028)
LTACC 20.801 (0.011) 20.073 (0.003) 20.069 (0.063)
LOSS 0.179 (0.115) 0.034 (0.008) 20.001 (0.924)
ASST 20.117 (0.004) 20.015 (0.000) 0.011 (0.012)
Intercept 2.130 (0.005) 0.263 (0.000) 20.226 (0.007)
Adjusted R
2
0.046 0.075 0.040
n 811 519 292
Notes: This table reports the regression results relating to VESO and discretionary accruals; different
notations used in the table are de?ned as follows: DACC – in Panel A absolute value of discretionary
accruals estimated according to War?eld et al. (1995) model and in Panel B absolute value of
discretionary accruals estimated according to modi?ed Jones model; DACC
þve
– absolute value of
income increasing discretionary accruals; DACC
2ve
– absolute value of income decreasing
discretionary accruals; VESO – logged value of market value of equity multiplied by the percentage of
share ownership by the executive directors; ESO – percentage of ordinary shares owned by the
executive directors of the board; USUBSP – percentage of ordinary shares owned by the unaf?liated
(excluding the directors) substantial shareholders; LEV – leverage, calculated as the ratio of book
value of debt and book value of total assets; BIND – board independence calculated as the number of
independent directors scaled by the size of the board; AUD – dummy variable 1 if the ?rm is audited
by Big 4 auditors; MB – market to book ratio; LTACC – lagged total accruals; LOSS – loss dummy
variable; ASST – natural log of book value of assets; year and industry dummies are not reported; the
reported results are heteroskedasticity and autocorrelation consistent; ?gures in the parentheses are
p-values
Table IV.
Relation between VESO
and discretionary
accruals (War?eld et al.,
modi?ed Jones models)
Director share
ownership
47
D
o
w
n
l
o
a
d
e
d
b
y
P
O
N
D
I
C
H
E
R
R
Y
U
N
I
V
E
R
S
I
T
Y
A
t
2
1
:
1
7
2
4
J
a
n
u
a
r
y
2
0
1
6
(
P
T
)
The fact that the coef?cients of some other control variables are statistically
signi?cant suggests that discretionary accruals are also in?uenced by other factors.
Speci?cally, discretionary accruals are positively related to loss (LOSS) and negatively
related to board independence (BIND) and ?rm size (ASST). All other control variables
are insigni?cant. A positive signi?cant coef?cient for loss (LOSS) is consistent with the
?ndings of Wang (2006) and implies that ?rms with negative earnings are associated
with greater discretionary accruals. The negative, signi?cant coef?cient for board
independence (BIND) is consistent with prior literature suggesting that independent
director monitoringconstrains the use of discretionaryaccruals (Peasnell et al., 2005). The
negative, signi?cant coef?cient for ?rmsize (ASST) is also consistent with Wang (2006).
We also document a number of insigni?cant coef?cients including unaf?liated
shareholdings (USUBSP), Big 4 auditor and leverage (LEV). The insigni?cant coef?cient
for substantial shareholders (USUBSP) implies passive monitoring by Australian
block holders (Dignam and Galanis, 2004). An insigni?cant coef?cient for the auditor
(AUD) variable suggests that Big 4 auditors do not have any signi?cant relation
with discretionary accruals in our dataset. This is also consistent with Peasnell et al.
(2005).
The sample ?rm-years are divided into two sub-samples according to the sign of
discretionary accruals, and we repeat the regression analysis for each sub-sample. The
results are presented in the second and third regression estimation results in Table IV,
Panel A. Observations with positive (negative) discretionary accruals are consistent
with income-increasing (income-decreasing) accrual adjustments and DACC
þve
(DACC
2ve
) indicates the absolute value for positive (negative) discretionary accruals,
respectively. For the DACC
þve
regression, all coef?cients for the VESO variables are
statistically signi?cant with the expected signs, that is, consistent with the main
regression. For the DACC
2ve
regression, all coef?cients of the VESO variables have
the expected signs, but, they are not statistically signi?cant. Taken together, this
suggests that VESO is signi?cantly associated with income-increasing but not
income-decreasing accrual adjustments. The difference in relations is consistent with
the contracting argument posited in this paper.
