the effects of ownership structure and monitoring mechanisms on earnings quality and market...

7/29/2019 THE EFFECTS OF OWNERSHIP STRUCTURE AND MONITORING MECHANISMS ON EARNINGS QUALITY AND MARKET ASSESSMENT

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THE EFFECTS OF OWNERSHIP STRUCTURE AND MONITORING MECHANISMS

ON EARNINGS QUALITY AND MARKET ASSESSMENT

ABSTRACT

This paper examines the relationship between ownership structure (cash flow/voting rights and

type of ultimate controlling party), monitoring mechanisms (audit committee and substantial

shareholding), various measures of earnings quality and the cost of equity as a form of market

assessment of information risk. There is no evidence that ownership structure and audit

committee characteristics affect earnings quality and the cost of equity. The significant

association between substantial shareholding and both earnings quality and cost of equity

suggests substantial shareholding plays a monitoring role and a role in increasing information

flow to the public and thus reduces the information risk.

JEL code:

Key words : Earnings quality, ownership structure, substantial shareholder, audit committee,

cost of equity

INTRODUCTION

Theoretical analyses (Berle & Means 1932, Jensen & Meckling 1976) have established

the moral hazard problems associated with information asymmetry when there is a separation

between ownership and control. In particular, the controlling party has an incentive to expropriate

companys resources and to take actions that may be in divergent to the interest of the other party,

who have no access to information in order to detect and monitor such practice. The separation of

control and ownership is particularly aggravated when the controlling party can further enhance

control through pyramid ownership structure, when there is concentration of ownership or with


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the existence of shareholders that could exercise control by virtue of these shareholders

relationship with the controlling party.

Since rules and regulations, and other non-legal monitoring mechanism cannot firewall

completely improper practices, it is reasonable to expect the higher the degree of separation of

ownership and control, the greater the likelihood of such improper practices. The improper

practices are potentially manifested in earnings which then result in low earnings quality. Thus

earnings quality is a proxy to the likelihood of improper practices.

Given the considerable amount of effort and resources that have been spent on putting in

place rules and standards for good corporate governance, it is not only important to examine if

good governance characteristics are associated with high earnings quality and vice versa, it is also

important to examine if the capital market is pricing correctly the companies based on the

earnings quality.

Thus the purpose of this research is to examine the relationship between the extent of

separation of ownership and control in Malaysian listed companies, together with the rule based

and market based mechanisms, and earnings quality. Further, drawing from a theoretical assertion

that information risk is priced, this study will determine if the capital market rewards or penalizes

companies for the companies quality of earnings through required return or cost of equity. As in

previous researches, this study characterizes earnings quality as information risk. Low earnings

quality poses a risk as investors cannot rely on earnings information to make investments decision

and accordingly affects cost of equity.

The characteristics associated with the separation of ownership and control poses

information risk as the controlling party is privy to more information. Drawing parallel to the

original work that characterizes information asymmetry between informed and uninformed

investors as information risk, it is here characterized that information asymmetry between the

controlling party and other investors as information risk. Thus this study examines if capital

market rewards or penalizes companies, assesses companies with characteristics associated with


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separation of ownership and control. The association between the monitoring mechanisms, audit

committee and substantial shareholders, with market assessment is also examined to see if these

monitoring mechanisms is priced and therefore perceived as effective in reducing the information

risk.

LITERATURE REVIEW

Market Assessment

Market assessment of information quality refers to the effect of information quality on

expected or required return and valuation of shares. Theoretical studies (Easly & OHara 2001,

Leuz & Verrechia 2005) establish two dimensions of information risks that are priced. One is

with regards to the imprecision of information which provides a link between earnings quality

and the cost of equity, a measure of required return by the market. The other is with regards to the

relative amount of information being made public or kept private by companies. This establishes

the expectation between ownership structure and the monitoring mechanisms being examined

with the cost of equity.

