Journal of Service Science and Management, 2011, 4, 351-356
doi:10.4236/jssm.2011.43041 Published Online September 2011 (
Copyright © 2011 SciRes. JSSM
Does Ownership Structure Affect the Motivation of
Compensation Contract of Earnings Management?
—From China’s Data
Jing Long, Yanxi Li, Xiuwen Xu, Linlin Fu
School of Management & Economics, Dalian University of Technology, Dalian, China.
Email:,, {xxw133, franfulinlin}
Received July 10th, 2011; revised August 16th, 2011; accepted August 25th, 2011.
This paper is to explore that if ownership structure exactly affects on earnings management, especially on how to con-
strain executive compensation motivation to earnings management in the emerging market of China. We use five vari-
ables to quantify various corporate governance mechanisms including ownership structure and executive compensation
for 1024 listed firms sample within two years. We find that earnings management is positively affected by executive
compensation motivation, while this influence is constrained mostly by ownership concentration. This finding reflects
the current situation for the weak corporate governance in the emerging market of China. Therefore, such a significant
relationship is useful to control level of earnings management and improve the Chinas emerging market developing
healthily, stably and harmoniously.
Keywords: Ownership Concentration, Executive Compensation, Earnings Management, Corporate Governance
1. Introduction
Over three hundred years ago, Adam Smith raised the
issue of the separation of ownership and stewardship in
joint-stock corporations in his masterwork “The Wealth
of Nations”. It was therefore suggested that a set of ef-
fective mechanisms should be in place to resolve the
conflict of interests between firm owners and managers.
The early 2000s were the years in which a numbers of
high-profile corporate financial frauds took place, in-
cluding large companies such as Enron, WorldCom,
Tyco, Global Crossing and others [1]. To respond to
these corporate financial frauds, the US Congress en-
acted the Sarbanes-Oxley (SOX) Act in 2002 and intro-
duced a new era of corporate governance, including re-
quirements for auditor independence, independence of a
firm’s audit committee, the responsibility of a firm’s
CEO and CFO on financial reports, and the protections
on whistleblowers. Since the occurrence of financial
frauds and the enactment of SOX in early 2000s, corpo-
rate governance has become a crucial mechanism for
government regulations on both corporate and capital
market operations.
Berle and Means [2] believed that when cooperate
shares are widely spread over to a great number of small
shareholders, there is a good separation between the
ownership and the power of operational management, in
which the managers act as the agents for the shareholders.
However, Fama [3], and Jensen and Meckling [4] argued
that when the managers do not own a great number of
shares, they may pursue personal interest at the expense
of the interest of shareholders while making managerial
decisions. Therefore, the business in a form of corpora-
tion exists with interest conflicts between owners and
managers, which is referred as traditional agency theory
or equity agency problem. Moreover, this equity agency
problem would become a central agency problem, in
which new conflicts arise between controlling and non-
controlling shareholders when mangers also own signifi-
cant amount of shares through stock options, pyramidal
ownership structure, or crossing holdings [5,6].
Healy [7] has empirically researched on bonus plan
and earnings management. He found that the managers
would choose the correspondingly policies and process to
lower the report earnings if the bonus plan proposed the
minimum and maximum process to lower the report
earnings. While the managers would choose the opposite
policies to increase the report earnings, as there is no
limitation on bonus plan.
Does Ownership Structure Affect the Motivation of Compensation Contract of Earnings Management?
—From China’s Data
Watts and Zimmerman [8] found that corporate gov-
ernance attributes help investors by aligning the interests
of managers with the interests of shareholders and also
by enhancing the reliability of financial information and
the integrity of reporting process. It confirmed that the
mechanism of corporate governance helps restrict man-
gers in the behavior of earnings management.
The purpose of this paper is to explore the mechanisms
of corporate governance used by listed firms in the Chi-
nese emerging capital market, and the effect of govern-
ance and ownership on earnings management, especially
on how to constrain executive compensation’s motiva-
tion to earnings management. The results of this research
will help users better analyze and understand the finan-
cial statements prepared by the Chinese listed firms. In
addition, our results will also help regulators and policy
makers in policy making, enactment of regulations/laws
and their enforcement.
In addition of this section of Introduction, the remain-
der of this paper is organized into six more sections. Sec-
tion 2 presents research framework and hypothesis. Sec-
tion 3 discusses the methodology used in this research.
Section 4 presents data, descriptive statistics and the re-
search results. Section 5 provides the sensitivity test and
section 6 proposes conclusion and suggestion.
