Audit committee characteristics, family control and earnings management : evidence based on Hong Kong firms after the corporate governance reform in 2004

Abstract

The existing literature mainly focuses on examining the effect of various audit committee characteristics on financial reporting quality. There are few studies which examine the economic determinants on audit committee characteristics. This study examines whether there is any association between family firms and audit committee characteristics. In addition, empirical evidence on the association between various audit committee characteristics and earnings management are not conclusive. It is possible that certain audit committee characteristics that can reduce earnings management in the western developed countries may not be effective in Hong Kong/China business environment. Cohen et al. (2008) observe that the theoretical focus of most audit committee studies are based on the agency theory. These studies based on agency approach implicitly assume that boards and audit committees that meet the standard or regulatory definitions of independence are more likely to be effective monitors of management's action. Although this approach provides many useful insights, one of the limitations is that independence in form may not be the same as independence in substance. This may be one of the reasons for the mixed results in prior studies that have examined the relationship between audit committee independence and earnings quality. Another strand of literature (for example, Kalbers and Fogarty, 1998; Spira, 1999, Dillard et al., 2004; Beasley et al., 2009) uses the institutional theory perspective to describe or explain the audit committee process. Institutional theory suggests that sometimes organizations use symbolic gestures and activities to maintain their forms to other parties to gain legitimacy and enhance their chances of survival (Cohen et al., 2008). This study draws on both the agency and institutional theories as alternative corporate governance perspectives in hypotheses development. This study uses the more detailed audit committee information made available after the corporate governance reform in 2004 to examine the relationship between various audit committee characteristics and earnings management using a large sample of Hong Kong listed firms. This study also examines how family firms may affect the association between audit committee characteristics and earnings management. Results of regression analysis of 385 Hong Kong listed firms for the four year period immediately after the 2004 corporate governance reform show that family firms are associated with less audit committee independence and less financial expertise. In addition, using accruals quality as proxy of earnings management, I find that audit committee financial expertise (but not audit committee independence nor diligence) is associated with less earnings management. I do not find any evidence that family firms nor firms that restructured their audit committees due to the corporate governance reform moderate the effectiveness of audit committee in constraining earnings management. Furthermore, though family firms are associated with less audit committee independence and financial expertise, there is no evidence that family firms are associated with lower earnings quality. In the additional analysis, I find that audit committee accounting financial experts (but not non-accounting financial experts) is associated with less earnings management for Hong Kong listed firms. Overall, the results are more consistent with the agency theory perspective. The audit committees of Hong Kong listed firms seem to provide substantive monitoring instead of merely serving as symbolic displays of conformity based on the data made available by the corporate governance reform. This study contributes to the literature by examining the association between family firms and audit committee characteristics. To the best of my knowledge, this is the first study that examines the association between family firms and detailed audit committee characteristics. Secondly, this is the first study that uses a large sample of Hong Kong listed firms to examine the relationship between various audit committee characteristics and earnings management. Finally, this is also the first study that examines whether family firms affect the effectiveness of various audit committee characteristics in constraining earnings management.