Melco Management Accounting Research
Discussion Paper Series
No.MDP2017-004
EARNINGS MANAGEMENT AND MAIN BANK MONITORINGMECHANISMS: EVIDENCE FROM JAPAN

April 2017
Hideaki Sakawa*
Associate Professor, Nagoya City University
Graduate School of Economics
1, Yamanohata, MIzuho-cho, Mizuho-ku, Nagoya-city, 467-8501, Japane-mail: sakawa@econ.nagoya-cu.ac.jp
Naoki Watanabe
Associate Professor, Nagoya City University
Graduate School of Economics
Akihiro Yamada
Associate Professor, Chuo University
Faculty of Commerce*Corresponding author

The Melco Foundation
Nagoya, Japan
Discussion Paper Series of the Melco Management Accounting Research, in order to promote
the study of management accounting, has published this unfinished paper onto the Web. Pleaseobtain the permission of the author when citing this paper.

EARNINGS MANAGEMENT AND MAIN BANK MONITORINGMECHANISMS: EVIDENCE FROM JAPAN 
Hideaki Sakawa
Naoki Watanabe
Akihiro Yamada
ABSTRACT
From the point of view of the agency problem, some monitoring mechanisms are
represented as shareholders and the other stakeholders as lenders. The features of monitoringmechanisms differ across countries. In countries with dispersed ownership structures, such as theUS, the largest block shareholders play a monitoring role to prevent opportunistic earnings
management. On the other hand, Japan is one of the largest countries that have concentrated andlong-term ownership structures, which differ from in Anglo-Saxon countries. There remains anempirical question about the relationship between Japanese corporate governance and theprevention of managerial opportunistic behavior. The effectiveness of monitoring roles has been
criticized in light of corporate governance failures in the country, but few studies have investigatedwhether or not main banks are effective monitors for earnings management. This study
investigates whether or not main bank systems are effective for mitigating client firms’ earnings
management behavior in Japan. Although Japanese traditional corporate governance mechanisms
are known as relational or bank-dominated systems, foreign ownership in the country has
increased since 1990s. In the period of transition to corporate governance, there remains thequestion of who is a gatekeeper for effectively decreasing opportunistic earnings management inJapan. We find that earnings management in firms with main bank relationships tend to be
mitigated, compared with firms without such relationships. In addition, foreign shareholdings
effectively help mitigate earnings management. This implies that main bank systems function as
effective gatekeepers under bank-dominated systems and can effectively substitute for block
shareholdings in the Anglo-Saxon system, that is, the system in countries with dispersedownership structures.

*We would like to thank Sudipta Basu, Masahiro Ida, Kiyohiko Ito, and Crystal Xiaoqiong Wang for theirinsightful comments. This research was financially supported by the Japan Ministry of Education, Culture, Sports,
Science and Technology, Grants-in-Aid for Young Scientists (B), Grant-in-Aid for research from Nagoya City University,and research grants from Melco Foundation.


Corresponding author. Telephone number: +81-52-872-5724, Fax number: +81-52-872-5724, E-mail address:

sakawa@econ.nagoya-cu.ac.jp (H. Sakawa)1

Keywords: Earnings management, Main bank monitoring, Transition, Corporate
governance, Foreign Shareholders

