Family control, board independence and earnings
management: Evidence based on Hong Kong firms
Bikki Jaggi
a,b,
*
, Sidney Leung
c
, Ferdinand Gul
d,e
a
Department of Accounting and Information Systems, School of Business, Rutgers University, Levin Building,
Piscataway, NJ 08854, United States
b
The Hong Kong Polytechnic University, Hong Kong
c
Department of Accountancy, City University of Hong Kong, Hong Kong
d
School of Accounting and Finance, The Hong Kong Polytechnic University, Hong Kong
e
The Faculty of Business and Accountancy, University of Malaya, Kuala Lumpur, Malaysia
article info
JEL classification:
G32
G34
M41
Keywords:
Corporate governance
Earnings management
Earnings quality
Family ownership concentration
Family board members

abstract
In this study, we document that independent corporate boards of
Hong Kong firms provide effective monitoring of earnings manage-
ment, which suggests that despite differences in institutional envi-
ronments, corporate board independence is important to ensure
high-quality financial reporting. The findings also show that the
monitoring effectiveness of corporate boards is moderated in fam-
ily-controlled firms, either through ownership concentration or the
presence of family members on corporate boards. The results based
on firms reporting small earnings increases provide additional sup-
port for our finding that the monitoring effectiveness of indepen-
dent corporate boards is moderated in family-controlled firms.
Ó 2009 Elsevier Inc. All rights reserved.
1. Introduction
Studies based on data for US and UK firms document that corporations with independent boards
tend to have less earnings management (see Dechow and Dichev, 2002; Peasnell et al., 2000). The Sar-
banes-Oxley Act (2002) especially emphasizes the need for corporate board independence to improve
earnings quality by reducing earnings management. Another strand of research indicates that the
institutional arrangements of a country have a significant impact on the magnitude of earnings man-
0278-4254/$ - see front matter Ó 2009 Elsevier Inc. All rights reserved.
doi:10.1016/j.jaccpubpol.2009.06.002
* Corresponding author. Address: Department of Accounting and Information Systems, School of Business, Rutgers University,
Levin Building, Piscataway, NJ 08854, United States. Tel.: +1 732 445 3539; fax: +1 732 445 32091.
E-mail addresses: , (B. Jaggi).
J. Account. Public Policy 28 (2009) 281–300
Contents lists available at ScienceDirect
J. Account. Public Policy
journal homepage: www.elsevier.com/locate/jaccpubpol
agement and earnings quality. For example, Leuz et al. (2003) document higher earnings management
in countries with low investor protection. Ball et al. (2003) argue that institutional factors have a

strong influence on the private benefits of control and managerial incentives for financial reporting.
Recently, some authors have argued that family ownership concentration also influences firm perfor-
mance and earnings quality (e.g., Anderson and Reeb, 2004; Ali et al., 2007).
We extend the existing research by investigating whether independent corporate boards provide
effective monitoring of earnings management in firms operating in institutional environments which
differ from those of US and UK firms. More importantly, we evaluate whether the monitoring effec-
tiveness of independent corporate boards is affected by the family ownership control or the appoint-
ment of family members on corporate boards. We conduct analyses on the Hong Kong firms, which
operate in an environment where family ownership control and appointment of family members to
corporate boards are well documented. Hong Kong has the third highest percentage of family owner-
ship of listed companies in the region after Indonesia and Malaysia (SCMP, 2002), and the Hong Kong
Society of Accountants (HKSA, 1997) documents that members of controlling families are routinely
appointed to corporate boards. On the other hand, Hong Kong regulations emphasize corporate board
independence (HKSE, 2004).
In this study, we first evaluate whether the negative association between board independence and
earnings management that has been documented in the US and UK (see Dechow and Dichev, 2002;
Peasnell et al., 2000) also holds for Hong Kong firms. Given the markedly different ownership structure
of Hong Kong-based firms, a separate study of this setting is warranted. Furthermore, as the leading
financial center in the region and one of the largest international financial centers, the Hong Kong
financial market attracts local and international investors, which has created demand for high-quality
earnings information. Investors are interested to know whether board independence, which has re-
ceived increased attention in the Hong Kong institutional environment, improves earnings quality.
We argue that despite differences in the institutional environments between Hong Kong and the US
and the UK, independent corporate boards are likely to provide stricter monitoring of managerial
behavior with respect to earnings management, which will lead to better earnings quality. Thus, we
expect earnings management to be low and earnings quality to be high in the Hong Kong firms with
more independent corporate boards.
Second, we examine whether family ownership control or family members on corporate boards
moderate the monitoring effectiveness of independent boards. Two opposing arguments exist as to
the effect of family control through ownership or the appointment of family members to corporate

boards on the effective monitoring by boards of earnings management. On one hand, family control
may not result in higher earnings management because founding families will limit the ability of man-
agers to manipulate earnings, and there will be less pressure on management to manage earnings to
look good in the short term since the controlling family will have a long-term interest in the firm (e.g.,
Jiraporn and DaDalt, 2007). This argument is consistent with family control reducing the Type I agency
problem (conflict between managers and shareholders). On the other hand, earnings management is
higher in countries where family ownership concentration is higher because of weak investor protec-
tion (e.g., Leuz et al., 2003) and majority shareholder motivation to expropriate minority shareholders’
interests (e.g., Fan and Wong, 2002; Cheung et al., 2006). This second argument is consistent with
firms operating in institutional environments in which the Type II agency problem (conflict between
controlling shareholder and minority shareholders) is more common. Thus, the overall effect of family
control on earnings management depends on whether the Type I or Type II agency problem
dominates.
In this study, we conjecture that the prevalence of family control in Hong Kong is likely to moder-
ate the monitoring effectiveness of independent corporate boards. The following three arguments are
presented in support of this conjecture. First, we argue that when insider ownership is high, the mon-
itoring role of corporate boards decreases (Jensen and Meckling, 1976). Second, controlling families
are more likely to appoint independent directors to seek expertise and advice on strategic direction
rather than give them the responsibility of monitoring and controlling managerial activities (Anderson
and Reeb, 2004; Johnson et al., 1996), thus weakening the monitoring effectiveness of independent
directors. Third, director independence is likely to be compromised when a family controls a firm
either through ownership domination or appointing family members to the board, because family
282 B. Jaggi et al. /J. Account. Public Policy 28 (2009) 281–300
members will have control over the appointment and reappointment of independent directors. Inde-
pendent directors are less likely to go against the wishes of controlling family members, especially
when they sit on corporate boards.
We use the proportion of independent non-executive directors (INED) on corporate boards as a
proxy for corporate board independence. Following Anderson and Reeb (2003), we use fractional equi-
ty ownership of the family as a measure of ownership control concentration. A cutoff of 20% owner-
ship is used to identify firms with family control concentration. We also conduct sensitivity analyses