Ownership Structure, Monitoring Mechanisms, Earnings quality And Market Assessment

Ownership structure of a company refers to the distribution of control and ownership in

the company. Control is the ability to affect decisions and for shareholders this is represented by

voting power. While ownership is the right to cash flows of the company and is proportionate to

shareholdings. In general, the separation of control and ownership of companies results in

information asymmetry and agency related problems namely moral hazards, between those in

control of and those who are not. Early studies (Berle and Means 1932 and Jensen and Meckling

1976 characterize the conflict of interest between a manager who is in control, who may or may

not own any shares, and shareholders who own the company and bears the cash flow


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consequences of any action. Managers do not own significantly any shares. However more recent

studies characterize the conflict as between the controlling shareholders (who could also be the

manager), i.e shareholders who have acquired sufficient number of shares to be able to affect

decisions, and the other or non-controlling shareholders (Shleifer & Vishny 1997). Ownership

could become separated from control through holdings of shares with different voting power, or

through holdings of shares in a pyramid structure. This latter type of control is reported to be

more common in East Asia, for example in Malaysia even though s55 of the Companies Act 1965

prohibits the issuing of shares that depart from one share one vote. Harris and Raviv (1988) and

Grossman and Hart (1988), analyze theoretically the separation of control and ownership problem

through the holdings of dual class of shares. They conclude that such separation leads to lower

accountability and specifically lead to situations where the controlling party could take actions to

maximize his utility while bearing costs not in proportion to the shareholdings.

A number of studies examine the effect of ownership structure with the possibility of

expropriation on earnings quality as perceived by the market i.e on market based measure of

earnings (Fan & Wong 2002, Jung & Kwon 2002, Francis, Schipper & Vincent 2005). Fan and

Wong (2002) reported that concentrated ownership and pyramidal structure which creates cash

flow and voting rights disparity are associated with low earnings informativeness as measured by

the earnings-return relation. This result, they explain, is consistent with the view that earnings

figure loses credibility to the market as there is a tendency for the controlling party to report

accounting information for self-interested purposes (Fan & Wong 2002). Another explanation is

that the controlling party may not disclose completely information regarding the company

activities.Similar results are found in a study by Jung and Kwon (2002) on Korean companies.

They reported that consistent with Jensen and Meckling (1976) convergence of interest PDiction,

earnings are more informative as the holdings of manager/owner increase as controlling and non-

controlling partys interests are aligned. On the effectiveness of external monitoring, they found

institutional investors and blockholders holdings are associated with earnings informativenesss.


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However , when they partition the sample into chaebol and nonchaebol companies, where

chaebol is a business group in Korea owned and controlled by family, they found no significant

relationship between earnings informativeness and owner holdings for the chaebol companies.

This evidence support the opposing view of the convergent of interest theory , that is the

controlling party become entrenched (Morck, Shleifer & Vishny 1988).

Consideration of the types of ultimate controlling party

Findings from various studies (Lim 1981,Claessens et al 2000) suggest the type of the

ultimate controlling party; manager, family, institution, government or politically affiliated group

may not only effect the propensity to expropriate, but also may create less demand for

transparency, thus effect the earnings quality. A Malaysian study, one of the earliest on corporate

ownership and control, is by Lim (1981). Although his study takes a socio-economic perspective,

his major findings are relevant to this study. His purposive sample consists of 100 large

companies listed on the Kuala Lumpur Stock Exchange, at the time. He proved that share

ownership is often concentrated in the hands of a few institutions, ultimately family or in the

hands of cliques or interest groups that share social or economic relationship. Further, the

concentration of ownership enables these large shareholders to inflate more control than his

portion of shares or voting power would have allowed.

Consideration of monitoring mechanisms substantial shareholders and audit committee

Koh (2003) and Chung, Firth and Kim (2004) found evidence of the effectiveness of

institutional holdings. The role of substantial shareholders can also be seen from information

argument (Fan & Wong 2002). A controlling party would have an advantage in terms of control

of the flow of knowledge about the company (proprietary knowledge). A controlling party could

limit the information flow to outsiders so as not to leak information to competitor. On the


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negative side this control could be potentially harmful as the controlling party could hide any

wrong doing. The presence of others, such as another substantial shareholder, potentially increase

the sharing of this proprietary knowledge as the substantial shareholder would want more

information, be more informed, in order for him to make investment decisions. Klein (2002)

found negative relationship between audit committee independence and abnormal accruals, a

proxy for earnings management. They also conclude that an independent board is effective in

monitoring earnings management behavior. Another study in the US (Abbott, Parker & Peters

2004) found significant negative relationship between each of audit committee independence and

activity level, and the incidence of financial restatement not involving fraud. The study also found

evidence of significant association between audit committee member of at least one with financial

expertise and the incidence of restatement. On the other hand, a study using Malaysian data,

Mohd Saleh et al (2004a) did not find relationship between audit committee characteristics

(frequency of meetings, size, accounting knowledge and proportion of non-executive members)

and earnings management. However Mohd Saleh, Rahmat and Mohd Iskandar (2004b) found

fully independent audit committee members (as opposed to audit committee with varying degree

of independence), and the interaction between proportion of audit committee members with

accounting knowledge and the frequency of meetings, reduce earnings management.

