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Earnings quality and internal control in bank-dominated corporate governance

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Abstract

This study examines the relationship between internal governance and earnings management in Japanese listed firms. Following recent accounting fraud in large companies, Japanese internal governance systems have been widely criticized. Japan has a bank-dominated corporate governance system. This study predicts that the bank–client relationship mitigates opportunistic earnings management by reducing the degree of information asymmetry. The results show that bank-appointed audit board members mitigate managerial earnings management. Neither outside directors nor audit committees help reduce opportunistic managerial earnings management. The findings imply that a lender monitoring system can substitute the monitoring role of outside directors and audit committees.

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Notes

  1. Aoki and Patrick (1994) provide examples of commercial bank involvement in the restructuring of client firms. Even in the 2010s, bank involvement is a typical means of supporting underperforming firms. Such practices have raised concerns among shareholders, particularly foreign investors (Financial Times 2012a).

  2. Empirical studies provide mixed evidence on the relationship between board structure and earnings management (Chin et al. 2006; Davidson et al. 2005; Xie et al. 2003). In firms with controlling shareholders, board members are likely to manipulate the firm’s financial earnings for their own interests (Fernandez et al. 1997).

  3. Following previous Japanese studies, board independence is defined in this study as the proportion of outside directors who have never served as executive directors, executive officers, or employees of the company or any of its subsidiaries, as reported in the companies’ annual reports. In addition, the introduction of the corporate governance code in 2015 made it necessary the appointment of independent directors. Thus, monitoring of independent directors is not expected in the sample period and board independence was measured by the ratio of outside directors as in previous research (Sakawa and Watanabel 2018).

  4. Large Japanese audit firms were restructured after Kanebo’s earnings fraud was uncovered in 2005. The large audit firms, known as the Big 4, included Deloitte Touche Tohmatsu, Ernst & Young Shin-Nihon, KPMG AZSA LLC, and Chuo-Aoyama PWC. In 2006, PWC was restructured as PWC Arata and Chuo-Aoyama was restructured as Misuzu, which became defunct in July 2007. Thereafter, during 2006–2007, the Big-5 audit firms were Deloitte Touche Tohmatsu, Ernst & Young Shin-Nihon, KPMG AZSA LLC, PWC Arata, and Chuo-Aoyama. After the Japanese FSA suspended Chuo-Aoyama for 2 months owing to Kanebo’s earnings fraud, Chuo-Aoyama lost their reputation (Skinner and Srinivasan 2012). Since 2008, Japan’s large audit firms comprised the Big-4, excluding Chuo-Aoyama.

  5. Addressing the suggestion of an anonymous referee, the estimation of real earnings management was further implemented following Roychowdhury (2006). There were no stable significant results. We interpret that bank–client relationships do not detect real earnings management. A previous study shows that real earnings management do not decrease rather increase post SOX periods (Cohen et al. 2008). Their study implies that internal control mechanisms cannot prevent real earnings management activities and our results are consistent with theirs.

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Acknowledgements

We thank for Masahiro Endoh, Naru Hagiwara, Takatoshi Ito, Hugh Patrick, and David Weinstein. This research was financially supported by the Japan Ministry of Education, Culture, Sports, Science, and Technology, Grants-in-Aid for Scientists (B, 17KT0036), Grants-in-Aid for Scientists (C, 17K03695), and Grants-in-Aid for Young Scientists (A, 17H04784).

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  1. Graduate School of Economics, Nagoya City University, 1 Yamanohata, Mizuho-cho, Mizuho-ku, Nagoya, 467-8501, Japan

    Hideaki Sakawa & Naoki Watanabel

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  1. Hideaki Sakawa
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Correspondence to Hideaki Sakawa.

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Appendix

Appendix

Definitions of the study variables

Variable

Description

Jones

The absolute value of discretionary accruals using the Jones model (%)

Modified Jones

The absolute value of discretionary accruals using a modified Jones model (%)

Modified CFO Jones

The absolute value of discretionary accruals using a modified Jones model with cash flow (%)

Board size

Number of directors on the board

Outside directors

Outside directors/Board size (%)

Bank directors

Outside directors from commercial banks/Board Size (%)

Bank audit board

Audit board members from commercial banks/Outside audit board members

Committee

Dummy variable, equal to one if a firm adopts the committee system, and zero otherwise

Audit board size

Number of audit board members

Volatility

Stock price volatility over a three-year period

ln (MV)

The logarithm of market value (adopted as firm size)

Market to book

Growth opportunity; market value/book value of capital

ROA

Return on assets

Leverage

Debt/Total assets

Topix 500

Topix 500 dummy variable, equal to one if a firm is included in the Topix 500 index, and zero otherwise

Big N

Big N audit firms, consisting of Big-4 or Big-5 audit firms

Management

Shareholding by board of directors (Morck et al. 2000) (%)

Stock option

Stock-based incentives (Sakawa et al. 2012). Stock Option is equal to one if a firm adopts stock options, and zero otherwise

Main bank

Main bank shareholdings (Morck et al. 2000) (%)

Foreign

Foreign shareholdings (%)

Cash to assets

The ratio of cash and security to assets

Bank debt ratio

The ratio of bank debt to market value (O’Brien et al. 2014)

Skewness

The skewness of daily returns

Beta

The slope of the coefficient from regressing daily returns

Min_Return

The minimum of daily returns

Std_Return

The standard deviation of daily abnormal returns

Corporate

Percentage of corporate shareholdings

ADR

ADR equals one if a firm has American depositary receipt (ADR) programs, and zero otherwise

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Sakawa, H., Watanabel, N. Earnings quality and internal control in bank-dominated corporate governance. Asian Bus Manage 20, 188–220 (2021). https://doi.org/10.1057/s41291-019-00100-3

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