on different cut-off points for family ownership concentration. Because of interlocking relationship
among firms and insufficient disclosure in annual reports about director ownership via corporate pyr-
amids, effective ultimate ownership and the ratio of family voting control over ultimate ownership are
not determinable. Therefore, we use the appointment of controlling family members on corporate
boards as an additional proxy for family control. We consider the board as family controlled when
two or more members of the controlling family are present on the board on the assumption that
two or more family members will exercise a significant influence on the board’s decisions. We use
two widely adopted proxies for earnings management: the magnitude of discretionary accruals, and
the discretionary component of accrual quality (see, for example, Kothari et al., 2005; Francis et al.,
2005). Discretionary accruals are measured on the basis of the performance-adjusted discretionary
accruals model (PACDA), suggested by Ashbaugh et al. (2003). The discretionary component of quality
of accrual (AQ) is measured based on the model suggested by Francis et al. (2005). A lower magnitude
of discretionary accruals and a lower discretionary component of AQ reflect lower earnings manage-
ment (or higher earnings quality).
Our study is based on all firms traded on the Hong Kong Stock Exchange (HKSE) during the period
1998–2000 for which financial data are available on the Global Vantage database. The final sample for
PACDA analysis consists of 770 firm-year observations. Because of non-availability of data, the AQ
analysis is based on 309 observations.
1
We conduct 2SLS regression with discretionary accruals (PACDA)
and discretionary component of accrual quality (AQ) as dependent variables, and use the predicted value
of ownership in the analyses to control for the potential endogeneity associated with family ownership.
We also conduct OLS regression analyses as a sensitivity analysis.
The 2SLS regression results, which control for the endogeneity problem, show a negative associa-
tion between earnings management and board independence, suggesting that a higher proportion of
INEDs on corporate boards results in more effective monitoring of earnings management that in-
creases earnings quality. The results based on family-controlled and non-family-controlled firms show
that the negative association between board independence and earnings management is moderated
by family ownership and control. We test the robustness of our findings by examining whether family
ownership and family board control have an impact on the effectiveness of independent boards to

control earnings management when firms report small earnings increases. The results of this test indi-
cate that more independent boards are associated with a reduced likelihood of reporting small earn-
ings increases. The results on the impact of family control show that the negative association between
earnings management and board independence is weak for family-controlled firms. Sensitivity tests
performed on different cut-off points for family ownership concentration for identifying family-con-
trolled firms do not change the result. Overall, our findings indicate that independent boards tend
to be effective in controlling earnings management only in non-family-controlled firms. Board inde-
pendence does not appear to improve earnings quality in family-controlled firms. An alternative
explanation for the results could be that independent directors and family control are substitutes
for controlling earnings management.
2
The findings of this study make the following contributions. First, the results indicate that, on aver-
age, INEDs provide effective monitoring of earnings management in Hong Kong firms. This finding
suggests that strengthening the independence of boards by appointing more INEDs is a positive step
toward improving earnings quality. Second, the monitoring effectiveness of independent directors is
moderated in family-controlled firms. Third, given similarities in the business and institutional
1
The number of AQ observations is much smaller than that of PACDA observations because of non-availability of observations
for running the time-series regression model to obtain the residuals that are used as a proxy of AQ.
2
We thank a reviewer for suggesting this alternative explanation of our results.
B. Jaggi et al. /J. Account. Public Policy 28 (2009) 281–300
283
arrangements of Hong Kong and countries in East and Southeast Asia (e.g., Taiwan), the findings based
on this study provide useful information for regulators in these countries. Fourth, the results suggest
the policy makers in Hong Kong and other Southeast Asian countries should be careful in borrowing
rules/regulations from the US/UK because they may not work as effectively in a different institutional
setting. Finally, the findings also provide useful information to investors in evaluating the impact of
board independence on earnings quality, especially in family-controlled firms.
The remainder of the paper is organized as follows: Section 2 introduces the background of the

study. Section 3 contains discussion on the development of hypotheses, and Section 4 presents re-
search design, including the sample selection procedures and research methodology. Discussion of re-
sults is provided in Section 5, and Section 6 presents the summary and conclusions.
2. Background of the study
2.1. Institutional environments of Hong Kong firms
La Porta et al. (1998) highlight the differences in the institutional and cultural environments among
different countries. Though Hong Kong’s legal framework is influenced by English common law, sig-
nificant differences exist between the business environment of Hong Kong and the business environ-
ments of western industrialized countries, especially with regard to corporate governance, ownership
and control. The corporate governance structure of Hong Kong firms is characterized by a personal
networking system (guanxi), which revolves around informal relationships rather than formal written
contracts. As a result, family ownership concentration in firms and the appointment of family mem-
bers to corporate boards are common (e.g., Claessens et al., 2000; Mok et al., 1992). The 10 most prom-
inent business families control 32.1% of all the corporate assets in Hong Kong (Tsui and Stott, 2004).
Additionally, according to the 1994 statistics, family ownership of Hong Kong firms was worth about
US$155 billion, representing 60% of total market capitalization (for example, see Weidenbaum and
Hughes, 1996).
As a result of family ownership concentration, market control mechanisms are weak in Hong Kong:
hostile takeovers and mergers and acquisitions are almost non-existent. Moreover, because of family
ownership concentration, institutional shareholdings is not very common (Tsui and Stott, 2004). Hong
Kong firms also differ from US firms with regard to corporate borrowings: private borrowing through
banks rather than issuing public debt is more common in Hong Kong.
2.2. Agency problems in the Hong Kong ownership structure
Family-controlled firms are likely to face agency problems different from those of non-family-con-
trolled firms. The phenomenon of family ownership concentration results in two distinct groups of
shareholders, i.e., majority and minority shareholders. As a result of these two groups of shareholders,
family-controlled firms are more likely to suffer from the Type II agency problem (conflict between
majority and minority shareholders) than the Type I agency problem (conflict between managers
and shareholders) (see Anderson and Reeb, 2004; Ali et al., 2007). Controlling shareholders have an
opportunity to maximize their private benefits by expropriating minority shareholders (e.g., Fan

and Wong, 2002; Cheung et al., 2006). Thus, some managerial actions in family-controlled firms
may not be in the best interest of outside (minority) shareholders.
2.3. Regulations on the presence of INEDs on corporate boards
The Hong Kong Stock Exchange’s (HKSE) guidelines at the time of this study required that firms ap-
point at least two independent non-executive directors on corporate boards. To strengthen corporate
board independence, the HKSE appointed a committee to improve the Stock Exchange’s operations
and strengthen the listing requirements so that corporate boards would assume greater responsibility
and accountability in ensuring reliability of reported information. The HKSE Committee (2004) recom-
284 B. Jaggi et al. /J. Account. Public Policy 28 (2009) 281–300
mended that the number of independent directors on Hong Kong corporate boards be raised from two
to three members effective for accounting periods starting on or after January 1, 2005.
3. Research questions and hypotheses
3.1. Corporate board independence and earnings management
The first research question addressed in this study is whether a higher degree of corporate board
independence of Hong Kong firms, proxied by the proportion of INEDs on corporate boards, is associ-
ated with lower earnings management.
The impact of corporate board independence on monitoring effectiveness has been examined in
prior studies. Most of these studies emphasize the importance of independent corporate boards, prox-
ied by a higher proportion of independent non-executive directors, to monitor managerial activities.
3
Fama and Jensen (1983) emphasize the importance of corporate board independence to provide effective
monitoring of managerial activities and initiatives. Williamson (1981) argues that the independence of
corporate boards is needed to protect investor interests. Roe (1991) supports the monitoring role of cor-
porate boards on the ground that managerial activities could not be targeted by legislative actions, and
argued that effective monitoring by corporate boards prevent the abuse of powers by managers.
Some studies have examined empirically the impact of board independence on earnings manage-
ment; these studies have primarily been based on data from the US and UK firms. Dechow et al. (1996)
evaluate the causes and consequences of earnings manipulation based on firms subject to enforce-
ment actions by the Securities and Exchange Commission (SEC). Their findings indicate that ‘‘the like-
lihood of earnings manipulation is systematically related to weaknesses in the oversight of