Earnings Quality And Market Assessment

Studies that examine the relationship between information quality and cost of equity

generally supports the theory. Most studies use cost of equity as a measure of market assessment

or consequences. A number of research explores empirically the link between information quality

as proxied by a number of measures, and cost of equity as most studies focus on usage of

information by equity investors. Botosan (1997) examines the relationship between disclosure

level and cost equity. She developed a voluntary disclosure index from information in annual

reports as proxy to disclosure level or quality. Estimates of cost of equity are based on the


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valuation formula developed by Edwards and Bell (1961), Ohlson (1995) and Feltham and

Ohlson (1995) which states that market price of a companys share is equal to the sum of

expected dividends discounted at the companys cost of equity. Botosan (1997) found a negative

association between disclosure level and cost of equity, after controlling for market risk (beta)

and companys size for companies that attract a low analyst following. However no significant

association was found for companies that have high analyst following. The reason for this is that

the disclosure index may not capture fully the level of information provided to investors as

analysts play a significant role in disclosure. Botosan and Plumlee (2001) reexamine the

association between disclosure and cost of equity by segregating different forms of disclosure

quality i.e level and timely. Findings for relationship between disclosure level and cost of equity

confirm previous results. However a positive association was found between timely disclosure

and cost of equity which is contrary to theoretical assertion. An explanation for this is that timely

disclosure increases volatility of share prices and hence cost of equity. Francis et (2008b) found

that voluntary disclosure as measured by a self-constructed index of items in companies annual

report has no distinct pricing effect. It is the earnings quality measured by a common factor of

three earnings attributes which is the primary driver of cost of capital. In other words companies

with high earnings quality tend to voluntarily disclose more. Francis et al (2004) examine the

relationship between earnings attributes as proxy to information quality and cost of equity.

Earnings attributes are categorized as market based and accounting based, each as described in

earlier paragraphs. As a whole their findings confirm previous results of negative relationship

between earnings quality and cost of equity. When considered individually the accounting based

earnings attributes, in particular accrual quality, have larger effect on cost of equity than market

based attributes. Chen, Chen and Wei (2003) examine the effects of various corporate governance

mechanisms and disclosure level on the cost of equity. They found significant negative

association between corporate governance mechanisms and disclosure level, and cost of equity.

Their study was on Asias emerging markets which include 42 Malaysian listed companies.


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Endogeneity of ownership structure

Demsetz 1983, Demsetz 1985, and Demsetz and Villalonga 2001 examine ownership

structure and performance, and also examine the relationship where ownership structure is

assumed to be endogenous. The argument for the endogeneity of ownership is that controlling

shareholders are also likely to change their holdings in response to performance. Mak and Li also

found significant interrelationship between board and ownership characteristics.

For the relationships examine in this study that involves ownership structure (both for the

ultimate controlling party shareholding and the next highest shareholding), it is conceivable that

ownership structure is endogenous. For example ownership structure could change by the

controlling party or the next controlling party changing his shareholding in response to changes in

market assessment (increase/decrease expected return) and changes in monitoring mechanisms

(increase/decrease monitoring). As Claessens et al (2000) found that type of owners (whether

family, government or institution) could explain ownership in terms of the level of separation of

ownership and control. Their results shows that the level of separation of ownership and control is

more in family owned than state controlled.

RESEARCH METHODOLOGY

Population and sample

The sample of companies is drawn from companies listed on Bursa Malaysia. However

the sample is limited by data availability, initially with regards to earnings forecast that are

needed to estimate cost of equity. IBES provides on Bloomberg services, earnings forecasts for

two years ahead. The earnings forecasts of years 2005 and 2006 are obtained for 213 companies.

These companies comprise the sample for this research. Thus the relationships are examined

contemporaneously for year 2004 because the earnings forecasts obtained for years 2005 and

2006 enable cost of equity to be estimated for year 2004 only.


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The sample is further reduced by the availability of data for estimating the earnings

quality variables. The companies are composed into three samples; 1) ACQ sample consists of

141 companies with sufficient data to estimate accrual quality, ACQ, 2)CAQ / TAQ sample

consists of 151 companies with sufficient data to estimate discretionary current (CAQ) and total

accruals (TAQ), and 3) PS / PD sample consists of 118 companies with sufficient data to

estimate Persistence (PS) and Predictability (PD).