One of the most commonly used models to estimate discretionary accruals is the
modi?ed Jones model and we use the time series version of the model to measure
discretionary accruals. The time series version requires extensive data which was
unavailable for some of the sample companies. Therefore, our sample ?rms reduce to 141
with a total of 811 ?rm-year observations. We present the results in Panel B of Table IV.
The ?rst regression shows a signi?cant coef?cient for VESO ( p ¼ 0.075) and a
signi?cant coef?cient for VESO
2
( p ¼ 0.036). The signs of VESOand VESO
2
are negative
and positive, respectively, which implies a non-monotonic relation between VESO and
discretionary accruals, consistent withthe earlier ?ndings. We also ?nd that discretionary
accruals are related to several control variables (LOSS, BIND, and ASST) that were
signi?cant in the earlier analysis using the War?eld et al. model. Additionally,
discretionary accruals are negatively related to lagged total accruals (LTACC). The
negative, signi?cant coef?cient for lagged total accruals (LTACC) implies that a highlevel
of lagged total accruals will probably reduce managers’ ability to manage discretionary
accruals upward and vice versa (Koh, 2003).
Once again, the sample is divided into two sub-samples according to the sign of
the discretionary accruals, and we repeat the regression analysis for each sub-sample.
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The results are reported in the second and third regressions in Table IV, Panel B
For the DACC
þve
regression we ?nd that all the coef?cients of VESO variables are
statistically signi?cant, consistent with the results for DACC as a whole. However, the
coef?cients for the VESO variables in the DACC
2ve
regression are not signi?cant.
The results of control variables in these two sub-samples do not show any qualitative
difference from results presented in the ?rst regression. Thus, we once gain ?nd that
VESO is associated with income-increasing but not income-decreasing accruals.
4.3 Robustness checks
Endogeneity of VESO. A theoretical possibility not considered by the prior studies is
that the levels of VESO may be endogenously determined as part of the ?rm’s broader
operating and ?nancing arrangements (Demsetz, 1983)[14]. The arguments supporting
incentive alignment and/or managerial entrenchment essentially take the view that
elements of corporate governance such as managerial ownership as well as value of
managerial ownership may develop independently and may be unrelated to the ?rm’s
broader operating and ?nancing arrangements. An alternative view is that some or all
of the corporate governance characteristics, including VESO, may be endogenously
determined as part of the ?rm’s broader operating and ?nancing arrangements
(Demsetz, 1983). In this view, ?rms with greater dif?culty in monitoring management
performance due to factors such as longer operating cycles, more uncertain future cash
?ows, and higher propensity to make losses (Dechow and Dichev, 2002) may be more
likely to adopt particular corporate governance arrangements (for example, higher
managerial ownership). Increases in accruals and the propensity for discretion in such
accruals may be more likely to arise from greater timing and matching problems in
?rms that have longer business cycles and/or more volatile business fundamentals. In
turn, these characteristics may also be related to VESO because higher VESO is likely
to make for more ef?cient contracting, due to information asymmetries and the
increased dif?culty in monitoring management performance (Demsetz, 1983).
Accordingly, we use a simultaneous equations system (3 SLS) to address the
endogeneity of VESO.