management” (p. 3), and they argue that firms with greater earnings manipulation are more likely
to have a board dominated by insiders. In another study, Beasley (1996) concludes that inclusion of
a larger proportion of outside directors on boards reduces the likelihood of financial statement fraud.
In a recent study based on a small sample of US firms, Xie et al. (2003) find a negative association be-
tween corporate board independence and discretionary accruals. Peasnell et al. (2000) find a similar
result using a sample of UK firms for pre- and post-Cadbury periods. Their findings show that in
the post-Cadbury period, there is less income-increasing accrual management to avoid earnings losses
or declines when the proportion of non-executive directors is high.
We extend the existing empirical research by evaluating whether the negative association between
corporate board independence and earnings management is also valid for Hong Kong firms, which
operate in a different institutional environment than US or UK. Based on the conceptual arguments
presented in the literature, we postulate that independent corporate boards provide effective monitor-
ing of managerial behavior in Hong Kong. Furthermore, in the absence of audit committees during the
study period, responsibility for ensuring high-quality earnings information falls on the boards. We test
the following hypothesis, stated in the alternative form:
H1: Higher independence of Hong Kong corporate boards, proxied by the percentage of INEDs on
corporate boards, is associated with lower earnings management.
3.2. Impact of family control on the association between board independence and earnings management
Our second research question examines whether family control has a moderating effect on the
monitoring effectiveness of independent boards. There are two opposing theoretical viewpoints on
the impact of family control on earnings management. On one hand, earnings management is ex-
pected to be lower in family-controlled firms. The results of studies based on US firms show that fam-
ily firms are significantly less likely to manage earnings (Jiraporn and DaDalt, 2007; Ali et al., 2007;
Wang, 2006). The following arguments are presented based on this finding. First, controlling families
3
Among others, these studies include those of Brickley et al. (1994), CALPERS (1998), Cadbury (1992), Fama (1980), Dahya and
McConnell (2005), American Law Institute (1982), Byrd and Hickman (1992), Mayers et al. (1997), and Dalton et al. (1998).
B. Jaggi et al. /J. Account. Public Policy 28 (2009) 281–300
285
are expected to monitor managerial behavior and actions effectively, which will reduce managerial

opportunities to engage in earnings management. Second, in accordance with the stewardship theory,
earnings are less likely to be manipulated because controlling families would identify their interests
more closely with the firms’ wealth (e.g., Tosi and Gomez-Mejia, 1989). Third, there will be less pres-
sure on management to meet short-term earnings expectations because controlling families focus
more on the long term.
On the other hand, family control of a firm is likely to result in the Type II agency problems, i.e., a
conflict of interests between majority and minority shareholders (e.g., Anderson and Reeb, 2004). In
this case, the majority controlling shareholders may use earnings management to camouflage the re-
ported earnings and hide expropriation from minority shareholders. Some studies find that the own-
ers of family-controlled firms extract private benefits at the cost of minority shareholders (e.g., Morck
et al., 1988; DeAngelo and DeAngelo, 2000). Type II agency problems are more serious in the East Asia
countries, where controlling family ownership is widespread, legal protection of minority sharehold-
ers is weaker, and financial reporting is less transparent (Fan and Wong, 2002; Ball et al., 2003). Empir-
ical studies also document higher earnings management in countries with lower investor protection
(e.g., Faccio et al., 2001; Leuz et al., 2003). These studies suggest that earnings management may be
used to maximize the private benefits of majority shareholders.
4
In view of the different expectations regarding the effect of family control on earnings manage-
ment, it is an empirical question whether family control moderates the monitoring effectiveness of
independent boards. We conjecture that family control through family ownership concentration or
appointment of family members to the board is likely to moderate the monitoring effectiveness of IN-
EDs for the following reasons. First, controlling families will appoint INEDs to seek their advice rather
than giving them the responsibility to monitor managerial activities (Anderson and Reeb, 2004). Sec-
ond, consistent with the Type II agency problem, controlling families will have a motivation to expro-
priate minority shareholders’ interest, and thus they will have an incentive to limit monitoring by
INEDs they appoint. Third, INEDs’ independence may also be compromised because of their closeness
and loyalty to the controlling family that appoints or reappoints them to corporate boards. We develop
the following hypothesis to test this expectation:
H2: The negative association between corporate board independence and earnings management is
moderated in firms with family ownership control or corporate board control through family board

members.
4. Sample selection and research methodology
4.1. Sample selection and data collection procedures
We started the sample selection process by searching the Global Vantage database (CD dated
December 2002) for Hong Kong firms for the three-year period from 1998 to 2000. The number of
Hong Kong firms that have financial data in Global Vantage by year is as follows: 391 firms in 1998,
394 firms in 1999 and 399 firms in 2000. In the second step, we examined the Global Vantage database
for financial data to estimate current discretionary accrual (PACDA) and total discretionary accruals
(TDA). Because of the requirement of at least 10 observations in a two-digit SIC code per year, we
could measure discretionary accruals for 943 of firm-years.
In the third step, we manually collected data on corporate governance and family control variables
from the annual reports of sample firms for each study year. As a result of missing reports or missing
values in the available statements, the sample size was reduced to 876 firm-year observations. As a
result of some missing values for the control variables, the final sample consists of 770 firm-year
observations. The data for measuring the quality of accruals based on the model of Francis et al.
4
The controlling shareholders may also use other means to expropriate minority shareholders, such as selling assets, goods, or
services to other companies under their control (e.g., Cheung et al., 2006). However, the Type II agency problem can come at a price
to the controlling owners and their firms because investors can discount the share prices in response to the agency conflict
(Claessens et al., 2000; La Porta et al., 2002).
286 B. Jaggi et al. /J. Account. Public Policy 28 (2009) 281–300
(2005) were obtained from the PACAP databases.
5
Because of the strict data requirement of the AQ esti-
mation that is based on the Fama and French (1997) portfolio approach, which requires residual values
for five years, the number of data observations was reduced to 309 for this variable.
The number of firm-year observations by SIC code and year is provided in Table 1.
The sample distribution indicates that there is no significant difference in the number of observa-
tions across the sample years. The sample distribution by industry classification shows a higher num-
ber of observations for SIC code 36 (electronic and other electric equipment), SIC code 50 (wholesale

trade – durable goods), and SIC code 51 (wholesale trade – nondurable goods). There is relatively a
small number of observations for SIC codes 22 (textile mill products) and 47 (transport services). Dis-
tribution of our sample is similar to the industry distribution of Hong Kong firms in the database.
4.2. Family board members and family ownership
The ‘directors and management profile’ in the annual reports of Hong Kong firms provides a profile
of each director. According to the listing rules of the Hong Kong Companies Ordinance and Stock Ex-
change, companies are required to disclose the profile of all directors and senior management and
their relationships, if any. The annual reports also contain the shareholding information for each direc-
tor, and disclosure of this information is done at three levels, namely personal interest, family interest
and corporate and other interest. Information contained in the annual reports enabled us to identify re-
lated family members on corporate boards. Based on this information, we could identify the following
relationships: father/mother and son/daughter, husband and wife, father/mother-in-law, son/daugh-
ter-in-law, brothers and sisters, nieces and nephews. The board is defined as family controlled when
two or more members of the controlling family are appointed as directors. Consistent with the liter-
ature (e.g. Ho and Wong, 2001), we find that controlling family members are routinely appointed as
chairman or as executive director to control board decisions (Ho and Wong, 2001).
5
We use the PACAP database for AQ estimation because it covers Hong Kong firms more extensively than does the Global
Vantage database. The PACAP databases are compiled by the Pacific-Basin Capital Markets Research Center at the University of
Rhode Island College of Business, and provide historical research data for Hong Kong, Indonesia, Japan, Korea, Malaysia, Singapore,
Taiwan and Thailand.
Table 1
Sample by industry and year.
Two-digit SIC group Year Total
1998 1999 2000
15 11 13 13 37
20 8 9 6 23
22 5 6 5 16
23 14 15 12 41
24–27 16 18 15 49