1 INTRODUCTION
Corporate governance refers to important mechanisms that influence the management
decision making of firms in which ownership and management are separate. From the point ofview of ownership differences in the agency problem (Jensen & Meckling, 1976), somemonitoring mechanisms are represented as shareholders and the other stakeholders as lenders. The
features of monitoring mechanisms differ across countries (e.g., La Porta, Lopez-de-Silanes, &Vishny, 1999). In countries with dispersed ownership structures, such as the United States, thelargest block shareholders play a monitoring role to prevent opportunistic earnings management(Hadani, Goranova, & Khan, 2011)1. In countries where firms have concentrated ownership,large-block shareholdings of one shareholder can be used to exploit other shareholders (La Porta,
Lopez-de-Silanes, Shleifer, & Vishny, 1998; 2000; La Porta et al., 1999; Shleifer & Vishny, 1997).
Therefore, the monitoring of block shareholders is not expected in countries with concentrated
ownership structures, unlike in countries where firms have dispersed ownership structures.
Previous studies imply that opportunistic earnings management would not be fully
prevented either by monitoring by large block shareholders or by commercial banks. Theoreticalstudies like those of Diamond (1984) and Fama (1985) show that banks perform monitoring at
lower costs because they are delegated monitors and have information advantages. In general, theopportunistic behavior of client firms directly worsens a bank’s financial health. Therefore,monitoring is the most distinctive and important activity for banks (Freixas & Rochet, 1997). The
association between ownership structure and earnings management differs from corporate
governance mechanisms (Garcia & Ballesta, 2009). Particularly for East Asia, Fan and Wong
(2002) point out that the conflicts between concentrated shareholders and minority shareholders
are associated with low protection of investors’ rights.
Based on the work of Leuz, Nanda, and Wysocki (2003), the following three distinct
country clusters are defined: (1) outsider economies with strong legal enforcement, like the UnitedStates; (2) insider economies with strong legal enforcement, like Japan; and (3) insider economies
with weak legal enforcement, like India. In countries with dispersed ownership structures or inoutsider economies with strong legal enforcement, such as the United States, the stronger the bankmonitoring of a firm’s earnings management, the more effective the monitoring is (Ahn & Choi,2009). On the other hand, Jha, Shankar, and Prakash (2015) show that the monitoring role ofprivate banks does not help mitigate earnings management in India. Therefore, studies haveproduced mixed evidence related to the effectiveness of bank monitoring.
Japan is one of the largest countries that have concentrated and long-term ownership
structures, which differs from those in Anglo-Saxon countries. In the 1990s, the Japanese2relationship-oriented corporate governance system, like main bank shareholdings, had been
regarded as one that functions well (Aoki, 1990; Aoki, Patrick, & Sheard, 1994; Sheard, 1994).
Japanese main bank systems are also known to delegate the role of monitoring for othercreditors and shareholders (Aoki et al., 1994; Morck & Nakamura, 1999). In fact, banks andcorporate shareholders play the important role of a disciplinary mechanism (Kaplan & Minton,1994), and main banks play the role of forcing turnover at firms with poor performance, likesignificant lost profits (Kang & Shivdasani, 1995). Therefore, their long-term shareholdings mightprovide an incentive for effective monitoring.
The Japanese corporate ownership structure after the financial deregulation period ischaracterized by an increase of foreign shareholdings, and this increase of foreign shareholdings isalso significant after the 1990s. Foreign shareholders typically have short-term investment
horizons (Uno & Kamiyama, 2010), and their interests are based on trade profits2. For the sake ofshort-term trading profits, they are expected to be less active in their monitoring activity ofdecreasing opportunistic earnings management.
There remains the empirical question about the relationship between Japanese corporate
governance and prevention of managerial opportunistic behavior. The effectiveness of monitoringroles has not been fully examined in Japan after the 1990s, despite having been criticized in light ofcorporate governance failures in the country. In fact, Plender (2007) raised questions about theeffectiveness of Japanese corporate governance. In addition, the recent corporate scandal involving
Olympus Corp. has been described by a former chief executive, Michael Wood (Soble, 2011), as a
typical case of false reporting induced by opportunistic earnings management in Japan in the 2000s.
However, few studies have investigated whether or not main banks are effective monitors forearnings management. In this study, we investigate whether or not bank-dominated governancesystems moderate earnings management as effective monitoring mechanisms in Japan.
The results of our study are summarized as follows. First, we find that main bankmonitoring activities are effective for preventing opportunistic earnings management. This finding
implies that main bank systems play an important monitoring role in financial reporting under theJapanese-bank dominated corporate governance system. Second, foreign shareholdings are notassociated with earnings management. These results suggest that Japanese bank-dominatedcorporate governance plays the important monitoring role of mitigating earnings management.
The rest of our paper is organized as follows. In Section 2, we provide a background ofJapanese corporate governance. In section 3, we construct our empirical hypotheses, and in Section
4, we explain our empirical strategies and data. In section 5, we present our empirical results, andin Section 6, we summarize and discuss the findings.

3

2 BACKGROUND OF JAPANESE CORPORATE GOVERNANCE
SYSTEM
The Japanese corporate governance system is regarded as being in a transitional period. Its
traditional corporate governance is a bank-centered and relationship-oriented system, different
from a market-oriented system such as that in the United States. Until the early 1990s, traditional
Japanese firms were characterized by their highly concentrated patterns of long-term ownership,such as having a main bank and adopting the keiretsu system (Aoki, 1990). A main bank acts as
the largest lender and shareholder for the client firm3. Like the keiretsu system, stable crossshareholdings are a feature of traditional Japanese corporate governance. Stable shareholdings inJapan are similar to those in other East Asian countries (Claessens, Djankov, & Lang, 2000).
After the financial deregulation, commercial banks were limited in their use of crossshareholding by the Banks’ Shareholding Restriction Law (Hoshi & Kashyap, 2010). Miyajima
and Kuroki (2007) report that cross shareholdings have decreased since 1997, and the Japanesefinancial deregulation is expected to restrict main bank shareholdings to less than 5%, which
would weaken main bank monitoring. The Japanese ownership structure is not characterized as
family controlled, as in most East Asian countries. Rather, they are controlled by the mutual
relationships and main bank shareholdings and cross shareholdings (Morck & Nakamura, 2005).
Because of these characteristics, short-term shareholders, such as foreign shareholders, haveincreased (Ahmadjian & Robbins, 2005), which implies a weakening of Japanese corporate
governance in the 2000s because the traditional main bank systems and keiretsu system might
have weakened.
Furthermore, audit quality is important for precise financial reporting. Audit quality also
depends on the audit firm size (Becker, DeFond, Jiambalvo, & Subramanyam, 1998; Francis,
Maydew, & Sparks, 1999). Large Japanese audit firms were restructured after the Kanebo Co.
earnings fraud case in 2005. In this fraud case, external auditors from Chuo-Aoyama PWC, one of
the Big 4 audit firms, were accomplices in falsifying accounting reports (Sanchanta, 2006)4.
However, even after the restructuring of the large audit firms, there remains the question ofwhether or not the audit quality of these large audit firms (i.e., Big N, or firms belonging to the Big
4 or Big 5) in Japan has improved. The recent corporate scandal of Olympus Corp. symbolizes thelack of internal controls in Japanese firms and raises doubts about whether or not even audit firms
with sterling reputations can be effective gatekeepers5. In that sense, there remains the importanttask of revealing who is a gatekeeper for effectively decreasing opportunistic earnings
management in Japan.