Data sources

Accounting data for the purpose of estimating earnings quality variables (ACQ, CAQ,

TAQ, PS and PD), market value, book to market value, prices and beta are obtained from

Datastream data base for the financial year end 2004 or as at financial year end 2004 as

applicable. For the purpose of estimating ACQ accounting data for year 2003 and 2005 are also

required. Estimated earnings per share for years 2005 and 2006 required for calculating cost of

equity are downloaded from Bloomberg data base services in January 2005. Data on audit

committee, voting rights of substantial shareholders, cash flow and voting rights of ultimate

controlling party are collected from the annual reports for the financial year ending in 2004.

Variable Description and Measurement

Table 1. Variables Brief Description and Measurement

Variables Measurement

Earnings Quality (EQ):

1. Accrual quality -

mapping cash flows

ACQ Absolute residual from the regression of changes in

working capital and past, current and future cash flows

(Dechow & Dichev 2002)


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2. Discretionary

current accruals

3. Discretionary total

accruals

CAQ

TAQ

Modified Jones (1991) model with discretionary

current accruals

Modified Jones (1991) model with discretionary total

accruals

4.Persistence PS Slope coefficient of earnings time series model. The

time series model is the regression of earnings per

share on lagged earnings per share.

5. Predictability PD Absolute value of the residuals from the earnings time

series model. As for persistence, the time series model

is the regression of earnings per share on lagged

earnings per share.

Monitoring mechanisms -Audit

committee (AC):

1. Independence

2. Competence

ACI

ACC

Proportion of members that are outsiders (those who

are not affiliated in any way with the company other

than being a director)

Proportion of members that have accounting/finance

knowledge (through experience or qualification)

Monitoring

mechanisms -

Substantial

shareholding (SS)

SHDG

The voting rights of the substantial shareholder who

has the next highest voting rights after the controlling

party

Ownership structure:

1.Separation of SOC Ratio of cash flow to voting /controlling rights


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ownership and control

- Cash flow to

voting/controlling

rights disparity

2. Type of ultimate

controlling party

TCP TCP is the shareholder that holds more than 20% of

shares and the one with the highest shares. There are 5

categories: manager, institution, government, family

and foreign company, and requires 4 dummy variable

as follows. Foreign company category is the reference

and

TCPMn = 1, for managerial controlled, =0 otherwise.

TCPInst= 1, for institutional controlled, =0 otherwise.

TCPGov = 1, for government controlled, =0 otherwise.

TCPFam =1, for family controole, =0 otherwise.

Market assessment:

Cost of equity :

Ex ante measure of

expected return

COE

COEA

Residual income model based on Gebhardt, Lee and

Swaminathan (2001)

Alternative estimation based on Ohlson and Juettner-

Nauroth (2000)

Control variables:

Size LGMV Log market value

Growth LBTMV Log book to market value

Risk Beta from Datastream

Capital Intensity CAPINT Net book value of property, plant and equipment to

total assets


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Operating cycle OC Log of the sum of a companys days accounts

receivable and days inventory

Standard deviation of

revenue

STDREV

Research framework

The relationship between separation of ownership and control, monitoring mechanisms,

earnings quality and cost of equity is examined through the following series of equations.

1. Ownership structure, monitoring mechanisms and earnings quality

Earnings quality 1,2,3,4,5 = 0 + i SOC + 2,3,4,5 TCP + 6 SHDG + 7 ACI + 8 ACC +

9SIZE + 10Controls for EQ + 1,2,3,4,5

Equation 1

2. Earnings quality and cost of equity

COE = 0 + 1,2,3,4Earnings quality 1,2,3,4 + 5 SIZE + 6 + 7 BTMV + 6

Equation 2

3. Ownership structure, monitoring mechanisms and cost of equity

COE = 0 + 1 SOC + 2,3,4,5 TCP + 6 SHDG + 7 ACI + 8 ACC +

9SIZE + 10BTMV + 11 + 7,8,9

Equation 3


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4. Relationship between ownership structure, monitoring mechanisms and cost of equity-

SOC and SHDG as a dependent variable

SOC = 0 + 1COE + 2,3,4,5TCP + 6 SHDG + 7 ACI + 8 ACC +

9SIZE + 10BTMV + 10,11,12

Equation 4(i)

SHDG = 0 + 1COE + 2,3,4,5TCP + 6 SOC + 7 ACI + 8 ACC +

9SIZE + 10BTMV + 10,11,12

Equation 4(ii)

The simultaneity of equations

A priori equation 1 and 2 are not simultaneous. However for equations 3, 4(i) and 4(ii)

simultaneity cannot be assumed. Endogeneity test is performed for the variables SOC and SHDG.