28–29 7 8 9 24
30–31 8 13 13 34
32–34 8 7 7 22
35 17 17 15 49
36 37 38 35 110
37–39 19 21 21 61
47 5 5 7 17
48 9 10 11 30
50–51 37 42 45 124
53 11 13 11 35
58 8 9 7 24
70 9 9 8 26
73 9 10 11 30
79–89 6 6 6 18
Total 244 269 257 770
B. Jaggi et al. /J. Account. Public Policy 28 (2009) 281–300
287
Our analyses are based on data for 1999. Among 269 firms in 1999, 141 (52.4%) have family mem-
bers representing family interest on the board, and 72 (51.1%) out of the 141 family-controlled firms
have two family members serving as directors. The number of firms with three family members on the
board is 36 (25.5%), and the number with four or more members is 33 (23.4%). Additionally, we find
that in 132 (93.6%) of the family-controlled firms, family members hold the position of Board Chair-
man, and an overwhelming majority of family board members (86.7% of firms) hold one of the key
positions (i.e., chairman, CEO, or executive directors). Also, the family-controlled firms with three or
more family members on the board occasionally appoint a family member as a non-executive director.
Additional analyses indicates that in half of the family-controlled firms (N = 70), a ‘father/mother
and son/daughter’ relationship exists among family board members, which shows that family firms
have a tendency to keep the business within the family over generations. In 26.2% of the 141 family
firms, husband and wife jointly represent the family interest on the board. Descriptive statistics also
indicate that controlling shareholders tend to have family members holding key managerial positions.

Information contained in annual reports also indicates families’ ultimate share ownership.
6
We use
a 20% cut-off point for family ultimate ownership control to identify the family-controlled firm.
7
4.3. Corporate board independence
The corporate board independence is measured by the proportion of INED on corporate boards.
Directors are considered to be INEDs if they do not hold any executive position in the firm, have no
relationship to the firm, and have no related-party transactions with the firm. Thus, grey directors
are excluded from the INED category.
4.4. Calculation of discretionary accruals and accrual quality
Our first proxy for earnings management is the magnitude of discretionary accruals. We calculate
both total and current discretionary accruals. Total discretionary accruals (TDA) are calculated using
the cross-sectional discretionary accruals model suggested by Jones (1991) and modified by Dechow
et al. (1995). Recently, some researchers have argued that current discretionary accruals are more sus-
ceptible to earnings manipulation (e.g., Ashbaugh et al., 2003), and others have argued that firm per-
formance should also be considered in calculating discretionary accruals (Kothari et al., 2005). Our
main results are based on the performance-adjusted current discretionary accruals (PACDA) model,
which takes both of these factors into consideration, and TDA is used in a sensitivity test. Details
for estimation of PACDA and TDA are provided in Appendix A.
8
As a second proxy, we use the quality of accruals, as suggested by Francis et al. (2005). Because of
estimation errors
9
in calculating discretionary accruals, the quality of accruals has recently been sug-
gested as an alternative proxy for earnings management (Francis et al., 2005). Dechow and Dichev
(2002) argue that earnings quality is better if accruals are better associated with realized cash flows
in the preceding, current and subsequent periods. The model of Francis et al. (2005) extends the Dechow
and Dichev (2002) accrual quality model by adding two variables, namely the change in revenues (
D

Rev),
and property, plant and equipment (PPE), both of which are scaled by the average total assets. McNichols
6
Family ownership is calculated as the fractional ordinary shares held by family directors as the sum of beneficial interests at
the personal, family and corporate levels. It represents the ultimate voting control of the family in the firm. Because the majority of
footnotes associated with corporate interest of directors are unclear about the effective ownership of family members, we cannot
measure the disparity between family voting control and ownership rights.
7
A similar ownership cutoff point for concentrated ownership has been used by Morck et al. (1988) and by Hermalin and
Weisbach (1991). Our results, however, are not sensitive to this cut-off.
8
Because the results for PACDA and TDA are qualitatively similar, the results on the magnitude of discretionary accruals are
tabulated for PACDA only.
9
Discretionary accrual models of earnings management have limitations (see Erickson et al., 2004). The measurement of
discretionary accruals is surrounded by the controversy whether discretionary accruals can be isolated from non-discretionary
accruals with precisions (Guay et al., 1996). Furthermore, discretionary accruals may not always represent opportunistic earnings
management. They could be used to signal managers’ private information to investors (Dechow, 1994, p.5).
288 B. Jaggi et al. /J. Account. Public Policy 28 (2009) 281–300
(2002) argues that in order to ‘‘extract” the estimation error in the form of a residual, it is necessary to
control for these two variables. The model is as follows:
TCA
i;t
¼ a
0
þ a
1
CFO
i;tÀ1
þ a

2
CFO
i;t
þ a
3
CFO
i;tþ1
þ a
4
D
Rev
i;t
þ a
5
PPE
i;t
þ
e
i;t
ð1Þ
where TCA is total current accruals, CFO is cash flow from operations,
D
Rev is change in revenue and
PPE is net property, plant and equipment.
10
All variables are scaled by the average of total assets.
Eq. (1) is estimated cross-sectionally for all firms (minimum of 10 firms) within each one of the 48
industry groups defined by Fama and French (1997) for each year. AQ is defined as the standard devi-
ation of the residual,
e

i,t
for years t À 4 to year t (a minimum of 3 years firm residual data is required). A
higher value of AQ means higher standard deviation, meaning higher variation in reported earnings,
and this reflects lower earnings quality.
Francis et al. (2005) decompose AQ into discretionary and innate components, where discretionary
component is more prone to managerial manipulation. We identify the discretionary component of AQ
by separating it from the innate component. Francis et al. (2005) suggest the use of the following five
factors to estimate the innate component of AQ: firm size, standard deviation of cash flow from oper-
ations (
r
(CFO)), standard deviation of sales (
r
(SALES), operating cycle, and incidence of losses. We
cannot calculate the operating cycle for Hong Kong firms because data on cost of sales (COGS) is
not available during the study period. As a result, we estimate the innate component of AQ by the fol-
lowing annual estimations:
AQ
it
¼ b
i0
þ b
1
SIZE
it
þ b
2
r
ðCFO
it
Þþb

3
r
ðSALES
it
Þþb
4
NEGEARN
it
þ e
it
ð2Þ
where SIZE is the log of total assets,
r
(CFO
it
) and
r
(SALES
it
) are the standard deviation of cash flow
from operations and sales respectively, calculated over the past seven years, NEGEARN is the propor-
tion of loss (negative earnings) years out of the past seven years. We require at least four observations
in the 7-year window.
11
The discretionary component of AQ (DISC_AQ) is the residual e
it
from Eq. (2).
4.5. Regression models
We evaluate the association between the proportion of INEDs on corporate boards (PINED) and
earnings management, after controlling for the impact of other relevant variables. The use of control

variables is based on their relevance to earnings management, as discussed in the literature. The find-
ings of Xie et al. (2003) suggest that board size (BD_SIZE) is related to the extent of earnings manage-
ment. Fama and Jensen (1983) as well as the Cadbury Committee (1992) have argued that corporate
boards would be more independent if the board chairman is independent of the firm’s chief executive
officer (CEO). To highlight corporate board independence through PINED, we use board chairman/CEO
duality as a control variable. The variable CEO is coded 1 when the board chairman and CEO positions
are held by one individual, and 0 otherwise. Because some Hong Kong firms established audit commit-
tees voluntarily during the study period, we also include an indicator variable for audit committee in
the model because it is likely to improve earnings quality (Klein, 2002). We use log of total assets
(F_SIZE) as a control variable to control for firm size. The impact of firm performance, firm growth
and liquidity are controlled through the use of return on assets (ROA), market-to-book ratio (MB)
and debt-to-equity-ratio (DE) respectively. In addition, we include a dummy variable for Big5 auditors
and we control for the effect of time periods by including year dummy variables.
The following model is used to evaluate the association between earnings management (EM) and
PINED:
EM
itj
¼
a
þ b
1
PINED
it
þ b
2
BD SIZE
it
þ b
3
CEO