2. Research Framework and Hypothesis
Dennis and McConnell [9] defines corporate governance
as “ the set of mechanisms that maintain an appropri-
ate balance between the rights of shareholders and the
needs of the board and management to direct and manage
the corporation’s affairs.” The corporate governance
mechanisms may help resolve the two sets of conflicts:
between owners and managers, and between controlling
shareholders and minority shareholders. It consist own-
ership structure, board of directors, executive compensa-
tions, financial disclosure, etc. In this paper, we consider
and assess ownership structure (e.g. concentration own-
ership), board of directors (e.g. board size, proportion of
independent directors, the duality of CEO), and the man-
agers (e.g. the top3 executive compensations), which
effect on earnings management.
2.1. Executive Compensation
We define the top managers as CEO, the chairperson of
the board of directors or supervisors, and the general
manager of a firm. Watts and Zimmerman [8] stated that
managers have incentives to advance the earnings from
the future to the current accounting period when a bonus
award plan exists. In their later studies, Dechow and
Sloan [10] consistently confirmed that managers would
use accounting judgments to increase earnings-based bo-
nus awards. We define sata-3 is the annual salaries of the
3 top managers. The following hypothesis flows from the
literature discussed as:
Hypotheses 1: The executive compensation (sala_3)
has a negative impact on earnings management.
2.2. Ownership Structure
It is believed that one of the most important ways through
which a firm maximizes its value is through well-de-
signed ownership structure of the firm’s shares. Concen-
trated equity ownership can be bad for the governance of
the firm since it gives the largest shareholders too much
discretionary powers of using firm resources in ways that
serve their own interest at the expense of other share-
holders. That is, too much concentrated ownership (the
largest shareholders) may accentuate the earnings man-
agement we mentioned earlier.
We investigate the related issue of how ownership
concentration affects earnings management, a topic which
has received a significant impact by the corporate gov-
ernance literature on the Chinese market. We define that
h10 is the ownership concentration variable represented
by the sum of the square of shares held by the ten largest
shareholders. Herfindahl is included to examine if the
power sharing among the largest shareholders was a bet-
ter mechanism of corporate governance rather than one
shareholder. Thus, hypothesis 2 is developed as follows:
Hypotheses 2: The ownership concentration (h10) has
a negative impact on earnings management.
Long, Li and Fu [11] suggested to use a cross item to
test the constrain of ownership structure. Then we use
sala_t3 × h10 as a multiplication cross item between ex-
ecutive compensation and ownership concentration to
test if compensation plan can be constrained by owner-
ship structure for the level of earnings management.
Based upon the aforementioned theory and studies, we
formulate hypothesis 3 as:
Hypotheses 3: The multiplication cross item between
executive compensation and ownership concentration
(sala_t3 × h10) has an impact on constraining motivation
of compensation plan to earnings management.
2.3. Board of Directors
2.3.1. Board Size
Beasley [12], Dechow [13] found that, the more numbers
of the board, the less ineffective supervision to the man-
agers, and the more possible to do earnings management.
Bai et al. [14] suggested board size have a positive effect
on earnings management. We define n_d as the number
of the board.
Hypotheses 4: When the number of the board (n_d) is
larger, there is a lower level of earnings management.
Copyright © 2011 SciRes. JSSM
Does Ownership Structure Affect the Motivation of Compensation Contract of Earnings Management? 353
—From China’s Data
2.3.2. Propor t i on of Independent Directors
Dechow [13] corroborated that when there is a higher
proportion of independent directors, there is lower level
of earnings management. We define the proportion of
independent directors as id. Thus, we develop hypothesis
5 as:
Hypotheses 5: When the proportion of independent
directors (id) is higher in a firm, there is a lower level of
earnings management.
2.3.3. CEO Duality
Fama and Jensen (1983) assert that when the CEO dual-
ity exists I a firm, the monitoring function of the board
will be weaker, that would also likely lead to more earn-
ings management. We define CEO Duality as dua. Thus,
hypothesis 6 is developed as follows:
Hypotheses 6: The CEO duality (dua) has a positive
impact on earnings management.
