Exploring the role of excess control rights on real earnings management in family-controlled firms

Abstract

Family-controlled firms are associated with financial reporting quality in two competing ways: incentives alignment hypothesis versus entrenchment hypothesis. Prior studies have investigated the potential effect of family-controlled firms on earnings management and/or the quality of financial reporting, but with inconsistent conclusions. This study uses the divergence between control rights and cash flow rights as a moderating variable and examines the association of family-controlled firms with real earnings management (REM) as compared to nonfamily-controlled firms in Taiwan. Taiwan is an emerging market where family owners play a dominant role in the decision-making process and are characterized by excess control rights. Based on unbalanced-panel data, empirical results indicate that family-controlled firms are more likely than nonfamily-controlled firms to engage in REM, which in turn results in poor subsequent operating performance. Further evidence reveals that this result is particularly pronounced for family-controlled firms with excessively high control rights. This suggests that excess control rights trigger family-controlled firms’ engaging in REM, thereby actually destroy operating performance. Our study performs several diagnostic tests and shows the results are robust in various specifications.