4

3 HYPOTHESES DEVELOPMENT
In this section, we describe the construction of two hypotheses about the relationshipbetween Japanese ownership structure and earnings management. Japanese corporate governancehas been in a transitional mode since after the 2000s when the financial deregulation was
implemented, and unstable shareholders, as represented by foreign shareholders, are expected toincrease. Therefore, we construct the hypotheses based on, respectively, traditional and recentchanges in Japanese corporate governance mechanisms.
Aoki et al. (1994) emphasize that main bank monitoring roles are a function of client firms
connected by their relationships with their main banks. Regarding bank-centered economies, mainbank ties present benefits for client firms because main banks appoint directors for client firms
when they are in a bad condition (Sheard, 1994). In addition, main banks tend to hold states in theclient firms as stable shareholders (Prowse, 1990). Main bank shareholdings have functioned as
effective monitors in Japan in the 1990s (Hiraki, Inoue, Ito, Kuroki, & Masuda, 2003; Morck &Nakamura, 1999; Morck, Nakamura, & Shivdasani, 2000)6. Japanese banks help provide positive
incentives for executives in firms with bank relationships (Colpan & Yoshikawa, 2012; Sakawa &Watanabel, 2008). As Goto and Uchida (2012) mention, main banks have played an effective
monitoring role in Japan since after the 2000s. Therefore, we construct the following hypothesis:
Hypothesis 1: Greater main bank shareholdings are associated with less earnings
management, proxied by discretionary accruals (DA).
Foreign shareholders increased rapidly during the 2000s. Regarding investment strategies,
Lang and McNichols (1997) point out that short-horizon investors trade more frequently for thesake of lower transaction costs. Uno and Kamiyama (2010) find that the investment horizon offoreign shareholders is less than a year. Shorter-term shareholders might not be interested inpreventing earnings management because they are more concerned about short-term profits.
However, foreign shareholdings might actively monitor to mitigate opportunistic earnings
management. In Japan, foreign shareholdings put pressure to disclosure in order to increase theirprofit and the firm’s market liquidity. (Sakawa, Ubukata, & Watanabel, 2014). In addition, foreign
investors seek profitability when the corporations diversify and their styles differ from those ofdomestic shareholders (David, O’Brien, Yoshikawa, & Delios, 2010). These findings suggest theactive monitoring by shareholders, such foreign shareholders. However, this previous evidence has
not determined whether or not foreign shareholdings effectively perform their monitoring function.
In the following hypothesis, we assume the effective monitoring of foreign shareholdings.
Hypothesis 2: Greater foreign shareholdings are associated with less earnings
management, proxied by discretionary accruals (DA).

5

4 EMPIRICAL STRATEGIES AND DATA
4.1 Empirical Strategies
Japanese corporate governance is a bank-centered and relationship-oriented system thatdiffers from the market-oriented system in the United States. After the 2000s, Japanese corporate
governance has been adopted as a feature of Anglo-Saxon-type corporate governance mechanisms.
After introducing earnings management metrics, we describe the construction of a model
examining the association between earnings management and corporate governance mechanisms.
In particular, we examine the relationship between earnings management and corporate
governance in Japan.
In this study, we use discretionary accruals as a proxy of earnings management, consistent
with previous studies (Bartov, Mohanram, & Seethamraju, 2001; Klein, 2002; Warfield, Wild, &Wild, 1995). We adopt the absolute value of discretionary accruals because managers adjust theearnings report upward or downward using positive or negative accruals, respectively. According
to the Jones and cross-sectional modified Jones models, discretionary accruals (DA) are calculated
as in equation (1), which represents a difference between total accruals (TA) and nondiscretionary
accruals (NDA), divided by total assets for the beginning period. The total accruals (TA) are thedifference between net income and cash flows from operations.

The total accruals (TA) are calculated as in the Jones and cross-sectional modified Jonesmodels (Dechow, Sloan, & Sweeney, 1995; Jones, 1991). Assets (A) denotes total assets for firm iin the year t. Each of the models is estimated using equation (2), and each model’s
non-discretionary accruals (NDA) are estimated separately using both equations (3) and (4).
＋

