The Investment Opportunity Set and Earnings Management: Evidence from the Role of Controlling Shareholders

Abstract

ABSTRACTManuscript Type: EmpiricalResearch Question/Issue: We examine the incentive and entrenchment effects of controlling shareholders on the association between the investment opportunity set and earnings management in Taiwan.Research Findings/Results: We find that firms with more investment opportunities are more likely to engage in earnings management. We also find incentive effects of controlling shareholders on firm's financial reporting behavior in that cash flow rights are negatively associated with absolute abnormal accruals under a growth opportunity setting. Our results further indicate that high‐growth firms with a high deviation between cash flow rights and control rights are more likely to engage in earnings management. Further analyses indicate that as the controlling shareholders have effective control of a firm, the effect of controlling shareholder deviation between control and cash flow rights on earnings management becomes stronger.Theoretical/Academic Implications: This study extends existing agency and contracting literature on the incentive and entrenchment effects of controlling shareholders in East Asia on firm value to the quality of financial reporting, which has been a consistent concern of regulators, practitioners, and academia. Our findings provide empirical evidence on the impact of controlling shareholders on the quality of financial reporting in a growth opportunity setting.Practitioner/Policy Implications: Our findings suggest that the institutional environment, such as the growth opportunity setting in Taiwan, matters to the firm's financial reporting behavior in an emerging market, where a corporate governance code has been enacted to protect minority shareholders. This study offers insights to policy makers interested in enhancing the mechanism of corporate governance in emerging markets, which have more potential conflict of interests between controlling shareholders and minority shareholders.