Joseph Fan, TJ Wong, and Tianyu Zhang Asset Specificity, Accounting Quality and Family Succession

2 Broad Research Questions  Using the sample of family succession of 3 Asian economies (HK, Singapore and Taiwan), we test if change in control across generations affect accounting quality  Succession effect only  We test if degree of control by family and/or founder shapes its accounting quality  Interacting family control and succession effects

3 Motivation  Contrast with US firms that examine primarily entrepreneurial firms, we look at Asian family firms.  Prior research (Fan and Wong, 2002) finds that control concentration of Asian firms is associated with lower accounting quality (earnings-return relation)  Succession compares before and after periods, reduce endogeneity  This paper provides an possible explanation for why family control is associated with accounting quality -- asset specificity, which lies deeper than ownership and agency conflicts

4 Definition of Succession  Succession as an event in which a controlling owner/manager steps down from the top executive (usually chairman in Asia) positions  It is anticipated that sometimes it will be ambiguous about when a succession starts and ends. Typically succession is a process that takes time to complete  We track firms from 5 years before to 5 years after their chairman turnovers.  The event window is set by data availability

5 Succession and Accounting

6 1. Family firms and their accounting system  Accounting: The family’s and/or founder’s control in the company will lead to an insider access accounting system that relies heavily on private channels rather than external financial reporting, increasing its accounting opacity to the public.  Reduction in control leads to more external access accounting system

7 2. Specific Assets and Accounting  An important benefit of family ownership is to protect and capitalize on specific assets or non-transferable property rights (Alchian, 1965, 1969; Coase, 1937, 1960; Demsetz, 1964, 1967)  e.g. family reputation, a secret formula, business network and political connections or assets that generate amenity utilities  Specific assets are associated with opaque accounting  Opacity helps to protection networks and connection  Hard to account for specific assets and related transactions e.g. reputation is not capitalized and its impairment is not associated with drop in earnings

8 2. Specific Assets and Accounting  Many of these specific assets are not fully transferable, not even to one’s children  This disruption during family succession allows us to examine if the reduction in asset specificity is associated with increase in accounting quality around succession  Succession --> higher accounting quality  Interaction: Reduction in family / founder control, further increase in accounting quality

9 3. Predecessor’s Entrenchment  Founder or departing chairman tries to hang on to power  Asset specificity can be highly correlated with entrenchment (hard to separate)  Firm experiences poor performance prior to succession and tries to cover up  Firm performance and accounting quality improves after the succession

10 Measuring Accounting Quality  How to measure quality in literature?  Accruals (unsigned discretionary accruals) [Leuz et al.]  Timely loss recognition [Bushman et al.]  Earnings-return relations [Fan and Wong, 2002]

11 Discretionary Accruals Estimation  Modified Jones Model with contemporaneous ROA  Total Acc / TA = 1/TA + b1 (  Sales-  AR) / TA + b2 PPE / TA + e  NI = Total Acc + CF, so higher Total Acc, higher NI  Residual “e” is the unexpected change in accruals. Manipulated level  Unsigned discretionary accruals measure how much firms smooth earnings

12 Timely Loss Recognition  NI / MV = a + b1 Ret + b2 RD + b3 Ret x RD + e  Ret, net-of-market annual stock returns, proxies for economic earnings  RD, dummy = 1 when Ret < 0, 0 otherwise  Firms typical report bad news promptly, not good news (conditional conservatism), b3 > 0  For firms that are opaque (insider access system), b3 is less positive.  Insider system and less TLR  Bushman et al., countries with more SOEs tend to have less TLR  Ball et al. find that firms in code law countries have less TLR

13 Table 1 Sample

14 Table 1 Sample

15 Accounting quality before and after succession Question 1: We expect lower quality before and higher quality after

16 Table 3 Level of discretionary accruals --Univariate analysis

17 Table 3 Level of discretionary accruals --multivariate analysis

18 Table 4 Timely loss recognition Panel A: Descriptive statistics

19 Table 4 Timely loss recognition Panel B: Succession v.s. non-succession

20 Table 4 Timely loss recognition Panel C: Before v.s. after succession

21 Table 5 Earnings persistence

22 Family/Founder control and accounting quality Question 2: Family/founder control is associated bigger change in Discretionary Accruals and TLR before and after succession

23 Proxies for Family/Founder Control  Control concentration  Family ownership concentration  Voting and control rights divergence  Board control prior to succession  Family % control of board  Founder as predecessor  Family control after succession  Departing chairmen remains in management  Heir successor  Regulated and amenity industries (asset specificity)

24 Table 6 Change is DA

25 Table 7 Change in TLR

26 Asset specificity and accounting quality TLR and Discretionary Accruals prior to succession

27 Table 8 Discretionary accruals prior to succession

28 Table 9 TLR prior to succession

29 Need further analysis Entrenchment? Predecessor holding on to power, thus opaque accounting.  Low accounting quality prior to succession. No difference after succession.  Passing control to heir successor or chairman hangs on to power, there is improvement in accounting but mainly due to poorer accounting prior to succession and not superior accounting after succession.  However, no significant drop in earnings prior to succession. Also there is no earnings management or shifting.

30 Further analysis  Asset specificity  There is significant drop in stock returns but no significant drop in earnings  We don’t find significantly positive discretionary accruals prior to succession (earnings management to sustain positive earnings)  There is also lower TLR prior to succession, and the TLR is lower for firms with more family and/or founder control prior to succession and those that pass the control to an heir.  What explains the drop in share value?  Specific assets are more like unrecognized goodwill. Their impairment will be reflected in the share value but not in earnings.  At the succession, there is a dissipation in value of the specific assets, which is reflected in the negative stock returns but there is little drop in short term earnings.

31 Conclusion  Succession affects accounting quality  Family control and asset specificity measures matter.  Need to know more about combination of asset specificity, way of transfer of control and accounting properties

32 Future Directions  Entrepreneurial firms are becoming important in China  China now has about 300 firms ultimately controlled by an non-state entity  These firms, when cross-listed in HK, have many accounting scandals. Why?  What shapes their governance structure and financial reporting incentives?  How can their governance and accounting be improved in the future?