＋

＋

＋

In these equations, TA stands for total accruals, measured as the difference between net
income (earnings before extraordinary items and discontinued operations) and operating cash
flows for firm i in the year t; ΔREV signifies change in net revenue for firm i in the year t; ΔAR isthe change in accounts receivable for firm i in the year t; PPE represents property, plant, and6equipment for firm i in the year t; and εit represents error terms for firm i in the year t. A previous
study of Japanese companies by Darrough, Pourjalali, and Saudagaran (1998) do not use either the
Jones or modified Jones model because of limitations in the historical data. Therefore, we adopt
and extend these models from the previous studies on Japan. The model is estimated separately foreach Nikkei industry three-digit code and year to obtain industry-specific estimates of thecoefficients, following Teshima and Shuto (2008). The change in accounts receivable (ΔAR) is notincluded in estimating the parameters of TA in equation (2), but it is included in the estimation of
non-discretionary accruals (NDA) in equation (4).
The increases of transient shareholders, such as foreign shareholders, tend to be significant
for our sample period. These gradual changes in Japanese corporate governance have influenced
earnings management. We examine the following ordinary least squares (OLS) regression
equation.
＋In this equation, |DA| stands for the absolute value of discretionary accruals (DA) using theJones and modified Jones models.
We include two ownership variables to analyze the two empirical hypotheses. We define themain bank as the largest lender of the clients (Aoki et al., 1994). Therefore, Main Bank
Shareholdings represents the proportion of the largest lender’s shareholdings, following Morck etal. (2000). Foreign shareholdings is defined as the proportion of large foreign investors that own
more than 5 percent7.
The control variables are selected as in previous studies. Cross shareholdings is equal to the
proportion of cross shareholdings. Japanese business groups, or Keiretsu, are known as a major
entity in cross shareholdings. These cross shareholdings are a kind of “mutual insurance” thatprevents hostile takeovers (Dow & McGuire, 2009). Management Shareholdings means the
proportion of the board of directors’ shareholdings, following Morck et al. (2000) and Teshima andShuto (2008). Top 10 Ownership is adopted to control for ownership concentration. R&D Intensity
is measured by the ratio of annual R&D expenditure to sales. We adopt stock return volatility(Volatility) to control for firm risk, as well as M&A and Big N dummy variables. M&A Dummy isequal to 1 if a firm experiences M&A activity and is 0 otherwise, and Big N is equal to 1 if a firm isaudited by a Big 4 or Big 5 audit firm and is 0 otherwise. We control for growth as amarket-to-book ratio (MTB) because growing firms are more likely to be associated with earnings
management (Matsumoto, 2002). Firm size is controlled for by the logarithm of market value(MV), and firm profit by return on assets (ROA). We also adopt a negative profit dummy variable(Negative Profit) that is equal to 1 if return on assets (ROA) is negative and is 0 otherwise. We also
7

include financial leverage (Leverage) to control for correlation with discretionary accruals(DeFond & Jiambalvo, 1994; Frankel, Johnson, & Nelson, 2002), and executive stock optioncompensation (Stock Option) (Sakawa, Moriyama, & Watanabel, 2012) to control for long-term
incentives. Finally, we also use directors’ compensation (Director Compensation) as a control
variable, following Teshima and Shuto (2008).
We also control for several bank characteristic variables following Ahn and Choi (2009).
The deposit relationships are controlled by cash balance, defined as the ratio of cash and deposits
to total assets. This ratio is predicted to have aearnings management because banks with stronger
deposit relationships have more discernible information. Collateral loan might also be related tobank monitoring, and we control for collateral loan with a dummy variable that is equal to 1 if
firms have collateral debt and is 0 otherwise. We also control for loan type using transactional debt
ratio, which is calculated as the ratio of transactional debt, consistent with David, O’Brien, andYoshikawa (2008), and is related to bank monitoring activity. Finally, we control for refinance risk
using debt term, which is defined as the ratio of short-term debt. Barclay and Smith (1995) statethat firms with low refinance risk are likely to issue short-term debt. Thus, firms with lower debt
terms are predicted to face higher refinance risk and are monitored by banks, consistent with Ahn
and Choi (2009).
4.2 Data and Descriptive Statistics
We select the data from nonfinancial firms listed in the first section of the Tokyo Stock
Exchange during 2006–20108. The financial accounting data are collected from the Nikkei Needs
Corporate database, and the corporate governance data, including stock ownership and board
composition, are obtained from the Nikkei Needs Corporate Governance Evaluation System(CGES) database. The audit firms’ information is hand-collected by Toyo Keizai (2006–2010).
The Big N audit firms consist of Big 4 or Big 5 audit firms during our sample period9. Our selected
sample consists of 6,134 firm–year observations10.

8

Table 1. Summary Statistics
Variable
Dependent Variables
Jones DA
Modified Jones DA
Performance-matched
Jones DA ROAt
Performance-matched
Modified Jones DA ROAt

N

Mean

Median

S.D.

5%

95%

6134
6134
6134

0.039
0.039
0.056

0.027
0.027
0.039

0.048
0.048
0.064

0.002
0.002
0.003

0.111
0.111
0.163

6134

0.056

0.039

0.064

0.004

0.162

Ownership Structure
Main Bank Shareholdings
Foreign Shareholdings
Cross Shareholdings
Management Shareholdings
Top 10 Ownership

6134
6134
6134
6134
6134

1.206
1.665
9.330
3.372
47.217

0.000
0.000
7.580
0.394
44.835

1.773
5.684
8.659
7.227
13.880

0.000
0.000
0.000
0.029
27.7004.770
10.53026.55018.38472.480

Other Variables
R&D Intensity
Volatility
M&A Dummy
Big N
Market to Book
ROA
Negative Profitln (MV)
Leverage
Stock Option
Director Compensation
Cash Balance
Collateral
Transaction Debt
Debt Term

6134
6134
6134
6134
6134
6134
6134
6134
6134
6134
6134
6134
6134
6134
6134

0.037
2.434
0.015
0.821
1.386
5.381
0.100
10.98851.716
0.347
281.3
0.122
0.370
0.114
0.522

0.016
2.325
0.000
1.000
1.080
4.436
0.000
10.77052.560
0.000
208.0
0.100
0.000
0.000
0.508

0.070
0.780
0.120
0.383
1.210
6.075
0.300
1.583
19.709
0.476
280.3
0.091
0.483
0.202
0.309

0.000
1.397
0.000
0.000
0.433
-2.2900.000
8.747
18.340
0.000
65.0
0.021
0.000
0.000
0.000

0.141
3.840
0.000
1.000
3.212
15.241
1.000
13.91182.400
1.000
725.0
0.299
1.000
0.583
1.000