it
þ b
4
AC
it
þ b
5
ROA
it
þ b
6
DE
it
þ b
7
BIG5
it
þ b
8
F SIZE
it
þ b
9
MB
it
þ b
10
DUM YEAR99 þ b
11
DUM YEAR00 þ

e
it
ð3Þ
10
Data on gross PPE are not available in the PACAP database. As a result, we use net PPE in the estimation of Eq. (1).
11
We use a 7-year rolling window and require at least four observations in the past 7 years, whereas Francis et al. (2005) use a
10-year window and require at least five observations in the past 10 years. We use a narrower window because the number of
Hong Kong firms covered in the database is much smaller in the earlier years.
B. Jaggi et al. /J. Account. Public Policy 28 (2009) 281–300
289
Table 2
Descriptive statistics and correlations.
N Mean Std. dev. Minimum Median Maximum
Panel A: descriptive statistics of all variables
PACDA 770 0.117 0.175 0.000 0.068 2.141
AQ 352 0.066 0.043 0.004 0.057 0.294
DISC_AQ 309 À0.000 0.038 À0.099 À0.004 0.208
PINED 770 0.432 0.177 0.125 0.400 1.000
FAMOWN 770 0.196 0.246 0.000 0.000 0.932
NUMFAM 770 1.508 1.708 0.000 2.000 8.000
NBD_SIZE 770 8.260 2.394 2.000 8.000 20.000
ROA 770 À0.079 0.528 À7.975 0.015 3.366
DE 770 0.297 1.133 0.000 0.166 23.452
F_SIZE 770 4.866 1.285 0.579 4.765 9.092
MB 770 1.116 2.283 À12.286 0.583 23.194
Dichotomous variables 0 1
CEO 384 (49.87%) 386 (50.13%)
AC 372 (48.31%) 398 (51.69%)
BIG5 43 (5.58%) 727 (94.42%)

DUM_YEAR99 501 (65.06%) 269 (34.94%)
DUM_YEAR00 513 (66.62%) 257 (33.38%)
PACDA AQ DISC_AQ PINED FAMOWN NUMFAM BD_SIZE CEO AC ROA DE BIG5 F_SIZE MB DUM_
YEAR99
Panel B: Pearson correlation coefficients between variables
AQ 0.411
**
DISC_AQ 0.332
**
0.893
**
PINED À0.105
**
À0.109
*
À0.039
FAMOWN À0.071
*
À0.055 À0.033 À0.010
290 B. Jaggi et al. /J. Account. Public Policy 28 (2009) 281–300
NUMFAM À0.115
**
À0.150
**
À0.062 0.025 0.721
**
BD_SIZE À0.056 À0.004 0.028 0.152
**
À0.048 0.143
**

CEO À0.009 À0.097 À0.050 À0.024 0.060 0.026 À0.213
**
AC 0.029 0.069 À0.013 0.041 À0.024 À0.049 0.104
**
À0.073
*
ROA À0.205
**
À0.134
*
À0.115
*
0.057 0.023 0.053 0.078
*
À0.092
*
0.077
*
DE 0.038 0.214
**
0.197
**
À0.028 0.007 0.009 À0.040 0.059 À0.089
*
À0.567
**
BIG5 0.018 0.041 À0.016 0.032 À0.051 À0.027 0.030 À0.005 0.104
**
0.004 0.002
F_SIZE À0.171

**
À0.097 À0.027 0.185
**
À0.077
*
0.054 0.313
**
À0.089
*
0.128
**
0.295
**
À0.176
**
0.085
*
MB À0.025 À0.077 0.144
**
0.001 À0.055 À0.074
**
À0.006 0.033 0.042 0.007 À0.069 0.055 À0.023
DUM_YEAR99 0.012 0.019 0.000 À0.004 0.004 0.005 À0.013 À0.005 0.170
**
À0.008 0.060 0.048 0.012 0.097
**
DUM_YEAR00 0.042 0.131
*
0.000 0.004 À0.024 À0.020 0.020 À0.038 0.279
**

0.071
*
À0.056 0.052 0.005 À0.035 À0.519
**
PACDA = The absolute value of discretionary current accruals, scaled by lagged total assets.
AQ = Standard deviation of firm residuals, from years t À 4tot from annual cross-sectional estimations of the Francis et al.(2005) model.
DISC_AQ = Discretionary component of AQ.
PINED = Proportion of non-executive directors on the board of directors.
FAMOWN = The fraction of shares owned by family members on Corporate board.
NUMFAM = Number of directors from the same family on the board of directors.
BD_SIZE = Dummy variable: 1 if the total number of directors on the board is greater than the median value of the sample; 0 if the total number of directors on the board is smaller than or
equal to the median value of the sample.
CEO = Dummy variable: 1 if the CEO and the chairman of the board of directors are the same person and 0 otherwise.
AC = Dummy variable: 1 for presence of audit committee; 0 otherwise.
ROA = Ratio of net income before extraordinary items to total assets.
DE = Ratio of total debt to total assets.
BIG5 = Dummy variable: 1 for big5 auditor; 0 for non-big5 auditor.
F_SIZE = Natural log of the total assets.
MB = Ratio of the firm’s market value of common equity to book value of common equity.
DUM_YEAR99 = Dummy variable: 1 if year = 1999; 0 if year = 1998 and 2000.
DUM_YEAR00 = Dummy variable: 1 if year = 2000; 0 if year = 1998 and 1999.
*
Correlation is significant at the 0.05 level (two-tailed).
**
Correlation is significant at the 0.01 level (two-tailed).
B. Jaggi et al. /J. Account. Public Policy 28 (2009) 281–300
291
where
EM
it

earnings management of firm i for period t by using different proxies for EM (i.e., PACDA and
DISC_AQ)
PINED proportion of independent non-executive directors on the board of directors
12
BD_SIZE dummy variable: 1 if the total number of directors on the board is greater than the median va-
lue of the sample; 0 if the total number of directors on the board is smaller or equal to the med-
ian value of the sample
CEO dummy variable: 1 if the CEO and the chairman of the board of directors are the same person
and 0 otherwise
AC dummy variable: 1 for the presence of an audit committee; 0 otherwise
ROA ratio of net income before extraordinary items to total assets
DE ratio of total debt to total assets
BIG5 dummy variable: 1 for big5 auditor; 0 for non-big5 auditor
F_SIZE natural log of total assets
MB ratio of the firm’s market value of common equity to book value of common equity
DUM_YEAR99 dummy variable: 1 if year = 1999; 0 if year = 1998 and 2000
DUM_YEAR00 dummy variable: 1 if year = 2000; 0 if year = 1998 and 1999
e
it
residual term
We evaluate the impact of family control on the association between PINED and earnings manage-
ment by including an interaction term between PINED and family control.
EM
itj
¼
a
þ b
1
PINED
it

þ b
2
FAM
itj
þ b
3
ðFAM
itj
à PINED
it
Þþb
4
BD SIZE
it
þ b
5
CEO
it
þ b
6
AC
it
þ b
7
ROA
it
þ b
8
DE
it

þ b
9
BIG5
it
þ b
10
F SIZE
it
þ b
11
MB
it
þ b
12
DUM YEAR99
þ b
13
DUM YEAR00 þ
e
it
ð4Þ
where FAM
it
is family control of firm i for period t, and is measured as the fraction of shares owned by
a family (FAM_OWN). We expect that b
3
>0.
5. Discussion of results
5.1. Descriptive statistics
Descriptive statistics on the variables used in the regression tests are provided in Table 2.