We introduce the following equation in addition to our original equation to address
the potential endogeneity of VESO:
VESO ¼ d
0
þd
1
ðDACCÞ þd
2
ðMVEQÞ þd
3
ðLEVÞ þd
4
ðVOLÞ þd
5
ðLIQÞ
þd
6
ðINVÞ þd
7 to 12
ðIndustry dummiesÞ þd
13 to 18
ðYear dummiesÞ þ1
ð4Þ
The control variables usedinthis equationare leverage, volatility, market value of equity,
investment and liquidity. Holderness et al. (1999) report that the market value of equity
negatively in?uences the proportion of total managerial ownership because of
managerial wealth constraints. On the other hand, market value of equity is positively
associatedwithVESO. Riskmeasuredbyvolatilityof earnings is included to examine the
possibility that high ?rm speci?c uncertainty affects the level of managerial ownership
(Cho, 1998). The use of leverage may lessen the need for external ?nancing thereby
resulting in an increase in managerial ownership (Cho, 1998) as well as an increase in
VESOor leverage and VESOmay be perceived as an alternative monitoring mechanism
(War?eldet al., 1995). Cho also argues that managers may prefer to have a higher stake in
highly liquid ?rms due to the ease of discretionary spending. Himmelberg et al. (1999)
argue that ?rms with high investment spending may have high managerial ownership to
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alleviate the monitoring problems caused by discretionary managerial investment,
which may result in a positive relation between managerial ownership and investments.
Table V presents the results of our simultaneous equations system. Panel A reports
the results using our primary measure of discretionary accruals and Panel B reports
the results using the modi?ed Jones model. In Panel A we document signi?cant
p-values for VESO (0.061) and VESO2 (0.043) in the DACC regression. The signs of
those two variables are consistent with our previous ?ndings. Once again it implies a
non-monotonic relation between VESO and discretionary accruals. In the VESO
regression, the coef?cient of DACC shows a positive but insigni?cant p-value implying
that DACCdoes not affect VESO. In Panel Bwe measure discretionary accruals by using
the modi?ed Jones model. In the DACC regression the ?ndings in relation to VESO
variables are consistent with our original ?ndings. Once again, our VESO regression
does not suggest an insigni?cant relation between DACC and VESO[15].
Panel A (War?eld et al. model) Panel B (modi?ed Jones model)
DACC VESO DACC VESO
VESO 20.074 (0.061) 21.124 (0.087)
VESO
2
0.006 (0.043) 0.097 (0.079)
USUBSP 20.016 (0.397) 20.039 (0.223)
LEV 0.002 (0.971) 20.147 (0.053) 20.209 (0.694) 0.234 (0.524)
BIND 20.034 (0.252) 20.489 (0.414)
AUD 20.005 (0.643) 20.297 (0.152)
MB 0.001 (0.053) 0.018 (0.064)
LTACC 20.014 (0.056) 20.099 (0.028)
LOSS 0.043 (0.000) 0.059 (0.033)
ASST 0.006 (0.512) 20.339 (0.159)
MVEQ 0.002 (0.000) 0.001 (0.028)
VOL 22.659 (0.000) 21.193 (0.018)
LIQ 0.456 (0.134) 1.009 (0.060)
INV 0.149 (0.756) 1.996 (0.043)
DACC 0.295 (0.475) 0.098 (0.164)
Intercept 0.187 (0.213) 5.729 (0.000) 6.481 (0.025) 5.406 (0.000)
Adjusted R
2
0.059 0.628 0.056 0.642
n 1,173 811
Notes: This table reports the regression results relating to VESO and discretionary accruals;
different notations used in the table are de?ned as follows: DACC – absolute value of discretionary
accruals estimated according to War?eld et al. (1995) model/modi?ed Jones model; VESO – logged value
of market value of equity multiplied by the percentage of share ownership by the executive directors;
ESO – percentage of ordinary shares owned by the executive directors of the board; USUBSP –
percentage of ordinary shares owned by the unaf?liated (excluding the directors) substantial
shareholders; LEV – leverage, calculated as the ratio of book value of debt and book value of total assets;
BIND – board independence calculated as the number of independent directors scaled by the size of the
board; AUD – dummy variable 1 if the ?rm is audited by Big 4 auditors; MB – market to book ratio;
LTACC – lagged total accruals; LOSS – loss dummy variable; ASST – natural log of book value of
assets; MVEQ – natural log of market value of common equity; VOL – volatility of earnings calculated
as a SD of earnings of preceding ?ve years scaled by book value of assets; LIQ – liquidity, calculated as
the ratio of net operatingcash?ows and bookvalue of assets; INV – investment, calculatedas the ratio of
capital expenditure to book value of assets; year and industry dummies are not reported; the reported
results are heteroskedasticity and autocorrelation consistent; ?gures in the parentheses are p-values
Table V.