3. Methodology of the Research
Earnings management has also been rampant in the
emerging market of China. China Securities Regulatory
Commission (CSRC) requires listed companies to meet
certain return on equity (ROE) criteria before they can
apply for permission to issue additional shares to existing
shareholders; the most important criterion for delisting a
listed company is a reported net loss for three consecu-
tive years. Whenever a contract or regulation is based on
accounting numbers, managers have an incentive to ma-
nipulate those numbers to serve their own or the firm’s
interests. We try to illuminate how controlling share-
holder and the board affect the level of earnings man-
In order to examine the relationships among ownership
concentration, the board of directors, and earnings man-
agement, we first establish the following regression equa-
DA =
1 sala_t3 +
2 h10 +
3 sala_t3 × h10
4 n_d +
5 id +
6 dua +
7 size_a +
8 leve +
DA = discretionary accruals of the firm, as an indica-
tor for earnings management;
sala_t3 = natural logarithm of the total salary of the
top 3 executives
h10 = index of Herfindahl for ownership concentra-
sala_t3 × h10 = the multiplication cross item equaling
sala_t3 multiplied by h10;
n_d = number of the directors.
id = the proportion of independent directors;
dua = a dummy variable that equals 1 if the CEO is the
chairman or a vice chairman of the board of directors,
and 0 otherwise;
size_a = logarithm of the total assets;
leve = Debt ratio calculated by dividing liabilities by
After the regression equation has been properly con-
structed, the next step is to find a way to measure the
discretionary accruals (DA). Jones[15] suggested that
earnings management can be achieved by various means
such as the use of accruals, changes in accounting meth-
ods, and changes in capital structure (e.g., debt defea-
sance, debt-equity swaps). This study focuses on total
accruals (TA) as the source of earnings management.
Total accruals (TA) include discretionary accruals (DA)
and non-discretionary accruals (NDA). Discretionary
accruals (DA) are used to measure the level of earnings
management of a firm, and are calculated as follows:
TAit =α1(1/Ait–1) + α2(ΔREVit/Ait-1) + α3(PPEit/Ait–1)+ εit
NDAit = α1(1/Ait-1)+α2(ΔREVitΔRECit )/Ait–1
+ α3(PPEit/Ait–1)
DAit = TAit – NDAit (2)
DAit = dealing accruals in year t for firm i;
NDAit = non-dealing accruals in year t for firm i;
TAit = total accruals in year t for firm i;
ΔREVit =revenues in year t less revenues in year 1 – t
for firm i;
ΔRECit = accounts receivables in year t less accounts
receivables in year t – 1for firm i;
PPEit = gross property, plant, and equipment in year t
for firm i;
Ait = total assets in year t – 1for firm i;
εit = error term in year t for firm i
4. Data and Descriptive Statistics
4.1. Data Collection
We conduct our analysis with the full set of non-financial
companies which were continuously listed on the Shang-
hai Stock Exchange (SHSE) and the Shenzhen Stock
Exchange (SZSE) from 2006 to 2008 period. In these
three years, there are both top performance and bottom
influence in China’s stock market as a emerging market
of China. And this time period provides more recent data
and at the same time avoids duplication of time spans
with previous studies.
Based on above criteria, we extract 1024 SHSE and
SZSE listed firms each year and total 2048 firms for our
analyses. We use RESSET and CSMAR data sources to
collect the data required. These databases are used to
collect the corporate governance data and the accounting
Copyright © 2011 SciRes. JSSM
Does Ownership Structure Affect the Motivation of Compensation Contract of Earnings Management?
—From China’s Data
Copyright © 2011 SciRes. JSSM
4.2. Summary Statistics
Table 1 provides some summary statistics for the above
variables. As revealed, these 1024 companies have an
average dealing accruals (DA) of –0.0259. The mean of
logarithm of total executives’ compensation is 13.68.
And the average of h10 is 0.1688.
The number of board is from 5 to 19, the average is
9.31, which is very fit for the regulation of the Chinese
Corporation Law. The mean of the proportion of inde-
pendent directors is 35.9%, which is satisfied not less
than “1/3” in the regulation of the Chinese Corporation
Law. And the mean of the duality of CEO is 0.1270,
which reflects CEO is mostly not the chairman of the
board in most companies.
Finally, in the controlling variables, the mean of scale
of assets (size_a) is 21.65, and debt ratio (leve) is
4.3. Related Coefficient Validity Test
Table 2 use Pearson related coefficient validity test and
Spearman related coefficient validity test to test the self-
relation among the independent variables. The Bottom
Left lists the coefficient of Pearson method and the upper
right lists the coefficient of Spearman method. Both two
methods have showed the acceptable validity test results
in Table 2.
4.4. Regression Models
In this section, we carry out our econometric analysis.