The mean (median) of absolute values of performance-adjusted current discretionary accruals
(PACDA) is 0.117 (0.068), and the mean and median values of discretionary AQ are À0.000 and
À0.004 respectively. On average, 43.2% of directors are INEDs. This percentage shows that a significant
number of board members are executive directors. The median number of directors on corporate
boards is 8. The sample firms are almost equally divided between those that have and those that
do not have a dual board chairman/CEO (50.13% vs. 49.87%). The mean and median numbers of direc-
tors from the same family are 1.508 and 2, respectively. On average, 19.6% of outstanding ordinary
shares are owned by one family.
The results (unreported) of annual regression of Eq. (2) show that the coefficient estimates on
r
(CFO),
r
(SALES), and NEGEARN are in the expected direction, positive and significant for all three
years (the mean coefficient estimates are 0.172, 0.030, and 0.032 respectively). The coefficient esti-
mate on SIZE is positive, but insignificant (mean coefficient estimate is 0.0032). The explanatory
power of the equation averages 15.7% across yearly estimations.
The operating performance (ROA) of sample firms varies significantly, and on average it is negative
– possibly because of recessionary conditions during the period. The average debt ratio is 29.7%, and
12
It is not uncommon that annual reports of Hong Kong firms in the sample years only label directors as either executive
directors or non-executive directors without providing further classification whether they are independent non-executive
directors. We exclude those grey non-executive directors who have a relationship to the firm or related-party transactions from
the INED category based on the information in the annual reports.
292 B. Jaggi et al. /J. Account. Public Policy 28 (2009) 281–300
the median value shows that 50% of the sample observations have less than 17% debt. There is a sig-
nificant variation in the market-to-book (MB) ratio; the median for this ratio is 58.3%.
The correlation matrix is provided in Panel B of Table 2. The correlations indicate that the absolute
value of PACDA is significantly negatively associated with PINED, P_FAM, D_LG_BD, BD_SIZE, F_SIZE,
and ROA. These results suggest that earnings management is lower when the proportion of INEDs
on corporate boards is high, corporate board size and firm size are large, firm’s operating performance

is high, and family members are present on corporate boards. As expected, DISC_AQ is significantly
positively associated with PACDA (0.294), indicating that firms with higher levels of discretionary
accruals have lower accrual quality (high DISC_AQ values mean lower accrual quality).
5.2. Regression results
5.2.1. INEDs and earnings management
We conduct regression tests to evaluate the association between independent corporate boards
(PINED) and absolute values of performance-adjusted current discretionary accruals (PACDA) and dis-
cretionary component of AQ as proxies for EM (Eq. (3)), The regression results are reported in Model 1
of Table 3. The results based on PACDA show that the coefficient for PINED is negative and statistically
significant, suggesting that firms with a higher proportion of INEDs on corporate boards are associated
with lower discretionary accruals, i.e., lower earnings management. In other words, more independent
Hong Kong corporate boards, proxied by a higher proportion of INEDs, are associated with lower mag-
nitude of discretionary accruals. The results on the discretionary component of AQ, however, show
that the PINED coefficient is negative, but insignificant.
13
The PINED coefficients in Eq. (4) are signifi-
cantly negative for PACDA and DISC-AQ (see Model 2 in Table 3). These results support our hypothesis H1
that there is a negative association between independence of Hong Kong corporate boards and earnings
management.
5.2.2. Family control, INEDs and earnings management
To evaluate the impact of family control on the association between earnings management and
PINED, we include an interaction variable between PINED and family control (Eq. (4)). Prior studies
suggest that family ownership and firm performance may be endogenously determined (Anderson
and Reeb, 2003; Demsetz and Lehn, 1985), and this may bias the results based on the OLS regression.
We address this problem by using an instrumental variable in the two-stage least squares (IV-2SLS)
regression (e.g., Anderson and Reeb, 2003). Demsetz and Lehn (1985) suggest that ownership is a func-
tion of firm size and risk. Following Anderson and Reeb (2003), we first regress family ownership (FA-
M_OWN) on the natural log of total assets, the square of the natural log of total assets and monthly
stock return volatility (standard deviation of the 60 monthly stock returns in the previous five years)
to obtain the predicted value of family ownership. In the second stage, we use the predicted value of

the family ownership to replace the actual family ownership. The IV-2SLS regression results based on
the predicted value of family ownership are presented in Table 3 (Model 2).
The results show that the coefficient of PINED is significantly negative for regression tests with
PACDA or discretionary AQ as the dependent variables. The interaction term on PINED
*
PFA-
M_OWN is positive and statistically significant at the 0.05 level for PACDA and the 0.001 level
for discretionary AQ. These results are consistent with our hypothesis H2, indicating that family
control in Hong Kong firms moderates the negative association between independent corporate
boards and earnings management. These results suggest that higher independent corporate boards
in non-family-controlled firms are more effective in controlling earnings management than in fam-
ily-controlled firms.
13
As a result of the requirement of a minimum of 10 observations in each industry (based on Fama and French, 1997) for each
year for model estimation and a minimum of 3 years residual values for the computation of the standard deviation (AQ measure),
the sample size for this test is significantly reduce. This test is based on 309 observations rather than 770 observations.
B. Jaggi et al. /J. Account. Public Policy 28 (2009) 281–300
293
As an additional analysis, we conduct regression tests on the sub-samples of family-controlled and
non-family-controlled firms separately.
14
The sample is divided into high and low family ownership
control by the using the cut-off point of 20% ownership
15
(40.5% of the sample with family ownership
over 20% is defined as the high family ownership sub-sample). The sample is also divided into two groups
based on the corporate board control by using two or more family members on the corporate board as
the cut-off point. The subsample results for PACDA (untabulated) show that the coefficients of PINED for
Table 3
Regression analysis of earning management, board independence and family control based on the predicted value of family

ownership.
PACDA DISC_AQ
Model 1 Model 2 Model 1 Model 2
Coeff. t-Stat. Coeff. t-Stat. Coeff. t-Stat. Coeff. t-Stat.
Intercept 0.196
***
3.43 0.235
***
3.81 0.015 1.00 0.033
*
1.29
PINED À0.074
***
À2.01 À0.180
**
À2.10 À0.013 À0.71 À0.087
***
À3.03
PFAM_OWN À0.105
**
À2.13 À0.032
**
À1.66
PINED
*
PFAM_OWN 0.182
**
2.03 0.100
***
2.83

BD_SIZE À0.002 À0.17 À0.010 À0.83 0.003 0.63 0.003 0.56
CEO À0.011 À0.85 À0.009 À0.64 À0.004 À0.82 À0.003 À0.63
ROA À0.081 À1.15 À0.149
***
À2.29 À0.004 À0.72 À0.010
*
À1.44
DE À0.019 À0.96 À0.017
**
À1.71 0.024
***
2.65 0.023
***
2.56
BIG5 0.019 1.13 0.003 0.17 À0.004 À0.41 À0.010 À0.93
F_SIZE À0.016
*
À1.48 À0.008 À0.86 À0.002 À1.00 0.000 0.04
MB À0.003 À1.18 À0.003 À1.03 À0.003
***
À2.24 À0.003
**
À2.18
AC 0.008 0.58 À0.003 À0.20 À0.000 À0.09 À0.000 À0.10
DUM_YEAR99 0.019
*
1.28 0.034
**
2.09 0.003 0.62 0.004 0.82
DUM_YEAR00 0.026