Relation between VESO
and discretionary
accruals: simultaneous
equation systems
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Reconciliation of managerial ownership and value of managerial ownership. Since VESO
has two variable components (value and proportion), it may be argued that the level of
control dominates the value and vice versa. This concern is addressed by forming
portfolios of managerial ownership based on the proportion of ownership and examining
the relation between VESO and discretionary accruals within these portfolios.
Accordingly we create four portfolios of managerial ownership – the ?rst portfolio
with the least managerial ownership (based on proportion) and the fourth portfolio with
the greatest managerial ownership. The results are reported in Table VI. In the ?rst three
portfolios we document a signi?cant non-monotonic, convex relation between VESO and
discretionary accruals. Whilst we ?nd a similar non-monotonic, convex relation in the
last portfolio, the results are not signi?cant. Overall these results suggest that it is the
value, rather than the proportion of managerial ownership that is associated with
discretionary accruals.
Additional analysis. First, we also followthe prior literature and we replace VESOand
VESO
2
withexecutive director share ownership(ESO) andthe square of executive director
ownership (ESO
2
) in all the analyses of the full sample reported in Tables IV-VI. In
untabulated results, we ?nd signi?cant p-values for the coef?cients ESOand ESO
2
but the
signs of ESO and ESO
2
are positive and negative, respectively. In other words, we ?nd a
positive relation between managerial ownershipand discretionary accruals upto a certain
point followed by a negative relation. Implied is a non-monotonic, concave relation
between managerial ownership and the absolute value of discretionary accruals. This is
inconsistent with the theory outlined in Section 2 of this paper (and any of the results
reported in the admittedly fairly limited prior literature). A possible explanation for the
initial positive relation is that increased ownership arises from the increased volatility in
accounting earnings re?ected in higher accruals. However, the system of simultaneous
equations used to test for endogeneity did not indicate that accruals and managerial
ownership (ESO) were co-determined. Overall, this suggests that VESO may be more
appropriate to identify the incentives associated with managerial ownership.
Second, we use an alternative approach to control for industry differences.
Consistent with the Australian economy, around 17 per cent of our sample are resource
Variable Portfolio 1 Portfolio 2 Portfolio 3 Portfolio 4
VESO 20.057 (0.071) 20.139 (0.039) 20.102 (0.029) 20.100 (0.262)
VESO
2
0.003 (0.079) 0.010 (0.080) 0.006 (0.040) 0.007 (0.217)
Intercept 0.251 (0.032) 0.506 (0.009) 0.450 (0.179) 0.259 (0.432)
Adjusted R
2
0.035 0.034 0.037 0.017
Notes: This table reports the regression results relating to VESO and discretionary accruals to test
whether the proportion of ownership dominates value in VESO-DACC relation; we split the sample
into quartiles based on proportion of ownership and create four portfolios of managerial ownership;
the ?rst portfolio includes those ?rm-year observations that have least managerial ownership and the
last portfolio includes ?rm-year observations with greatest managerial ownership; different notations
used in the table are de?ned as follows: DACC – absolute value of discretionary accruals estimated
according to War?eld et al. (1995) model/modi?ed Jones model; VESO ¼ logged value of market
value of equity multiplied by the percentage of share ownership by the executive directors; the
reported results are heteroskedasticity and autocorrelation consistent; ?gures in the parentheses are
p-values
Table VI.