Note: The variables are defined in Appendix A.
Table 1 presents the descriptive statistics. The mean of the absolute value of discretionary
accruals (DA) using the Jones and modified Jones models are about 4% of total assets. The averageof Main Bank Shareholdings is about 1.2%, which means that these banks’ stakes are smaller. This
lower degree of ownership might be the result of the financial deregulation, which restricts bankownership to less than 5%. The average of Foreign Shareholdings is about 1.7%, which is larger
than the main bank shareholdings. The mean of Cross Shareholdings is about 9%, which implies
that traditional cross shareholdings are maintained. The average of Management Shareholdings
9and Top 10 Ownership are about 3.4% and 47%, respectively. As for the other characteristics of thesample firms, Big N accounts for 82% of the firms on average, which implies that most firms
employ large audit firms with good reputations. The average of the market-to-book ratio (MTB) is
about 1.4. Stock Options have been introduced at about 35% of the firms, which implies that morethan one-third of executives have long-term incentives. The descriptive statistics of the bankcharacteristic variables are summarized as follows. The average of cash balance is about 0.122.
The mean of collateral is about 0.37, smaller than that reported for the United States by Ahn andChoi (2009). Transactional debt occupies about 0.114, which is similar to the evidence forJapanese firms in the early 2000s by David et al. (2008). The average of debt term is about 0.552.

5 EMPRICAL RESULTS
5.1 OLS Results
Our OLS results for equation (5) are presented and interpreted in this subsection. Using the
OLS results, we investigate the adequacy of our two hypotheses about the relationship between
corporate governance structure and earnings management. We first report the OLS results forequation (5) in Table 2, which shows that Main Bank Shareholdings is negatively associated withearnings management, consistent with H1. Main bank shareholdings are effective for preventing
managerial opportunistic earnings management, which implies that after the financial deregulation,
main bank shareholdings have remained effective in restricting bank stakes. In contrast, we could
not obtain significant results for foreign shareholdings, inconsistent with H2.

10

Table 2. Estimated Results (OLS)(1)
Cash
Balance
Main Bank Shareholding
Foreign Shareholdings
Cross Shareholdings
Management Shareholdings
Top 10 Ownership
R&D Intensity
Volatility
M&A Dummy
Big N
Market to Book
ROA
Negative Profitln (MV)
Leverage
Stock Option
Director Compensation
Cash Balance-0.001 **(-2.80)0.000(1.09)
0.000 ***(-5.32)0.000(1.04)
0.000 *
(2.54)-0.006(-0.43)0.012 ***
(6.43)
0.014 **
(2.62)-0.003 +(-1.76)0.003 **
(2.77)
0.000(-0.65)0.009 **
(2.64)-0.001 +(-1.69)0.000 +
(1.94)
0.004 *
(2.25)
0.000(-0.68)0.017(1.39)

Collateral Ratio

(2)

(3)
Modified Jones DA
Collateral
Transaction
Debt

(4)

(5)

Debt
Term

Full

(6)
Jones DA
Full

-0.001 **(-2.74)0.000(1.13)
0.000 ***(-5.66)0.000(1.34)
0.000 *
(2.29)-0.005(-0.33)0.013 ***
(6.88)
0.015 **
(2.68)-0.003 +(-1.82)0.003 **
(2.85)
0.000(-0.48)0.010 **
(2.88)-0.001 +(-1.85)0.000 *
(2.15)
0.004 *
(2.39)
0.000(-0.61)-0.001 **(-2.75)0.000(1.10)
0.000 ***(-5.82)0.000(1.22)
0.000 *
(2.43)-0.005(-0.32)0.013 ***
(6.72)
0.014 **
(2.67)-0.003 +(-1.83)0.004 **
(2.93)
0.000(-0.49)0.009 **
(2.85)-0.002 *(-2.10)0.000(1.50)
0.004 *
(2.37)
0.000(-0.57)-0.001 *(-2.58)0.000(1.09)
0.000 ***(-5.20)0.000(1.14)
0.000 *
(2.33)-0.005(-0.34)0.013 ***
(6.48)
0.014 **
(2.68)-0.003 +(-1.87)0.003 **
(2.69)
0.000(-0.53)0.009 **
(2.66)-0.001 +(-1.75)0.000 *
(2.40)
0.004 *
(2.29)
0.000(-0.64)0.015(1.21)-0.004 *(-2.54)0.002(0.55)-0.004 +(-1.66)0.007(0.65)
6134
0.096
12.03 ***

-0.001 **(-2.70)0.000(1.10)
0.000 ***(-5.25)0.000(1.10)
0.000 *
(2.20)-0.008(-0.54)0.013 ***
(6.42)
0.013 **
(2.70)-0.003 +(-1.94)0.003 **
(3.18)
0.000(-0.84)0.008 *
(2.37)-0.002 +(-1.93)0.000 *
(2.34)
0.004 *
(2.49)
0.000(-0.60)0.015(1.22)-0.005 *(-2.57)0.002(0.71)-0.004 +(-1.80)0.010(0.88)
6134
0.097
12.60 ***

-0.001 **(-2.83)0.000(1.12)
0.000 ***(-5.82)0.000(1.20)
0.000 *
(2.55)-0.006(-0.41)0.013 ***
(6.74)
0.014 **
(2.63)-0.003 +(-1.77)0.004 **
(2.95)
0.000(-0.46)0.009 **
(2.86)-0.002 *(-2.08)0.000(1.48)
0.004 *
(2.37)
0.000(-0.60)-0.005 **(-2.65)

Transaction Debt

0.003
(1.00)