**
2.17 0.021
*
1.56 0.002 0.45 0.003 0.68
N 770 627 309 290
Adj. R-SQ 0.0657 0.1539 0.0341 0.0688
F-value 5.92 9.76 1.99 2.64
The reported t-statistics are white-adjusted (White, 1980) values to control for heteroskedasticity.
PACDA = The absolute value of discretionary current accruals, scaled by lagged total assets.
DISC_AQ = Discretionary component of AQ.
PFAM_OWN = Predicted value of family ownerships is the predicted value of regressing family ownership on the natural log of
total assets, the square of the natural log of total assets, and return volatility (standard deviation of 60 month stock market rates
of return for the previous 5 years).
PINED = Proportion of non-executive directors on the board of directors.
BD_SIZE = Dummy variable: 1 if the total number of directors on the board is greater than the median value of the sample; 0 if
the total number of directors on the board is smaller than or equal to the median value of the sample.
CEO = Dummy variable: 1 if the CEO and the chairman of the board of directors are the same person and 0 otherwise.
ROA = Ratio of net income before extraordinary items to total assets.
DE = Ratio of total debt to total assets.
BIG5 = Dummy variable: 1 for big5 auditor; 0 for non-big5 auditor.
F_SIZE = Natural log of the total assets.
MB = Ratio of the firm’s market value of common equity to book value of common equity.
AC = Dummy variable: 1 for presence of audit committee; 0 otherwise.
DUM_YEAR99 = Dummy variable: 1 if year = 1999; 0 if year = 1998 and 2000.
DUM_YEAR00 = Dummy variable: 1 if year = 2000; 0 if year = 1998 and 1999.
*
Designates statistical significance at the 0.1 level, one-tailed test.
**
Designates statistical significance at the 0.05 level, one-tailed test.
***

Designates statistical significance at the 0.01 level, one-tailed test.
14
It has been argued that tests based on full sample with an interaction variable may be less precise under certain circumstances
if the coefficients on the control variables differ between two groups. An analysis based on pooled data forces the coefficients of all
variables other than the test variables to be equal for the two groups. It has been further suggested that separate regression tests
on the two groups may provide better results when the association between the X variable (PINED) and Y variable (PACDA) is
hypothesized to be contingent on the moderator variable Z (family control) (e.g., Staw and Oldham, 1978; Wright et al., 1996, p.
452).
15
Morck et al. (1988) and Hermalin and Weisbach (1991) use a similar ownership cutoff for concentrated ownership.
294 B. Jaggi et al. /J. Account. Public Policy 28 (2009) 281–300
both the family-controlled and non-family-controlled groups are negative, but the coefficient is signifi-
cant only for non-family-controlled firms, and insignificant for family-controlled firms. Similarly, the
untabulated results for the discretionary component of AQ show that the PINED coefficient is negative
and significant for non-family-controlled firms and is positive and insignificant for family-controlled
firms. Although the subsample analysis does not provide a direct test on the effect of family control,
these results indirectly support that family control moderates the negative association between indepen-
dent corporate boards, proxied by the proportion of INEDs, and earnings management.
5.2.3. Discussion on control variables
The results for control variables based on model 1 of Table 3 show that the CEO duality coefficient
is negative, but it is statistically insignificant. This finding thus indicates that the CEO duality does not
have any significant impact on earnings management. The results on firm size consistently show low-
er earnings management by large firms. The results, however, do not show any significant impact of
Big-5 on earnings management. The negative coefficient on ROA suggests good firm performance is
associated with lower earnings management. Results for DE are, however, mixed.
5.2.4. Earnings benchmark test
We also conduct an earnings benchmark test to evaluate whether family ownership control and
family board control have an effect on the effectiveness of independent boards to control earnings
management. Specifically, we focus on the firms reporting small earnings increases (e.g., Degeorge
et al., 1999; Ashbaugh et al., 2003) and examine weather family control weakens the negative associ-

ation between board independence and the likelihood of small earnings increases. We modify Ashb-
augh et al.’s (2003) logistic model (p. 630) for the earnings benchmark test as follows:
INCREASE
it
¼ b
0
þ b
1
PINED
it
þ b
2
FAM
itj
þ b
3
ðFAM
itj
à PINED
it
Þþb
4
LITIGATION
it
þ b
5
MB
it
þ b
6

lnMVE
it
þ b
7
BIG5
it
þ b
8
LOSS
it
þ b
9
PACDA
it
þ
e
it
ð5Þ
where INCREASE represents small earnings increases and is coded 1 when the difference between
the current year and previous year’s net income, scaled by beginning-of-year market capitalization
of equity, falls in the interval [0.00, 0.02], and 0 otherwise. We could not examine the impact of
independent boards on managing earnings to meet or beat analyst earnings forecasts because ana-
lyst forecasts were not commonly available for the sample firms for the study years.
16
FAM
itj
is fam-
ily control of firm i for period t. The value of j is equal to 1 when family control is measured as the
fraction of shares owned by a family (FAM_OWN). The value of FAM_OWN is equal to 1 when family
ownership is more than 20%, and 0 otherwise. The value of j is equal to 2 when family control is mea-

sured as the family control on corporate boards (FAM_BD). The value of FAM_BD is equal to 1 when
two or more family members are on corporate boards, and 0 otherwise. We include PINED, FAM
and their interaction in the model as the experimental variables. We expect that b
3
> 0. Other variables
are similar to those of Ashbaugh et al. (2003) with two exceptions. First, the audit fee variable is not
included because audit fee data are not available on the database. Instead, we include a BIG 5 auditor
variable (BIG5) to control for audit quality. Second, institutional shareholding is not included because
institutional shareholding in HK firms is generally small and such data are not publicly available. LIT-
IGATION is an indicator variable equal to 1 if the company operates in a high-risk industry.
17
MB is the
market-to-book equity ratio for growth. LnMVE is firm size, defined as the log of the market value of
equity. LOSS is an indicator variable equal to 1 if the firm reports a net loss and PACDA is performance-
adjusted discretionary current accruals.
Due to non-availability of beginning-of-year market values on the database in the INCREASE
analysis, the sample is reduced to 593 observations, of which 70 observations report small earnings
increases. The results of the logistic regression are reported in Table 4. The results clearly indicate
16
We examined whether analyst forecasts are available for the time period of this study. Our search indicated that the IBES
database contained less than 20% of the sample firms for the study’s time period.
17
We find a negative and insignificant coefficient on LITIGATION. The result is consistent with the institutional environment in
Hong Kong that shareholder litigation is not an important issue.
B. Jaggi et al. /J. Account. Public Policy 28 (2009) 281–300
295
significantly negative coefficients on PINED and significantly positive coefficients on the interaction
variable between PINED and FAM irrespective of whether FAM is represented by family ownership
or family board control. The evidence suggests that higher board independence reduces the likeli-
hood of reporting small earnings increases, which is a potential outcome of earnings management.

The evidence also confirms the reduction in the INEDs’ monitoring effectiveness in family-controlled
firms. The findings are consistent with our earlier reported discretionary accruals and accrual-qual-
ity results.
5.2.5. Additional robustness tests
First, we perform sensitivity checks by varying the family ownership’s cut-off point from 20% to
25%, 30% and 50%. The results are robust to different cut-off points in classifying the family- and
non-family-controlled firms.
Second, we perform a robustness check to control for the effect of potential outliers. We winsorize
all variables that exceed four standard deviations of their respective means and rerun the regression
tests. The results based on these observations indicate that the results reported in the tables become
stronger in some cases, which suggests that the results are not affected by outliers.
Table 4
Logistic regression on meeting earning benchmark of small earnings increase.
INCREASE
it
¼ b
0
þ b
1
PINED
it
þ b
2
FAM
itj
þ b
3
ðFAM
itj
à PINED

it
Þþb
4
LITIGATION
it
þ b
5
MB
it
þ b
6
lnMVE
it
þ b
7
BIG5
it
þ b
8
LOSS
it
þ b
9
PACDA
it
þ
e
it
:
Family ownership Family board control