Relation between VESO
and discretionary
accruals: simultaneous
equation systems
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(metal and mining and energy) companies. Accordingly, we also use a resource dummy
in all regressions and document a signi?cantly positive coef?cient for this variable. It
suggests that the resource companies are more likely to manage earnings than the
non-resource companies but otherwise our results remain unchanged.
Third, Himmelberg et al. (1999), in a managerial ownership-performance context,
argue that managerial ownership may also be endogenously determined by unobserved
?rm heterogeneity. Therefore, we repeat all the analyses using a random effect model
and fail to ?nd any qualitative difference to our main ?ndings.
Fourth, we then split our sample into two different sub-samples based on time
periods – from 2000 to 2004, 2005 to 2006 and replicated the original analysis. The
purpose of splitting the sample is to test any impact of the major corporate regulatory
changes (for example, the introduction of ASX corporate governance guidelines in
2003) that took place during our study period. The results for these sub-samples are
qualitatively similar to the original results.
Fifth, we also examine the impact of the dollar value of ownership by all directors,
that is, executive and non-executive directors, on discretionary accruals by repeating
all regressions using this alternative de?nition and ?nd no qualitative differences
in results. However, when we repeat the analyses using dollar value of ownership
by non-executive directors, we ?nd no relation between discretionary accruals and
dollar value of ownership by non-executive directors. Our results may re?ect the
non-executive directors lack of operational responsibilities and hence the inability to
manage earnings. Alternatively, it is also possible that they may be immune to the
theorised incentive alignment or entrenchment effects associated with share
ownership.
5. Conclusion
We examine the relation between the value of managerial share ownership and
discretionary accruals in Australian ?rms. We argue that VESO is a direct driver of
incentive alignment and/or managerial entrenchment and our results strongly support
this contention. These results show a non-monotonic, convex relation between VESO
and discretionary accruals consistent with incentive alignment up to a certain level of
VESO, followed by entrenchment effects. We also ?nd that these results are driven by
?rms with income increasing, as opposed to income decreasing, discretionary accruals.
Our results are robust to alternative measures of discretionary accruals as well as in
regard to autocorrelation, heteroskedasticity, multicollinearity and potential issues of
endogeneity.
Executive remuneration in Australia continues to be the subject of much societal
debate and long term incentives such as equity in their ?rms form an increasing
proportion of executive remuneration. Accordingly, understanding the incentive effects
associated with managerial share ownership is an important issue that potentially
impacts a wider policy debate. More speci?cally, our research shows regulators and
other stakeholders that the value, rather than proportion, of managerial share ownership
may be an effective internal governance mechanism to align incentives. Moreover, the
lack of a relation between discretionary accruals and the dollar value of ownership by
non-executive directors may re?ect the non-executive directors’ inability to manage
earnings or that they may be immune to the theorised incentive alignment or
entrenchment effects associated with share ownership.
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We acknowledge that, ideally, VESO should be examined in the context of each
manager’s personal wealth but the information on the latter is not publicly available.
Whilst introducing the concept of VESO into the literature is novel, we are cognisant of
the fact that the results may be speci?c to an institutional context hence replication of
this work in other jurisdictions is desirable. Additionally, the recognition of employee
stock option plans in Australian ?nancial statements was made mandatory with the
introduction of “AASB 2: share-based payment” in 2005. A useful extension of this
research would be to consider the impact of managerial stock option plans in the
relation examined. Finally, our study looks at top 300 ASX listed companies. It is
possible that the documented relation between VESO and discretionary accruals may
not hold in smaller ?rms.
Notes
1. Aprincipal-agent relationshipis establishedwhere one or more parties (the principal(s)) engage
another party (the agent) to perform some duties on their behalf which involves delegating
some decision-making authority to the agent ( Jensen and Meckling, 1976). Although an agent
is expected to act in the best interest of the principal, being a “rational economic person”,
the utility maximizing agent may have different goals and risk preferences and thereby seeks
to undertake actions that maximize his/her own interest ( Jensen and Meckling, 1976). Such
divergence of interests creates a potential con?ict in a the relationship.