Debt Term
Constant
Num. obs.
Adjusted R -squared
F Test0.003(0.24)
6134
0.095
11.53 ***

0.008
(0.82)
6134
0.095
12.21 ***

0.009
(0.88)
6134
0.094
11.01 ***

-0.004 +(-1.88)0.012(1.15)
6134
0.095
10.80 ***

Notes: The dependent variables are the modified Jones discretionary accruals (DA) in
Models (1)-(5) and Jones discretionary accruals (DA) in Model (6). The standard errors are11

two-way clusters with t-values shown in parentheses. The robust t-statistics are shown inparentheses. +, *, **, and *** indicate that the estimates are significant at 10%, 5%, 1%, and 0.1%,
respectively.
The results for the control variables are summarized as follows. Cross Shareholdings
also has a negative and significant relationship with earnings management, and Top 10 Ownershipis significant and positive at 5% for the sample firms. The variables Volatility and M&A Dummy
are significant and positive, and Big N is not significant at 5%. Market to Book is positively
associated with earnings management, suggesting that earnings management is greater for firms
with high growth opportunities, consistent with Matsumoto (2002). ROA is not significant, but
Negative Profit is significant and positive. ln(MV) is not significant at 5%. Stock Option ispositively associated with earnings management, which contradicts our prediction. Finally,
Collateral is significantly negative, inconsistent with Ahn and Choi (2009).

12

Table 3. Additional Estimated Result(1)
MatchedDA ROA(t)Main Bank Shareholding
Foreign Shareholdings
Cross Shareholdings
Management Shareholdings
Top 10 Ownership
R&D Intensity
Volatility
M&A Dummy
Big N
Market to Book
ROA
Negative Profitln (MV)
Leverage
Stock Option
Director Compensation
Cash Balance
Collateral Ratio
Transaction Debt
Debt Term
Constant
Num. obs.
Adjusted R -squared
F Test-0.001 *(-2.18)0.000(1.19)
0.000 ***(-3.68)0.000(1.59)
0.000 *
(2.05)-0.018(-0.93)0.012 ***
(5.27)
0.009(1.23)-0.004 *(-2.17)0.004 **
(3.05)
0.000(-0.66)0.015 **
(2.99)-0.001(-0.89)0.000(0.90)
0.003 +
(1.86)
0.000(-0.83)0.031 *
(2.36)-0.003(-1.20)0.002(0.58)-0.001(-0.32)0.016(1.13)
6134
0.063
7.59 ***(2)
Matched Modified
DA ROA(t)-0.001 *(-2.02)0.000(1.15)
0.000 ***(-3.95)0.000(1.55)
0.000 *
(2.05)-0.016(-0.89)0.012 ***
(5.21)
0.012(1.43)-0.004 *(-2.32)0.004 **
(2.75)
0.000(-0.40)0.015 **
(3.09)-0.001(-0.79)0.000(0.90)
0.003(1.63)
0.000(-0.82)0.031 *
(2.33)-0.003(-1.10)0.002(0.38)-0.001(-0.22)0.015(1.10)
6134
0.061
7.38 ***

Notes: The variables are defined in Appendix A. The dependent variables are the Jones model’s
performance-matched discretionary accruals (DA) with the current ROA in Model (1) andmodified Jones model’s performance-matched discretionary accruals (DA) with the current ROA
in Model (2). The standard errors are two-way clusters, with the t-values shown in parentheses.
13The robust t-statistics are shown in parentheses. +, *, **, and *** indicate that the estimates are
significant at 10%, 5%, 1%, and 0.1%, respectively.
To check the robustness of the results, we also estimate the Jones model’s
performance-matched discretionary accruals with the current ROA following Kothari, Leone, andWasley (2005)11. According to the estimated results shown in Table 3, Main Bank Shareholdings
is significantly negative, consistent with H1. Furthermore, Foreign shareholdings is not significant,inconsistent with H2, and Cross shareholdings is significant and negative. These results support
the robustness of the OLS results using performance-matched discretionary accruals.
5.2 Simultaneous Equations
We also consider endogeneity, an ownership variable, and earnings management. In
particular, we investigate the possible endogenous relationships between monitoring activity andearnings management. To explore the endogenous relationship between main bank monitoring,cross shareholdings, foreign shareholdings, and earnings management, we use two-stage
least-squares (2SLS) regression. We estimate four models to check the robustness of the results inTable 4. We adopt instrumental variables, namely the lagged variables of main bank monitoring,cross shareholdings, foreign shareholdings, and a dummy variable for American depositary receipt(ADR)12.

14

Table 4. Estimated Results (2SLS)(1)DA

Main Bank Shareholding
Foreign Shareholdings
Cross Shareholdings
Management Shareholdings
Top 10 Ownership
R&D Intensity
Volatility
M&A Dummy
Big N
Market to Book
ROA
Negative Profitln (MV)
Leverage
Stock Option
Director Compensation
Cash Balance
Collateral Ratio
Transaction Debt
Debt Term
Constant
Num. obs.
Adjusted R -squared
F TestHansen J Test

(2)
Modified DA(3)
MatchedDA ROA(t)(4)
Matched Modified
DA ROA(t)-0.001 *(-2.48)0.000(0.81)
0.000 ***(-5.18)0.000(0.39)
0.000 *
(2.37)
0.001(0.12)
0.011 ***
(6.02)
0.008(1.56)-0.003 +(-1.69)0.005 ***
(3.76)
0.000(-0.42)0.008 **
(2.97)-0.002 *(-2.31)0.000 +
(1.66)
0.004 *
(2.42)
0.000 +(-1.75)0.018 +
(1.69)-0.004 *(-2.10)0.005(1.32)-0.002(-0.94)0.013(1.24)
4768
0.087
10.54 ***
1.671

