Understanding earnings quality - MIT Sloan School of Management

estatements follows directly from the prediction that internal controls lower intentional and
unintentional errors.
5.3.3 Managerial ownership
There are two competing theories about the incentives that managerial ownership provides
for accounting choices: an entrenchment effect (i.e., controlling shareholders extrapolate private
benefits at the expense of minority shareholders) and an incentive alignment effect (i.e., controlling
shareholders’ benefits are closely tied to firm value). These two effects predict different directions
for the association between ownership concentration and earnings quality. The evidence on which
effect dominates is mixed.
Two early studies find that management controlled firms are more likely to choose an
accounting method (e.g., the depreciation method) that increases reported earnings or smoothes
earnings than owner controlled firms (Smith, 1976; Dhaliwal, Salamon, and Smith, 1982), which
supports the entrenchment effect. Warfield, Wild, and Wild (1995) find that managerial ownership
is negatively related to the magnitude of discretionary accruals and is positively related to
informativeness of earnings. Wang (2006) documents identical results for founding family
ownership. Similarly, Gul, Chen, and Tsui (2003) document that managerial ownership has a
mitigating effect on the positive association between audit fees and discretionary accruals. These
results support the incentive alignment effect. In contrast, Larcker et al. (2007) find that insider
power, primarily measured by managerial ownership, is positively associated with discretionary
accruals and restatements. LaFond and Roychowdhury (2008) find a negative relation between
managerial ownership and asymmetric timeliness, which they characterize as supporting a demand
for conservatism to mitigate the potential entrenchment effect.
95