Are independent directors effective in lowering earnings management in China?

Abstract

This study examines whether board independence is an effective corporate governance mechanism in reducing earnings management in China, a country with significantly different institutional and legal characteristics from the Anglo-Saxon countries. I investigate: (i) whether voluntary adoption of board independence prior to the China Regulatory Securities Commission (CSRC) regulation on board independence is associated with lower earnings management; and (ii) the extent to which the CSRC regulation is effective in achieving the aim of inhibiting earnings management. I employ two stage least squares techniques to control for potential simultaneity problems between earnings management and board independence and documents that failing to control for such problems will lead to biased and inconsistent estimates. Using three different measures of earnings management, I show that firms that voluntarily move towards board independence (i) have lower levels of discretionary accruals; (ii) employ less severe income smoothing strategies; and (iii) are less likely to manage return on equity to meet regulatory thresholds. In contrast, firms adopting board independence following the CSRC regulation in 2002 do not experience any changes in the levels of earnings management before and after the regulation. These results suggest that regulation alone is not a sufficient solution to motivate effective independent boards.