According to Berle and Means (1932), the separation of ownership and management in widely dispersed ownership firms commonly give rise to principal-agent conflicts. The misalignment of interest between agents and principals may create information asymmetry (Farrer and Ramsay 1998) whereby agents may withhold information and divert a firm’s resources for their own benefit, rather than the principals’ interests. Corporate governance mechanisms, such as corporate reporting and external auditing, may help reduce information asymmetry. However, managers’ opportunism of manipulating financial information may further increase information asymmetry, thus hindering shareholders’ ability to supervise and incentivise them effectively.
Agency theory suggests that monitoring by large owners or blockholders is an essential governance solution to the agency problem. It is more likely for blockholders to assume monitoring costs compared to the free-riding small shareholders, especially when the monitoring benefits exceed the monitoring costs and allow blockholders to recoup their investments (Gillan and Starks 2000, Shleifer and Vishny 1986). Notwithstanding, high ownership concentration of large shareholders helps align both majority and minority shareholders’ interests, because the wealth of the large shareholders is tied up with the firm. They therefore have more to lose if their decisions do not maximise firm value (Fan and Wong, 2002).
While the concentrated ownership structure can be effective in mitigating principal-agent conflict, it may, however, lead to principal-principal conflict. Principal-principal conflict refers to the conflict between controlling shareholders and minority shareholders, where
the controlling shareholders abuse their ownership control and expropriate the assets of minority shareholders. Misalignment of interest between large and minority shareholders often leads to wealth expropriation from the small investors’ wealth for private gain (Young and Ahlstrom, 2003). Information asymmetry and high costs of observing and verifying managers’ actions result in aggravating the principal-principal agency problem, which eventually results in weak corporate governance.
Family ownership is considered one of the major forms of concentrated ownership (La
Porta et al., 1999). There are two competing theories to explain how family ownership may
affect forced restatement; these are the alignment effect and the entrenchment effect (Wang 2006). On one hand, the alignment effect holds that family blockholders have the incentive to engage in more effective monitoring (Shleifer and Vishny, 1997) and are more inclined to report in good faith and preserve good reputation (Wang, 2006). As individuals who have developed their business from the ground-up, it is argued that family owners exhibit high confidence in their ability to run the business, and own great control over the business; this suggests that family blockholders are less likely to commit illicit behaviour
that could be harmful to the firm’s survival (Anderson et al., 2012). Family shareholders are
less likely to take up the short-term benefit of opportunistic reporting; this is based on their incentive to safeguard the family’s reputation and have their business passed on to future generations (Wang, 2006). Accordingly, family firms tend to report earnings faithfully to ensure long-term performance. Therefore, firms with family ownership are less likely to have forced restatement.
The entrenchment effect, on the other hand, holds that interest divergence and the existence of information asymmetry between family blockholders and minority shareholders provides them with the incentives to extract private benefits at the expense of the small investors. Fan and Wong (2002) contend that ownership concentration limits the flow of accounting information to the minority shareholders. The information asymmetry gives the opportunity for family members to be involved in the misstatement of accounting figures for personal benefit. Therefore, it is posited that firms with family ownership are more likely to have forced restatement.
Accordingly, findings from prior research have shown consistency with the expectation of
the alignment effect. For example, Wang (2006) and Ali et al. (2007) found that family firms
produce higher quality reported earnings relative to non-family firms. Martin et al. (2016)
potential damaging reputational consequences from such opportunistic practices. In the
context of a less developed market in Taiwan, Sue et al. (2013) documented that the
financial reporting quality of family firms and non-family firms shows no significant difference. However, when family firms are detected with financial irregularities, these inappropriate accounting practices would generally impact in more serious accounting
failure. The findings based on a study in Hong Kong by Filatotchev et al. (2011), however,
show consistency with the entrenchment effect, where family ownership and the high control over a firm’s board heighten the exploitation risk of private information. Family shareholders take the opportunity from firm opacity to exploit their dominant position to extract the wealth of the minority shareholders, which results in lower earnings quality. In Malaysia, the perspective of blockholding is specific as family firms are prevalent in the country. Relatively, family blockholders mainly hold a dominating interest in Malaysian
listed companies. For example, Claessens et al. (1999) examined 2,980 listed firms in nine
East Asian countries and found that 67.2 percent of the Malaysian firm sample was family owned. The highly concentrated family ownership among Malaysian firms can be dated back many years where, historically, the Chinese ethnic group dominated businesses in Malaysia, although the majority of 60 percent of the total population is accounted for by the Malay Bumiputra ethnic group (Johnson and Mitton, 2003). Therefore, many of the family firms are of Chinese origin. By nature, the Chinese family is high in collectivism where their business activities revolve closely around informal personal relationships. Based on this culture, Chinese families tend to pass their successful business to future
generations, thereby adopting a long-term investment approach in business (Ma et al.,
2016).