Coeff. Chi-square stat. Coeff. Chi-square stat.
Intercept À2.706 10.28
***
À2.602 9.57
***
PINED À1.763 3.02
**
À1.944 3.41
**
FAM_OWN À1.224 2.61
*
PINED Ã FAM_OWN 2.883 3.27
**
FAM_BD À1.360 3.29
**
PINED Ã FAM_BD 3.126 3.84
**
LITIGATION À0.182 0.30 À0.230 0.47
MB 0.011 0.04 0.011 0.03
LnMVE 0.433 18.39
***
0.433 18.74
***
BIG5 À0.094 0.02 À0.088 0.02
LOSS À1.342 9.81
***
À1.365 10.15
***
PACDA À0.667 0.71 À0.732 0.86
N 593 593

Pseudo R-SQ 0.1966 0.1983
The reported t-statistics are white-adjusted (White, 1980) values to control for heteroskedasticity.
INCREASE = Dummy variable: 1 when the difference between current year and previous year’s net income, scaled by MVE t À 1,
falls in the interval [0, 0.02], and 0 otherwise.
PINED = Proportion of non-executive directors on the board of directors.
FAM_OWN = Dummy variable: 1 if the fraction of shares owned by family members on Corporate board is greater than 20%, 0
otherwise.
FAM_BD = Dummy variable: 1 if the family has two or more members on the broad of directors; 0 otherwise.
PINED Ã FAM_OWN = Interaction term between PINED and FAM_OWN.
PINED Ã FAM_BD = Interaction term between PINED and FAM_BD.
LITIGATION = Dummy variable: 1 if the firm operates within a high-litigation industry and 0 otherwise, where high-litigation
industries are industries with SIC codes of 2833–2836, 3570–3577, 3600–3674, 5200–5961, 7370–7374.
MB = Ratio of the firm’s market value of common equity to book value of common equity.
LnMVE = Natural log of the firm’s market value of common equity.
BIG5 = Dummy variable: 1 for big5 auditor; 0 for non-big5 auditor.
LOSS = Dummy variable: 1 if the firm reports a net loss, 0 otherwise.
PACDA = Performance-adjusted discretionary current accruals, scaled by lagged total assets.
*
Designates statistical significance at the 0.1 level, one-tailed test.
**
Designates statistical significance at the 0.05 level, one-tailed test.
***
Designates statistical significance at the 0.01 level, one-tailed test.
296 B. Jaggi et al. /J. Account. Public Policy 28 (2009) 281–300
6. Conclusion
This paper evaluates the association between corporate board independence and earnings manage-
ment in Hong Kong firms. Additionally, it examines whether family control influences the association
between INEDs and earnings quality. Overall, the findings provide evidence that a higher proportion of
INEDs is associated with more effective monitoring to constrain earnings management. This suggests
that a higher proportion of INEDs on corporate boards is likely to deter managers from manipulating

the reported earnings; thus the quality of reported earnings of firms with a higher proportion of INEDs
is expected to be high. However, the monitoring effectiveness of INED’s is reduced in family-controlled
firms, proxied by family ownership concentration or the presence of family members as board direc-
tors. These results suggest that an increase in the proportion of outside directors to strengthen board
monitoring is unlikely to be effective in family-controlled firms.
Like most studies of this nature, this study is subject to some limitations. First, the validity of these
findings depends upon discretionary accruals and accrual quality as proper proxies for earnings qual-
ity. Second, although we have used two proxies for family control, the validity of the findings is also
subject to proper estimation of family control of the firm. Third, our results are for the period 1998–
2000, and caution should be exercised in extrapolating these results to more recent times. Finally, the
results may have been influenced by the control variable of ROA which is on average negative, indi-
cating recessionary conditions during the study period.
Despite their inherent limitations, the findings provide useful insights to regulators for developing
appropriate regulations on the corporate governance mechanism of Hong Kong firms, especially the
appointment of independent non-executive directors on corporate boards. The findings are relevant
for countries with an institutional environment similar to that of Hong Kong. Investors may also ben-
efit from the findings because they provide insight into the impact of a higher proportion of INEDs on
the reliability of reported earnings. Last, but not least, the consideration of family board control adds
to the corporate governance literature on the role of family ownership.
Acknowledgement
Authors are grateful to the Research Grants Council of the Hong Kong Special Administrative Re-
gion, China for financial support (Project No. CityU 1133/03H).
Appendix A
A.1. Calculation of performance-adjusted current discretionary accruals (PACDA)
The cross-sectional performance-adjusted current discretionary accruals (PACDA) are calculated by
including the lagged variable of ROA, as suggested by Kothari et al. (2005). The PACDA are similar to
RECDA calculated by Ashbaugh et al. (2003). The parameters for calculation of expected current accru-
als ECA are estimated by using the following equation:
TCA
it

AT
itÀ1
¼ a
0
1
AT
itÀ1

þ a
1
D
REV
it
AT
itÀ1

þ a
2
ðROA
itÀ1
Þþ
e
it
ð1Þ
The expected current accruals (ECA) use the estimated parameters as follows:
ECA
it
AT
itÀ1
¼ a

0
1
AT
itÀ1

þ a
1
D
REV
it
À
D
AR
it
AT
itÀ1

þ a
2
ðROA
itÀ1
Þð2Þ
where
TCA total current accruals is net income (earnings before extraordinary items and discontinued oper-
ations) plus depreciation and amortization minus operating cash flows for firm i in the year t
D
REV change in net revenue for firm i in the year t
D
AR change in accounts receivable for firm i in the year t
ROA ratio of net income before extraordinary items to total assets for firm i in the year t À 1

AT total assets for firm i in the year t
e
it
error term for firm i in year t
B. Jaggi et al. /J. Account. Public Policy 28 (2009) 281–300
297
Consistent with the models developed by Kothari et al. (2005) and Ashbaugh et al. (2003), current
discretionary accruals are defined:
PACDA ¼
TCA
it
AT
itÀ1
À
ECA
it
AT
itÀ1

The model is estimated separately for each combination of two-digit SIC code and year to obtain
industry-specific estimates of the coefficients in Eq. (1).
A.2. Calculation of total discretionary accruals (TDA)
According to the modified Jones model, the scaled total discretionary accruals are calculated as a
difference between total accruals and non-discretionary accruals, scaled by total assets for the begin-
ning period, whereas the total accruals (TA) are the difference between net income and cash flows
from operations.
Discretionary accruals ðTDAÞ¼
TA
it
AT

itÀ1
À
NDA
it
AT
itÀ1

ð3Þ
The parameters for calculation of non-discretionary accruals (NDA) are estimated by using the fol-
lowing equation:
TA
it
AT
itÀ1
¼ a
0
1
AT
itÀ1

þ a
1
D
REV
it
AT
itÀ1

þ a
2

PPE
it
AT
itÀ1

þ
e
it
ð4Þ
The NDA are estimated based on the parameters obtained from Eq. (4):
NDA
it
AT
itÀ1
¼ a
0
1
AT
itÀ1

þ a
1
D
REV
it
À
D
AR
it
AT

itÀ1

þ a
2
PPE
it
AT
itÀ1

ð5Þ
where
TA total accruals, measured as the difference between net income (earnings before extraordinary
items and discontinued operations) and operating cash flows for firm i in the year t
D
REV change in net revenue for firm i in the year t
D
AR change in accounts receivable for firm i in the year t
PPE property, plant and equipment for firm i in the year t
AT total assets for firm i in the year t
e
it
error term for firm i in year t
The model is estimated separately for each of two-digit SIC code and year to obtain industry-spe-
cific estimates of the coefficients. In case the number of observations for the two-digit SIC is less than
8, we combine the two-digit SIC codes. It should also be noted that, as suggested in the literature,
change in accounts receivable (
D
AR) is not included in estimating the parameters, but is included
in estimating non-discretionary accruals (e.g., Ashbaugh et al., 2003).
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