RESULTS AND DISCUSSION

Descriptive Statistics

The mean of SOC reported in table 2 is lower than that in Claessens et al 1998b study.

This suggests that a higher disparity between CF and VR is found in this sample. As in previous

studies (Francis et al 2004, Mohd Saleh 2007) the earnings quality measures are highly dispersed.

Similarly with the SHDG measure. The means of ACI (0.608-0.636) and ACC (0.339-0.345)

suggest that companies in the sample maintain audit company independence and competence just

so to meet the Malaysian Code of Corporate Governance requirement.

Table 2 Mean and dispersion of common variables in the three sample


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ACQ CAQ & TAQ PS and PD

Mean

Std.

Deviation Mean

Std.

Deviation Mean

Std.

Deviation

SOC 0.490 0.218 0.488 0.216 0.506 0.225

SHDG 0.087 0.077 0.091 0.080 0.087 0.084

LGMV 6.585 1.377 6.555 1.338 6.955 1.401

BETA 0.961 0.413 0.932 0.475 1.008 0.483

LBTMV -0.394 0.645 -0.406 0.641 -0.283 0.633

ACI 0.634 0.200 0.636 0.196 0.608 0.221

ACC 0.339 0.165 0.345 0.170 0.341 0.197

COEA 0.147 0.066 0.149 0.065 0.145 0.070

COE 0.099 0.034 0.099 0.033 0.094 0.037

Multivariate analysis

Tables 3 to 6 (i & ii) provides the results of the regressions of the 5 equations. The

coefficients for all the regressions are Whites-adjusted for heteroskedasticity. The variance

inflation index are all below 10, thus multicollenearity is not a severe problem in all the

regressions. Tables 4 to 6 (i & ii) show results of regression using one estimate of COE. The

results of regressions using the alternative measure COEA are not shown due to limitation of

space.

The results given in table 3, show a significant negative relationship between EQ

measures of ACQ, CAQ and PS and SHDG. There is no evidence at all to show that EQ is

influenced by any of the ownership structure measures, SOC and type of ultimate controlling

party. This suggests that substantial shareholder plays a significant monitoring role as the higher

the SHDG, the higher the earnings quality (read as lower measure).


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To investigate further, the samples are separated into companies with pyramidal structure

and those that are without pyramidal structure. The results are largely the same except for the PD

non-pyramidal sample where it is found that the ownership variable (SOC) is found to be

significantly and positively associated with PD, which is the opposite expected relationship. This

could indicate the entrenchment effect taking place. Further research needs to be carried out with

larger sample size for a more robust results.

Table 3 Coefficients of equation 1 regression

Earnings quality 1,2,3,4,5 = 0 + i SOC + 2,3,4,5 TCP + 6 SHDG + 7 ACI + 8 ACC +

9SIZE + 10Controls for EQ + 1,2,3,4,5

(***, **, * Coefficients that are significant 1%, 5% and 10% level respectively )

Predicted

sign ACQ TAQ CAQ PS PD

(Constant)

TCPMn +ve -0.01 0.28 -0.36 -0.18 -0.04

TCPInst +ve 0.01 -0.81 -0.20 -0.23 -0.09

TCPGov +ve -0.01 -0.42 -1.18 -0.05 0.03

TCPFam +ve 0.00 -0.13 -0.59 -0.06 0.03

SHDG ?

-

0.09*** -2.01 -3.41*** -0.77** -0.28

ACI -ve 0.01 1.11* 0.43 0.06 0.04

ACC -ve -0.02 -0.81 -0.15 0.11 0.02

SOC -ve -0.01 0.52 -0.21 -0.00 0.08

LGMV -ve -0.004* -0.24** -0.14* -0.05 0.00

CAPINT -ve -0.03** -1.07** -0.64


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OC +ve 0.87* 1.47***

STDREV +ve 0.17 0.29*

R2 0.12 0.21 0.26 0.06 0.08

F 1.82 3.40 4.37 0.58 0.76

Sig 0.06* 0.00*** 0.00*** 0.82 0.67

N 141 141 151 151 118

The evidence of whether EQ is priced is rather mixed. Table 4 shows significant

relationship between EQ measures of ACQ and PD with COE measure. When COE measure is

replaced with the alternative measure COEA, it is found that all the EQ measures except PS

explained significantly the cost of equity as predicted. Thus there is a fairly strong association

between EQ and COE. This is especially consistent for the accrual quality measure, ACQ and PD.