We investigate the effects of the corporate governance
mechanisms on earnings management. This study gives
us some ideas about the magnitude of the corporate gov-
ernance premiums which are used to measure the level of
corporate governance and earnings management.
Table 3 reports regression results of earnings man-
agement variables on the five variables used to measure
some of the governance mechanisms and earnings man-
agement for China’s listed companies. The regression
model is regressed by debt ratio and the size of assets as
two control variables. Three interesting findings are
listed in order.
First, the executive compensation has a positive rela-
tionship with earnings management and the coefficient is
statistically significant at 1% level in each model. This
result is on the opposite side of the hypothesis 1.
Second, the ownership concentration is positive sig-
nificantly in model 3 and 4 while not significantly in
model 2, which is different with the hypothesis 2. Thus,
as added in a multiplication cross item of executive
compensation and ownership concentration, the coeffi-
cient of the multiplication cross item is negative and ad-
verse to the sign of the coefficient of executive compen-
sation. And it is statistically significant at 1% level, same
as the hypothesis 3. This data result represents the con-
straint function of ownership concentration to executive
compensation on the level of earnings management.
Third, the board variables, such as number of the di-
rectors, proportion of independent directors, CEO duality,
Table 1. Descriptive statistics of dependent and independent
Variable Mean SD Min Max
DA –0.0259 0.1384 –0.7352 3.0349
sala_t3 13.6823 0.7865 11.1419 21.4206
h10 0.1688 0.1192 0.0023 0.7264
sala_t3 × h102.3068 1.6491 0.0310 10.5430
dua 0.1270 0.3331 0 1
n_d 9.3081 1.9482 1 18
id 0.3588 0.0500 0 0.6
size_a 21.6531 1.0932 18.8266 27.3463
leve 0.4997 0.1761 0.0182 0.9669
Table 2. Pearson and spearman correlation matrix.
DA sala_d3 h10 dua n_d id size_a leve
DA 1.0000 0.1934 0.0805 –0.0138 0.0281 0.0316 0.3336 0.2454
sala_t3 0.1559 1.0000 0.0449 –0.0143 0.1613 0.0147 0.4086 0.2892
h10 0.0446 0.0397 1.0000 –0.0525 –0.0068 –0.0182 0.1835 0.1621
dua –0.0070 –0.0211 –0.0615 1.0000 –0.1086 0.0628 –0.0903 0.0069
n_d 0.0149 0.1628 –0.0103 –0.1017 1.0000 –0.1819 0.2258 0.0182
id 0.0331 –0.0046 0.0041 0.0598 –0.1978 1.0000 0.0351 –0.0337
size_a 0.1981 0.3898 0.2520 –0.0972 0.2544 0.0186 1.0000 0.1317
leve 0.2842 0.1513 0.1021 –0.0002 –0.0223 –0.0001 0.0557 1.0000
Notes: the Pearson related coefficients are listed on the bottom left and the Spearman related coefficients are listed on the upper right.
Does Ownership Structure Affect the Motivation of Compensation Contract of Earnings Management? 355
—From China’s Data
Table 3. Regression results on earnings management for each model.
Model 1 Model 2 Model 3 Model 4
variable pred. sign coef. t_value coef. t_value coef. t_value coef. t_value
sala_t3 - 0.0150 3.62*** 0.0322 4.83*** 0.0315 4.59***
h10 - –0.0140 –0.54 1.4170 3.29*** 1.3327 2.98***
her_sa - –0.1035 –3.31*** –0.0979 –3.02***
id - 0.0401 0.64
n_d - –0.0024 –1.43
dua + 0.0012 0.13
size_a 0.0247 7.9*** 0.0294 9.9*** 0.0255 7.83*** 0.0267 7.85***
leve –0.0789 –4.43*** –0.0835 –4.69*** –0.0798 –4.47*** –0.0772 –4.20***
_cons –0.7278 –10.77*** –0.6180 –10.11*** –0.9779 –9.64*** –0.9866 –9.38***
F-value 40.05 35.28 26.33 16.10
R2 0.056 0.049 0.061 0.062
Adj-R2 0.055 0.048 0.059 0.059
Note: *, ** and *** indicate significance at 10%, 5% and 1% levels, respectively.
do not show statistically significant with earnings man-
agement in model 4. The hypothesis 4, 5 and 6 are not
passed the empirical test.
Among the two control variables, size_a and leve, are
positive and negative significant relationship with earn-
ings management at 1% level.