2. The sample size of War?eld et al. (1995) is 4,778 ?rm-year observations over the period
1988-1990.
3. However, we also use share ownership by all directors in additional analysis.
4. Ideally this would be measured as a proportion of a manager’s personal wealth but, in the
absence of publicly available information about the personal wealth of managers, we use the
absolute value of managerial ownership as a proxy.
5. There can be a relative disjoint between VMSO and MSO. The correlation coef?cient of these
two measures in our sample is 0.517.
6. We also do the same analysis after trimming the top and bottom 1 per cent observations
based on the key variables, that is, VESO and DACC. Our results are not qualitatively
different from those reported in the paper.
7. The year 2006 was chosen as the terminating year to ensure that our analysis is not
compromised by the period of ?nancial crisis which had its genesis in 2007-2008.
8. Various discretionary accruals models of earnings management suffer from estimation
errors and are always subject to criticism (Dechow et al., 1995). A major limitation of this
research is that existing techniques for measuring discretionary accruals lack power as the
exisiting models have poor ability to isolate such accruals. Furthermore, tests using these
techniques are misspeci?ed due to correlated omitted variables in samples with extreme
?nancial performance, a situation that is not uncommon in tests for earnings management.
Alternative techniques have been proposed for identifying discretionary accruals (Dechow
and Dichev, 2002), but offer minimal improvements over previous models.
9. We apply White’s (1980) heteroskedasticity consistent standard errors for all regression
analyses performed in this study. Furthermore, we apply the ?rm clustering technique for all
the analyses because multiple observations from the same ?rm (but from different years) are
included in our dataset.
10. One of the measures of board monitoring that has been widely used in the previous literature
is board independence (Vicknair et al., 1993; Peasnell et al., 2005). The governance literature
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emphasises the role of independent directors in resolving agency problems between
managers and shareholders through the creation of appropriate employment contracts and
the subsequent monitoring of managerial behaviour. Whilst a number of control variables
could have been used, in the interest of having a relatively parsimonious model, board
independence has been used as a suitable proxy for corporate governance.
11. In the context of Australia, Koh (2003) and Davidson et al. (2005) reported the average DACC
to be 0.077 and 0.156, respectively.
12. The average VESO is AUD 2.1 million and is heavily skewed. Therefore, we use log of dollar
value of ownership.
13. To test the problem of multicollinearity we run the auxiliary regressions and check the R
2
values and tolerance factors from these regressions. The R
2
values and tolerance factors do
not suggest the presence of any serious multicollinearity problem.
14. There is empirical support for this proposition in the related area of the managerial
ownership-performance relation (Demsetz and Villalonga, 2001).
15. We also use an alternative regression technique to examine the relation between VESO and
level of discretionary accruals. In particular, we use an IV regression (2 SLS) and predict
VESO using the average age of executive directors as well as the other independent
variables. We ?nd that average age of executive directors signi?cantly in?uences VESO.
The ?rst-stage ?tted values for VESO are then used in the second-stage OLS regression. Our
unreported results are consistent with the ?ndings in Table IV.
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Further reading
ASX Corporate Governance Council (2003), Principles of Good Corporate Governance and Best
Practice Recommendations, ASX Corporate Governance Council.
Corresponding author
Paul Mather can be contacted at: [email protected]
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Director share
ownership
55
D
o
w
n
l
o
a
d
e
d
b
y
P
O
N
D
I
C
H
E
R
R
Y
U
N
I
V
E
R
S
I
T
Y
A
t
2
1
:
1
7
2
4
J
a
n
u
a
r
y
2
0
1
6
(
P
T
)
doc_782253336.pdf