Accordingly, this study will examine the effect of family ownership on the likelihood of forced restatement. For the purpose of measuring family ownership, this study takes family
ownership per se. This is because family ownership in Malaysia is a highly insider
ownership. The World Bank (2001) reported that in half of Malaysian listed firms, the five largest shareholders owned an average of 60 percent of outstanding shares, and over 50 percent of voting shares. Malaysian family firms are heavily attached to the family for funding and employment (Jasni, 2002). The pervasive pyramidal ownership and cross- holding structure in Malaysia further leverage family blockholders’ control in the companies (Claeesens, 2002).
Consistent with Filatochev et al. (2011), Sue et al. (2013) and Hasnan et al. (2013), this study measures family ownership by using the proxy of a dummy variable equal to one if at least 20% of the firm’s equity is owned by the family members, and zero otherwise. Prior empirical research claims that ownership blocks as small as 20% are considered adequate
for the owner to exercise full control over a company (La Porta et al., 1999; Claessens et al.,
2000; Faccio et al., 2001; Faccio and Lang, 2002). High concentrated ownership and control via crossholdings and pyramiding are ubiquitous in Malaysia (Claessens et al., 2000; Faccio et al., 2001; Haniffa and Hudaib, 2006; Hasnan et al., 2013), which leverage the controlling power of family shareholders. La Porta et al. (1999) document that the probability of becoming a single controlling owner via the holding of only 20% of a company’s stock is really high (above 80%) in East Asian countries, as it was found that control can be attained with substantially lesser share ownership via pyramiding as well as cross-ownership structure. Some leading families are also politically well-connected, which gives them more power to exercise control over a firm (Rachagan and Kuppusamy 2013). Family blockholders, especially among the Chinese, are also found to be high in collectivism; this is manifested in their wide social networking and guilds linked within the business community (Lim, 1998), thus further intensifying family control in businesses. With the presence of a large family shareholding, the family blockholder has more incentive and capability to influence managers to divert firm resources for their own benefit at the expense of the minority investors, which leads to the likelihood for forced restatement to occur. Although a dummy variable is used to measure family ownership, a sensitivity test will be performed (as shown later in Chapter 6), where family ownership is measured in terms of the percentage of equity shareholdings held by family members from the top ten largest equity
shareholders (Hasnan et al., 2013)16.
Family firms in Malaysia are mainly family-controlled firms as the family members commonly hold important positions in the management team and on the board (Anderson
and Reeb, 2003; Wang, 2006; Hasnan et al., 2013). Having large shareholders holding
managerial positions enables them to exert influence and control over the firm. Two competing arguments arise on how family control may impact on forced restatement. First, family can readily align the interests of the firm with the family’s. It is argued that a controlling family tends to monitor managers’ actions more effectively (Shleifer and Vishny, 1997). A controlling owner would ensure that managers act in line with maximising
16
The sensitivity analysis of family ownership was done on the ten largest shareholders as many studies have found it to represent a large proportion of shares ownership (more than 50%) in Malaysian listed companies (see for example, Zulkafli et al., 2005; Tam and Tan, 2007;. Rachagan and Kuppusamy, 2013).
shareholders’ wealth, thus reducing the likelihood of forced restatement. Second, controlling family owners may encounter less severe principal-agent conflicts, but rather more severe principal-principal conflict, in relation to non-family firms (Sue et al., 2013). Bennedsen and Nielson (2010) argue that a controlling owner has no incentive to monitor managers, i.e., themselves. Thus, huge family control on the board does not improve monitoring efficiency. There is also the likelihood that only family members are appointed to hold a firm’s management position at the expense of hiring more talented outside professional managers, which may result in suboptimal decision making (Anderson and Reeb 2003). Firms with a controlling family may thus mask information to outsiders, especially minority investors, to enable the expropriation of larger assets for private benefit, thus increasing the likelihood of forced restatement.