-0.001 *(-2.15)0.000(1.06)
0.000 ***(-3.39)0.000(1.48)
0.000(1.57)-0.013(-0.87)0.010 ***
(4.79)
0.005(0.59)-0.004(-1.57)0.006 ***
(3.71)
0.000(-0.83)0.015 ***
(3.70)-0.001(-1.32)0.000(0.65)
0.004 *
(2.14)
0.000(-0.67)0.039 **
(2.77)-0.002(-0.91)0.004(0.78)
0.002(0.72)
0.022(1.55)
4768
0.058
8.17 ***
0.558-0.001 *(-2.08)0.000(1.01)
0.000 ***(-3.55)0.000(1.42)
0.000(1.57)-0.012(-0.87)0.010 ***
(4.76)
0.006(0.70)-0.004 +(-1.68)0.006 ***
(3.61)
0.000(-0.65)0.015 ***
(3.82)-0.001(-1.31)0.000(0.60)
0.004 *
(1.98)
0.000(-0.62)0.040 **
(2.82)-0.002(-0.77)0.004(0.75)
0.003(0.86)
0.022(1.58)
4768
0.057
8.23 ***
0.650-0.001 *(-2.43)0.000(0.75)
0.000 ***(-5.27)0.000(0.40)
0.000 *
(2.27)-0.001(-0.08)0.011 ***
(5.98)
0.008(1.58)-0.003 +(-1.79)0.005 ***
(3.76)
0.000(-0.56)0.008 **
(2.67)-0.002 *(-2.34)0.000 +
(1.65)
0.004 **
(2.69)
0.000 +(-1.68)0.018 +
(1.69)-0.004 *(-2.24)0.004(1.30)-0.003(-1.11)0.014(1.38)
4768
0.086
10.25 ***
1.559

Notes: The dependent variables are the Jones discretionary accruals (DA) in Model (1),modified Jones DA in Model (2), Jones model’s performance-matched DA with the current ROA
in Model (3), and modified Jones model’s performance-matched DA with the current ROA in
Model (4). All estimations use the instrumented variables Main Bank Shareholdings, Foreign
Shareholdings, and Cross Shareholdings. Our instrumental variables are lagged variables of mainbank shareholdings, foreign shareholdings, cross shareholdings, and American depositary receipt
15

(ADR). The Z-values are in parentheses. +, *, **, and *** indicate that the estimates are significant
at 10%, 5%, 1%, and 0.1%, respectively.
From Table 4, we find that the estimated results of the 2SLS regression are almost identicalto the OLS results. Main Bank Shareholdings is negatively associated with earnings management
for all four models, which is consistent with H1. Foreign Shareholdings is not significant, which
implies that such shareholdings are ineffective monitors for preventing opportunistic earnings
management. As for the other firm characteristic variables, the coefficient of Cross Shareholdings
is significant and negative after considering endogeneity. Top 10 Ownership is positive but notsignificant at 5%. M&A Dummy is not significant. Big N is also not significant, which implies thatlarge audit firms with good reputations do not help mitigate opportunistic earnings management inJapan. As for the bank characteristic variables, collateral is the only significantly negative variable
for the Jones and modified Jones models, and we could not find significant effects of the bankcharacteristic variables.

6 CONCLUSIONS
6.1 Key Findings and Implications
In this study, we examine the relationship between earnings management and Japanese
corporate governance structure, represented as main bank monitoring and foreign shareholdings,
respectively. The Japanese corporate ownership structure is characterized by main bank ownershipand cross-shareholders such as keiretsu, different from the dispersed ownership structure thatprevails in the United States. The recent increase of foreign shareholdings might occur the
possibility that the increase of these institutional investors would change monitoring systems inJapan. Therefore, we investigated whether or not these Japanese corporate governance features
mitigate opportunistic earnings management.
Our empirical findings show that main bank shareholdings function as effective gatekeepers.
Despite the restriction of financial shareholdings by the financial deregulation after the 2000s, mainbank shareholdings remain effective. As for foreign shareholders, we could not obtain significant
results. In other words, recent Japanese ownership structural changes, such as regarding foreign
shareholdings, are expected not to provide incentives to seek precise financial reporting13. We
obtain significant results for cross shareholdings, which implies that cross shareholdings havefunctioned effectively to mitigate earnings management in Japan since the 2000s.
These results imply that main bank shareholdings persist as an important component ofJapanese corporate governance since the financial deregulation after the 2000s. Under Japanesebank-dominated corporate governance, main banks’ roles have remained important even after thetransitional period of market-oriented corporate governance mechanisms. This result implies thatthe monitoring activity of main banks plays an important role under bank-dominated corporate
16

governance and as a substitute for block shareholdings in countries with dispersed ownership
structures.
6. 2 Limitation and Future Research
Japanese audit quality has been discussed frequently since the emergence of two important
cases of corporate fraud in the past decade involving Kanebo Co. (2005) and Olympus Corp.
(2011). In our study, we specifically examine whether or not the main bank relationships, whichhave recently weakened, have functioned as effective monitors. Ascertaining the effectiveness ofthe monitoring by main bank systems is invaluable to preventing managerial opportunistic
behaviors in the transitional period for ownership structure, such as that with the increase of foreign
owners. These findings are expected to provide lessons for other emerging countries that anticipate
an increase of foreign shareholdings. The institution of Japanese corporate governance haschanged recently. For example, corporate governance code has been introduced to expect for more
effective corporate governance mechanisms like the reform of internal control. These reforms
would change Japanese corporate governance, and thus, investigating them would be a valuable
future task.