Table 4 Results of equation 2 regression using COE estimate

COE = 0 + 1,2,3,4Earnings quality 1,2,3,4 + 5 SIZE + 6 + 7 BTMV + 6


Predicted

sign ACQ TAQ CAQ PS PD

(Constant)

EQ +ve 0.13** 0.00 0.00 0.00 0.04**

LGMV -ve -0.004*** -0.01*** -0.004*** -0.01*** -0.00***

BETA +ve 0.002 -0.00 -0.00 -0.00 -0.01

LBTMV +ve 0.03*** 0.03*** 0.03*** 0.03*** 0.03***

R2 0.39 0.40 0.40 0.40 0.45

F 21.99 24.34 24.60 18.64 23.20


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Sig 0.00 0.00 0.00 0.00 0.00

N 141 151 151 118 118

Equations 3 and 4 are tested for simultaneity and found to be not so. Thus ordinary least

square regressions are carried out for both the equations and the results are shown in tables 5 and

6 (i & ii)respectively.

Consistent with the results that substantial shareholding plays a significant monitoring

role and found in certain instances to be significantly associated with EQ (table 3), results given

in table 5 shows SHDG to be consistently and significantly associated with COE in all the

samples. This suggests that market prices the monitoring role of substantial shareholder.

Similarly, there is no significant association between SOC and COE in all the samples as they do

not explained significantly EQ. The same results are found when COEA replaces COE in the

regression. Thus market does not perceive the disparity between cash flow and voting rights,

SOC, as information risk, as SOC has no influence over EQ. This may be due to the mitigating

effect of substantial shareholders significant monitoring role.

Another possible explanation to this is that cash flow rights do not provide an incentive to

expropriate or manipulate earnings for this sample because as further explained below, the

companies in this sample are with ultimate controlling party with a higher level of control rights

than those in previous researches (Claessens 1998(b), Fan & Wong 2002) and therefore the cash

flow rights is not an incentive to expropriate.

The comparison between Claessens (1998b) sample and the samples under study

provides an insight why this is so. The minimum voting rights found in the samples in this study

is quite close to the mean of 28% in Claessens (1998b) study. 75% of companies in the samples

have ultimate controlling party with voting rights above 37%. Similarly the mean cash flow rights

in all samples in this study are almost twice that reported in Claessens (1998b). 75% of the

companies have ultimate controlling party with cash flow rights above 28%.


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Similar pattern is observed in Fan and Wong (2002) whose study includes 177 Malaysian

companies. The mean voting rights is 31% whilst the mean cash flow rights is reported to be

26%. As in Claessens et al (1998b) study the reported mean SOC is 85%. Further both Claessens

et al (1998b) and Fan and Wong (2002) capped the voting rights at 50%. They stopped analyzing

the voting rights of the ultimate controlling party once the voting rights breach 50%. So the

maximum voting rights for the companies in the sample is 50%.

Francis et al 2005 reported significant association between disparity of cash flow and

voting rights, and informativeness of dividends and earnings for US listed companies. It is well

known that capital markets in Europe and the US consist of companies with diffused ownership.

Thus the controlling party ownership rights is likely to be at lower level.

The other noteworthy difference is that both Fan and Wong (2002) and Francis et al

(2005) use market based of earnings quality measures. Thus they examine association between

market perception as embedded in the measure of informativeness and cash flow/controlling

rights disparity. Thus what they are measuring is the credibility of earnings figures in the face of

cash flow/controlling rights disparity. In Fan and Wong (2002) words - This does not always

mean that there is an outright earnings manipulation to cover up possible earnings effect of

wealth extraction. The accounting based earnings quality measures as used in this study are

measuring earnings manipulation after controlling for other economic condition. Francis et al

(2004) reported low correlation between market based and accounting based earnings quality

measures.

