Bridge over ocean
1 November 2017 CFA Institute Journal Review

Do Foreign Directors Mitigate Earnings Management? Evidence from China (Digest Summary)

  1. Antony Jackson, CFA
A higher proportion of foreign directors on Chinese boards helps mitigate earnings management, but the effect is less pronounced in state-owned enterprises, where political force may substitute for the benefits of board diversity—advising and monitoring—that foreign directors bring to an organization.

How Is This Research Useful to Practitioners?

It is generally accepted that firms in emerging markets lag behind their developed market peers in terms of corporate governance, internal controls, and adoption of international accounting standards. The authors examine the effectiveness of foreign directors in mitigating earnings management by Chinese firms while controlling for a wide range of influential variables identified in the literature. Practitioners will be able to use the authors’ findings to better judge the reliability of Chinese firms’ published financial statements and to better study the various findings from the anomalies literature, which has mainly focused on US firms. A better understanding of earnings management—and the mitigating role of foreign directors—will help practitioners better judge the range of risk premiums they should expect to earn from holding Chinese stocks.

One of the authors’ key findings is that foreign directors help mitigate earnings management but have less effect in state-owned enterprises. If foreign directors are located in close geographic proximity, they tend to more effectively carry out the monitoring role, and they are most helpful in companies that are not already audited by a Big 10 accounting firm.

How Did the Authors Conduct This Research?

The sample consists of all Chinese A-share firms except those in banking, insurance, and other financial industries. The data cover the period 2004–2012, with the final sample including 11,529 firm-year observations.

The analysis is based on multiple regressions that include variables that the literature identifies as being important drivers of earnings management, plus new variables related to the role of foreign directors. Supplementary tests address the endogeneity issue, which is the risk that what is actually being seen in the data is the tendency for foreign directors to be attracted to prestigious, high-quality firms that already have higher standards of corporate governance. The authors’ main two hypotheses—the mitigating role of foreign directors on earnings management and the less pronounced effect in state-owned enterprises—still hold after controlling for the endogeneity effect.

Various robustness checks—for example, reclassifying foreign directors as those from outside of Hong Kong, Macau, and Taiwan—do not detract from the authors’ main findings. The authors also consider alternative definitions of earnings management and procedures for controlling for endogeneity.

Abstractor’s Viewpoint

We need to be a little skeptical of multiple regression analysis with a large number of independent variables because we do not know how many alternative specifications were considered before arriving at the final published version, which variables were tested but omitted, and so on. Nevertheless, the authors are very careful to justify their included variables with reference to a wide variety of sources from the literature. On average, foreign directors reduce the incidence of earnings management, but that proves neither that all Chinese companies with foreign directors are free of earnings management nor that all those without them engage in earnings management.

It should be noted that financial firms have been omitted from the sample, so practitioners may wish to test for themselves the role of foreign directors in mitigating earnings management in Chinese financial firms. Corporate governance standard setters and ESG investors may wish to take careful note of this research.

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