17

NOTES
1. Lin and Manowan (2012) classify outside block shareholders and analyze their role inmitigating earnings management.
2. Sakawa et al. (2014) find that foreign shareholdings are positively associated with market
liquidity in Japan.
3. There is a long-term relationship between a firm and a bank from which the firm obtains
its largest share of borrowings (Aoki et al., 1994).
4. In 2005, the large audit firms included the Big 4 Japanese audit firms: Deloitte Touche
Tohmatsu, Shin-Nihon Ernst & Young, KPMG Azsan LLC, and Chuo-Aoyama PWC. In 2006,
PWC became Arata PWC, and Chuo-Aoyama became Misuzu, before eventually ceasing
operations in July 2007. Therefore, the Big 5 audit firms in 2006–2007 became the following:
Deloitte Touche Tohmatsu, Shin-Nihon Ernst & Young, KPMG Azsan LLC, Arata PWC, andChuo-Aoyama. From 2008 to the present, the Big 4 audit firms have excluded Chuo-Aoyama andhave remained important audit firms in Japan.
5. Soble (2012), for example, reported the recent corporate scandal of Olympus Corp. as
follows: “Both KPMG, which oversaw Olympus’ financial reporting until 2009, and its successor
E&Y signed off on the company’s accounts even though they found problems in parts of its
business that turned out to have been involved in disposing of hidden losses.”
6. Kwak, Lee, and Eldridge (2009) investigate how bank managers use discretionary
components of accruals in Japanese banks.
7. Previous studies expect the monitoring role of block shareholders and define them asshareholders who hold at least 5% of a firm’s shares (Brockman, Chung, & Yan, 2009; Heflin &Shaw, 2001; Mehran, 1995). Therefore, foreign shareholdings are defined as the proportion oflarge foreign investors that hold 5% or more of a firm’s shares.
8. We investigate the periods since the Kanebo Co. earnings fraud case during 2006–2010.
In 2011, Japanese firms were damaged by the devastating effects of the Great East Japan
Earthquake. Moreover, Japanese financial reporting systems were suddenly confused and delayed.
9. Previous studies adopt this method to gather audit firms’ information in Japan.
10. We restrict our sample firms using the following criteria: (i) financial statements areavailable for the sample period, and (ii) observations included at least five firms in the same
industry, as classified by the Nikkei Industrial three-digit code.
11. Previous studies like those of Lin and Yung (2014) and Tang and Chang (2015) also

check the robustness of results using of Kothari et al. (2005)’s model.
12. ADR is equal to 1 if a firm has ADR programs and is 0 otherwise. Kang and Stulz (1997)
find that firms with ADR programs have greater foreign ownership. Therefore, we adopt the ADR
dummy variable as an instrumental variable.
1813. This result might have changed after the institutional change in Japan. In June 2015, theCorporate Governance Code was introduced. Therefore, the monitoring of institutional
shareholders like foreign shareholders would be expected after the introduction of this code.

19Appendix A. Variable definitions
Variable

Definition

Dependent Variables
Jones DA

Absolute value of discretionary accruals (DA) using the Jones model

Modified Jones DA

Absolute value of discretionary accruals (DA) using the modified Jones model

Performance-matched Jones

The absolute value of the Jones model’s performance-matched discretionary

DA ROAt

accruals (DA) with the current ROA by Kothari et al. (2005)

Performance-matched

The absolute value of the modified Jones model’s performance-matched

Modified Jones DA ROAt

discretionary accruals (DA) with the current ROA by Kothari et al. (2005)

Ownership Structure
MainBank Shareholdings
Foreign Shareholdings

The proportion of main bank shareholdings
The proportion of foreign shareholdings that hold more than 5% of the shares
outstanding

Cross Shareholdings

The proportion of cross shareholdings

Management Shareholdings

The proportion of the board of directors’ shareholdings

Top 10 Ownership

The proportion of Top 10 ownerships

Other Variables
R&D Intensity

The ratio of annual R&D expenditure to sales

Volatility

Stock volatility during three years

M&A Dummy

A dummy variable that is equal to 1 if a firm experiences M&A activity and is
0 otherwise

Big N

The Big N audit firms, which consist of Big 4 or Big 5 audit firms

Market to Book

Market to Book = Market Value/Book Value of Capital

ROA

Return on assets

Negative Profit

A variable that is equal to 1 if the ROA is negative and is 0 otherwiseln (MV)The logarithm of the market value

Leverage

Financial Leverage = Debt/Total Assets (%)

Stock Option

A variable that is equal to 1 if a firm adopts stock option and is 0 otherwise

Director Compensation

The total amount of director’s compensation (million yen)

Cash Balance

The ratio of cash and deposits to total assets

Collateral

A variable that is equal to 1 if a firm has collateral debt and is 0 otherwise.

Transaction Debt
Type of Debt Term

The ratio of all bonds outstanding to the sum of all bank loans and all bonds
outstanding
The ratio of short-term debt to total debt

20

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