Certainly the off setting effect of increasing cash flow rights and increasing voting rights

is complex and merit more research. Previous research such as Claessens (1998b) also found that

at higher level of control the tendency to expropriate is higher. However the insignificant results

in this study is consistent with this finding and the prevailing theory and prediction regarding the

association between cash flow/voting rights and earnings quality. It suggests that at higher level

of control the ultimate controlling party with varying degree of disparity between cash flow and


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voting rights would expropriate. However the cash flow rights are not the incentive and thus the

lack of significant association.

Or the other possible explanation is that the ultimate controlling parties do not

expropriate as at higher level of control with the even higher level of cash flow rights, the

ultimate controlling parties of pyramidal and non-pyramidal companies may find the cash flow

loss is too much to expropriate.

Consider this hypothetical example of pyramidal companies. Suppose there are two

companies, A and B. The controlling party of A has cash flow rights of 8% and voting rights of

40%, thus SOC ratio of 20%. The controlling party of B has cash flow rights of 20% and

controlling rights of 100%, thus SOC of also 20%. The controlling party of company A would

share a loss of 80,000 for a loss of 1 million in company A, whilst a loss of 1 million in company

B, the controlling partys share in the loss is 200,000.

To prove interest alignment or otherwise entrenchment requires further research. It

requires measurement of not only expropriating behavior, but also measurement of value

maximizing behavior.

Results in table 3, although are not consistent across samples, show that certain types of

ownership structure are priced. The coefficients for managerial and family ultimate controlling

party (TCPMn, TCPFam) are significant in the ACQ and CAQ/TAQ samples. The coefficient for

government ultimate controlling party (TCPGov) is significant in ACQ sample only.

Table 5 Results of equation 3 regression using COE estimate

COE = 0 + 1 SOC + 2,3,4,5TCP + 6 SHDG + 7 ACI + 8 ACC +

9SIZE + 10BTMV + 11 + 7,8,9



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Predicted

sign ACQ TAQ/CAQ PS/PD

(Constant)

TCPMn +ve 0.221** 0.180* 0.022

TCPInst +ve 0.046 0.032 0.045

TCPGov +ve 0.165* 0.111 0.110

TCPFam +ve 0.354*** 0.286*** 0.226

SHDG ? -0.128* -0.164*** -0.139*

ACI -ve 0.067 0.053 0.076

ACC -ve 0.051 0.031 -0.075

LGMV -ve -0.190*** -0.179** -0.208**

LBTMV +ve 0.469*** 0.519*** 0.506***

BETA +ve -0.017 -0.039 -0.081

SOC -ve 0.093 0.088 0.030

R2 0.405 0.428 0.394

F 9.680 11.216 7.907

Sig 0.000 0.000 0.000

N 141 151 118

The purpose of running equations 4(i & ii) is to examine if ownership structure, i.e. SOC

and the next substantial shareholding, SHDG are in turn influenced by the monitoring

mechanisms and the cost of equity. Table 6 (i ) show that in all the three samples the coefficients

of SHDG are significant and negative. This indicates that in companies where the disparity

between cash flow and voting rights is high (the SOC ratio is low), i.e. where the expectation of

appropriation is high, there is a high substantial shareholding, and vice versa. The coefficient of


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ACI is significant in the PS/PD sample, whilst the coefficients of ACC are significant in the ACQ

and TAQ/CAQ. This is a fair evidence that ownership structure changes in response to increase

monitoring from substantial shareholders and audit committee.

Table 6

(i) Results of equation 4(i) regression using COE estimates

SOC = 0 + 1COE + 2,3,4,5TCP + 6 SHDG + 7 ACI + 8 ACC +

9SIZE + 10BTMV + 10,11,12


Predicted


(Constant)

TCPMn +ve -0.472 -0.449 -0.413

TCPInst +ve -0.064 -0.056 0.001

TCPGov +ve 0.063 0.053 0.092

TCPFam +ve -0.195 -0.170 -0.143

ACI -ve -0.064 -0.055 -0.144*

ACC -ve -0.133* -0.128* -0.134

LGMV +ve 0.045 0.109 -0.048

LBTMV -ve 0.127 0.113 0.125

COE -ve 0.120 0.116 0.038

SHDG ? -0.165** -0.157** -0.179**

R2 0.238 0.226 0.220

F 5.383 5.376 4.309

Sig 0.000 0.000 0.000

N 141 151 118


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The rather low R squared is expected as there are conceivably other factors that

determine the shareholdings of these shareholders. As any other shareholders, other than

performance of companies, a substantial shareholder would also consider for example the relative

risk/ return relationship in his portfolio of investments. This cannot be captured by the estimated

relationship.