Studies such as Chen (2005) have shown that controlling family owners were able to detect earnings manipulation very quickly, and that they do not rely too much on the firm’s
accounting-based performance measures to compensate managers. Ma et al. (2016)
further found that family control in Chinese family firms is less likely to misstate earnings. In this case, controlling owners help to minimise managerial opportunistic behaviour in financial reporting. The overall findings above support the view that the dominant power of controlling family owners over non-family management leads them to becoming effective
monitors. Contrarily, Filatotchev et al. (2011) provide evidence of negative effects that a
controlling family has on firm performance. They show that controlling families abuse private information at the expense of minority investors.
In addition to family ownership, this study will also examine the effect that family control has on the likelihood of forced restatement. In measuring family control over the firm, this
study uses four different proxies. First, is founder(s) on the board (e.g., Hasnan et al., 2013,
Sue et al., 2013, Ho and Kang, 2013). The influence of founders on the board facilitates in perpetuating a firm’s existing culture that tolerates opportunistic managerial behaviour (Agrawal and Chadha, 2005; Fich and Shivdasani 2007). As founders have been part of the business from the start, it is typical for them to have a strong emotional commitment and attachment to the firm. Due to such strong commitment, founders would safeguard the firm by doing almost anything, including shutting their eyes to opportunistic managerial
behaviour such as boosting earnings performance (Hasnan et al., 2013), thus increasing the
likelihood of income-decreasing forced restatement. Bennedson and Nielson (2010) found that in relation to non-family firms, family firms’ value is discounted almost five times
greater where the manager belongs to the family owners. Their finding suggests that family blockholders have no incentive to monitor, such that the increase in their power of control leads to the incentive for them to divert a firm’s resources for their own benefit.
Second, is founder CEO (e.g., Carcello et al., 2011, Ho and Kang, 2013). Dechow et al.
(1996) contend that founder CEOs tend to be less accountable to the firm’s board since they have high influence over business affairs and decision-making. A founder CEO has the power to control a firm regardless of the percentage of their shareholdings, leading to
expropriation of assets for their own benefit (Morck et al., 1988). They might even collude
with the management to inflate earnings in order to conceal their deviant behaviour and portray that their company is doing well. This would lead to the possibility of income- decreasing forced restatement.
Third, is CEO serving on the board’s nominating committee (e.g., Carcello et al., 2011). A
controlling owner often exerts huge influence over corporate affairs by using their power to
nominate family members to the board (Hansmann and Kraakman, 2001, Filatotchev et al.,
2005). When a CEO sits on the nominating committee, they are more inclined to appoint incompetent directors, more gray directors (e.g., having a family relationship) and fewer independent outside directors (Shivdasani and Yermack, 1999). The CEO uses their power to pick the board and appoint any directors he thinks suitable, especially among family members, to curb performance pressure. This provides opportunity for management to collude and engage in opportunistic behaviour, which includes producing false information, thus creating the likelihood for forced restatement.
Fourth, is CEO duality (e.g., Efendi et al., 2007, Baber et al., 2012, Lobo and Zhao, 2013).
Family owners may want to increase their managerial monitoring by holding a duality CEO- Chairman position on the board (Tam and Tan 2007). Being the figurehead of the company, the controlling family owner could concentrate better on management control and improve firm performance by virtue of their high power (Haniffa and Cooke, 2000). The duality position also gives power to the family to take control in ensuring timely and forceful intervention in cases of mismanagement or deterioration of a firm’s performance (Rachagan and Satkunasingam, 2009). However, CEO duality may give rise to conflict of interest between the board chairman (monitor) and the CEO (implementer of board’s decision). The CEO who serves as the board chairman may monitor and gain high influence over various firm-related matters such as board agendas, managerial compensation, and nomination of board members, although they might not formally be involved in serving on
the committees charged with the respective responsibilities (O’Connor et al., 2006). Such high influence may compromise a CEO’s integrity and their tendency to expropriate firm’s assets and misreport growth in earnings for private benefit, which eventually lead to the possibility for income-decreasing forced restatement to occur.
Whether the entrenchment or alignment effect dominates is an empirical issue; this study develops the hypothesis from the entrenchment view. The detrimental effect of the principal-principal agency problem on forced restatement may be larger in family firms relative to non-family firms, especially in Malaysia that has weak investor protection. The control that family blockholders have over firms can be leveraged through the use of cross- shareholdings and stock pyramid structures. It is thus expected that family ownership may pose a threat of intervention via family power of exerting pressure on the managers to report artificial favourable firm performance, which is detrimental to the small shareholders, hence the likelihood of income-decreasing forced restatement to occur. The following hypothesis is therefore posited:
H3: There is a positive relationship between the existence of a family blockholder and family control and the occurrence of forced financial restatement.