5. Sensitivity Test
From the above analysis, we find that the ownership
concentration has a significant constrain on compensa-
tion contract for earnings management. That is, the
stronger compensation motivation is, the higher level
earning management presents. With the constrain of the
ownership concentration, compensation contract shows a
indistinctively effect on the earning management.
For the sensitivity test, we use some alternative vari-
ables to see for the same sample data and same model if
we can get the same empirical results as the above. First,
for the executive compensation, we change the top 3
salary of chairman of board of directors or supervisors
or CEO to only top 3 managers, and only top3 board of
directors. Thus, we use these two variables to alternate
sala_t3, and we get the almost the same empirical re-
Second, we change the alternative variable for owner-
ship concentration from the top 10 stockholders (h10) to
the top 5 stockholders (h5). And the same significant
result and multiplication cross function show the con-
strain function of ownership concentration for executive
Then, even for the further proving, we use the sensitiv-
ity testrobust test in Stata 10.0to make if it still show
the same results as it illustrates as follows in Table 4.
6. Conclusions and Suggestion
This paper empirically studies the impacts of executive
compensation on earnings management and its constrain
by ownership. We find that some estimated effects of the
variables are consistent with theoretical predictions. In
particular, executive compensation has statistically sig-
nificant and positive effects on dealing accruals. This
emphasizes that the compensation contract is one of mo-
tivation of earnings management. The managers have
strong willing to make earnings management to improve
their compensation. While we still find that ownership
concentration could constrain the effects of compensa-
tion motivations on earnings management. It is owner-
ship concentration that constrains the compensation mo-
tivation on earnings management.
However, the corporate governance mechanisms, such
Table 4. Robust test for the regression models.
Model 3 Model 4
variable coef. t_value coef. t_value
sala_t3 0.0071582 1.73* 0.0076395 1.72*
h10 0.6354436 2.40*** 0.55208811.92**
sala_t3×h10 –0.0471493 –2.45*** –0.0417336–2.00**
dua 0.00161830.27
n_d –0.0027086–2.52***
id 0.02676860.66
size_a 0.023105 12.24*** 0.0251899 12.16***
leve 0.485133 21.04*** 0.4744188 19.36***
_cons –0.6800912–10.07
Copyright © 2011 SciRes. JSSM
Does Ownership Structure Affect the Motivation of Compensation Contract of Earnings Management?
—From China’s Data
as the board, do not affect the compensation motivation
on earnings management. And the board size, board in-
dependence and the CEO duality do not present signifi-
cantly effect on earnings management, which shows the
weakness of corporate governance in China’s listed firms.
The reason why board’s function is so weak may be for
the current situation and background of China’s stock
market. Recently, in most listed firms, the board govern-
ance is still not so effectively and the independence of
the board is not so significant, which weaken the board’s
influence on earnings management. The board govern-
ance regulation and system need to improve, not just on
paper, but on real practice. Thus, as a emerging market,
the Shanghai Securities Exchange named year 2009 is
“the corporate governance year for China’s listed firms”,
which enhance more effective measures on corporate
governance, especially board governance.
Our findings have valuable implications for both the
security regulators and listed companies in the emerging
market of China. It is known that many security regula-
tors in the world, including both the developed and de-
veloping countries, have recognized the serious problems
of earnings management. They have proposed various
ways, known as the best practice codes, to reduce earn-
ings management and improve a firm’s overall govern-
ance standard. It is our belief that our study sheds light
on the relative importance of various corporate govern-
ance practices about earnings management, and should
provide useful information for Chinese regulatory au-
thorities to design the best practice codes tailored to the
Chinese institutional background and current level of
emerging market development. In addition, it also pro-
vide useful guide for firms to design their corporate gov-
ernance mechanisms so that they can decrease earnings
management, and enhance their corporate governance
and improve the Chinese emerging market to develop
healthily, stably and harmoniously.
7. Acknowledgements
We are grateful to many members of the 2nd Financial
Risk & Corporate Finance Conference in Dalian Univer-
sity of Technology and the 8th International Conference
on Supply Chain Management and Information Systems
in Hong Kong Polytechnic University. Both authors ac-
knowledge financial support from National Natural Sci-
ence Foundation of China (71172136) and the Funda-
mental Research Funds for the Central Universities
(DUT10ZD107, DC10040208) and New Century Excel-
lent Talents in University (NCET -10-0281). We are re-
sponsible for all remaining errors.
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