However the limited purpose of the estimation and that is to examine whether the

substantial shareholders voting rights could be explained by the stated variables, is served. In all

the regressions the coefficients of COE, SOC and LBTMV are consistently significant. The

coefficient of COE is negative throughout the samples which suggests that high substantial

shareholders shareholdings is associated with low cost of equity.

The coefficient of SOC is negative, which also suggests that high substantial

shareholders shareholdings is associated with low cash flow/voting rights. In other words

substantial shareholders voting rights are high in companies where the separation of ownership

and control related problems are expected to be high.

Table 6

(ii) Results of equation 4(ii) regression using COE estimates

SHDG = 0 + 1COE + 2,3,4,5TCP + 6 SOC + 7 ACI + 8 ACC +

9SIZE + 10BTMV + 10,11,12


Predicted


(Constant)

TCPMn +ve -0.029

-0.031 -0.060


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TCPInst +ve

0.037 0.032 -0.034

TCPGov +ve

-0.049 -0.056 -0.051

TCPFam +ve

-0.015 -0.011 -0.026

ACI-0.011 -0.0145 0.014

ACC

0.045 0.047 -0.012

LGMV

0.001 0.001 -0.003

LBTMV 0.031**0.040*** 0.039***

COE -0.456* -0.627** -0.468**

SOC -0.071** -0.068** -0.083**

R2 0.141 0.159 0.118

F 2.140 2.651 1.428

Sig 0.026 0.005 0.178

N 141 151 118

CONCLUSION

A caveat is in order due to the sample size. Future research with a larger sample size may

provide a more robust set of results. However the results of this study does make some important

contribution. Firstly, the study shows that there is no significant relationship between ownership

structure and earnings quality and that investors do not perceive such ownership structure as

information risk and therefore priced. The consistency in the two findings is an important

contribution to the theory and the body of knowledge in ownership structure and the pricing of

information risks. Whilst past researches examine ownership structure and earnings quality, and

separately examine earnings quality and cost of equity, none has examined ownership structure as


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a source of information risk. Although the results are not in the affirmative, it confirms the

theory, that is what is perceived as a source of risk is priced.

Secondly, the fairly strong association between the cost of equity and earnings quality is

nothing new, except that this study examines companies in an emerging market. Therefore even

in an emerging market investors are sophisticated and do price earnings quality with low earnings

quality being perceived as information risks. In relation to the ownership structure, investors do

not however perceive ownership structure in particular the cash flow and voting rights disparity

as the primary driver of earnings quality. An important finding and therefore contribution is the

significance of predictability as a dimension of earnings quality in required return. Whilst there

have been many studies on Malaysian companies that examine abnormal accruals in relation to

many variables such as board characteristics, managerial ownership, etc. there is none to date on

predictability, a dimension that standard setters have long expounded as an important attribute of

accounting information. The finding that predictability is priced has an important implication to

Malaysian standard setters and preparers of accounts because it is a desired attribute of earnings.

There has never been any Malaysian studies that provide evidence that abnormal accruals are

priced. The consequence of this is that the preparer may gain in manipulation of accounts but they

stand to lose in terms of higher required return by investors.

Finally, this study consistently shows that substantial shareholders voting rights is

significantly associated with earnings quality especially the discretionary ones which suggest the

presence of substantial shareholder is an important monitoring mechanism. In contrast to the

results shown by the rules based mechanism in particular audit committee, where none of the

characteristics of audit committee is significantly associated with earnings quality and neither is it

priced. The finding that substantial shareholders shareholding is priced is a new and significant

contribution not only in the Malaysian context but also elsewhere. Thus not only substantial

shareholder is an important mechanism, it is also perceived as such by the market. The amount of

shares that substantial shareholders buy in the company depends on a number of factors which is


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beyond this research. However it is not conceivable that it is related to the cash flow/voting rights

of the controlling party, even though statistically they are correlated. Given that in the reverse

relationship test, substantial shareholding can affect the cash flow/voting rights of the controlling

party, it is an important contribution in the sense that it confirms the belief that ownership

changes in response to changes in market, even though as earlier reported ownership does not

response to market assessment or changes in cost of equity. The controlling party can change his

shareholding in the face of changing market expectation. Market expects with increase in

substantial shareholding there will be an increase in monitoring and increase information to the

market.

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