Volume 52015

Accrual-Based and Real Activities BasedEarnings Management Behavior of Family Firms in Japan*
TAI-YUAN CHENZHAOYANG GU

Department of Accounting,
HKUST Business School
HONG KONG UNIVERSITY OFSCIENCE AND TECHNOLOGY

School of Accountancy,
CUHK Business School
CHINESE UNIVERSITY OF HONG KONG

KEIICHI KUBOTA†

HITOSHI TAKEHARA

Graduate School of Strategic Management,
CHUO UNIVERSITY

Graduate School of Finance, Accounting and Law,
WASEDA UNIVERSITY

ABSTRACT
We have explored the extent of accrual-based and real activities-based earnings
management using data from family and non-family firms in Japan. Family firms are
expected to have lower agency costs because family shareholders and management are
more congruent in their pursuit of mutual firm goals and seek lower levels of earnings
management. However, this collusion may lead to entrenchment and higher levels of
earnings management, which becomes opaque to outside shareholders. A founding
family is concerned with the reputation of their firm for sustained socioemotional
wealth and family firms may conduct cosmetic earnings management to conceal bad
news. We empirically assess the levels of earnings management and investigate whether
the level will be lower or higher for family or non-family firms, and identify which
method is more costly. The level of accruals and cost may vary among the family firm
* This paper was presented at the 5th The Japanese Accounting Review Conference, 2014 American Accounting
Association Annual Meeting; the 21st Annual Conference of the Multinational Finance Society; the IFERA 2014
Annual Conference; the 2014 Nippon Finance Association Annual Conference; the 2014 Eastern Regional Meetingof Japan Finance Association Meeting; and the 2014 January meeting of the Japanese Association for Research inDisclosure. The authors thank Massiomo Bau, Masahiro Enomoto, Herman Frank, Giulio Greco, Isao Nakano,Takashi Obinata, Kazuhisa Otogawa, and Yoshihiro Tokuga for useful discussion and comments. Keiichi Kubota andHitoshi Takehara acknowledge financial support from the Grant-in-Aid for Scientific Research ((A) 25245052)
from the Ministry of Education, Culture, Sports, Science and Technology of Japan. Hitoshi Takehara acknowledges
financial support from the Health Labour Sciences Research Grant (Research on Policy Planning and Evaluation)and the Grant-in-Aid for Scientific Research ((C) 24530581). All remaining errors are our own.
†
Corresponding Author. Address Graduate School of Strategic Management, Chuo University, 1-13-27 Kasuga,
Bunkyo-ku, Tokyo 112-8551 JAPAN. Telephone +81-3-3817-7478
E-mail kekubota@tamacc.chuo-u.ac.jp
Received October 9, 2014; accepted June 4, 2015; available online July 31, 2015 (Advance publication by J-STAGE)
DOI: 10.11640/tjar.5.2015.02
Copyright©2015 Research Institute for Economics & Business Administration – Kobe University.

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The Japanese Accounting Review, 5 (2015), 21-47

types; that is, whether or not shareholdings are large or the CEO is from the founding
family. We find that the level of both accrual-based and real activity measures is lower
for family firms. With cross-section regressions, we find that family shareholding
increase the level of abnormal accruals management, whereas the family CEO decreases
the level of abnormal accruals, but in both cases the amounts were not significant. We
also find that family-related variables decrease the levels of real-activities earnings
management. When we introduce economic measures related to the costs of earnings
management, we find that Japanese family firms utilize accrual-based earnings
management more often than real activities-based earnings management.
JEL Classification: M41; G32; M14
Keywords: Earnings Quality; Founding Family; CEO; Abnormal Accruals; Overproduction

Chen, Gu, Kubota and Takehara:
Accrual-Based and Real Activities Based Earnings Management Behavior of Family Firms in Japan23

1. Introduction to Japanese Family Firms
Among the literature on earnings quality (Sloan, 1996; Xie, 2001; Desai et al., 2004;
Richardson et al., 2005), few studies use US family firm data except for Ali et al. (2007) and
Wang (2006). Although the financial performance of family firms with Japanese data has been
investigated by Claessens et al. (2000), Allouche et al. (2008), Saito (2008), Asaba (2013), andMehrotra et al. (2013), few studies adopt the perspective of financial disclosure quality. Ebihara etal. (2012) find that the earnings quality of Japanese family firms is lower than that of non-family
firms from univariate analysis using the Jones and modified Jones models and find that earnings
quality is higher for family firms with founding family shareholdings of up to 33% using
multivariate pooled regressions. However, the study’s sampling period is limited to three years,
and the study investigated only accrual-based earnings management. Kubota and Takehara (2013)
find that family firms adopt more conservative earnings reporting than non-family firms.
In the current paper, we explore both accrual-based earnings management (hereafter AEM)
and real activities-based earnings management (hereafter REM) of family firms in Japan using
data from all family and non-family firms listed on the Tokyo Stock Exchange from the year 2004
to the year 2011. We chose Japanese family firm data for our research for the following reasons.
First, Bennedsen and Fan (2014) argued that Japanese family firms have a unique history andculture relative to other countries’ family firms including those of other East Asian countries; thisuniqueness provides motivation for research on Japanese family firms. Although earnings
management for family firms has been investigated in detail (Prencipe et al., 2014), the test
sample is mainly limited to US and European firms with the exception of for Kim and Yi (2006),
who study Korean firms.
Although European family firms have a longer history than their US counterparts, thehistories of Japanese family firms far surpasses those of European family firms and many datefrom the eighth century AD (the private family firms Kongo Gumi and Hoshi Ryokan, forexample). Moreover, the management culture of family firms in Japan may be substantiallydifferent from the culture of European (Achleintner et al., 2014) and US family firms (Ali et al.,2007 and Wang, 2006).
Second, the proportion of Japanese public firms owned by families is approximately equal tothe proportion of American firms owned by families. Among the large listed family firms in Japanare Toyota Motor Corporation, Panasonic, Kikkoman Corporation, and Epson. These
multinational family firms have a strong influence on the Japanese and world economies.
Accordingly, it is imperative for accounting researchers to explore the degree of earnings
management of family firms versus non-family firms.
Third, we consider it important to explore whether the paternalistic Japanese management
style (Itami, 2002) is still practiced among family firms versus non-family firms. If this is the case,management may be more concerned with the redistribution of revenue to their employees thanthe base-line net income. Because employees are sometimes considered family members of firms(Miller and Le Breton-Miller, 2005), we explore whether family firms in Japan are less subject toearnings management of net income.
Finally, the type of corporate governance structure of the majority of Japanese firms isconventional and defined in the Companies Act. At least one internal auditor and outside CPA
firm are required to check board performance and the fair representation of financial statements.
Another type of governance also defined in the Companies Act is committee style governance, for

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The Japanese Accounting Review, 5 (2015), 21-47

which three committees composed of board members and a CPA firm oversee the management
performance and the fairness of financial statements, as in the US. However, few Japanese firms
adopt this latter form of governance (Sony, for example). The generated income numbers for theformer type of corporate governance may be subject to higher earnings management because
board members and an internal auditor may function as insiders, and this tendency may bestronger among family firms.
Family firms are expected to have lower agency costs because family shareholders andmanagement are more congruent in their pursuit of mutual firm goals by family shareholders
and/or executive positions and seek a lower level of earnings management. However, suchcollusion may lead to entrenchment, a higher level of earnings management, and outside
shareholders may be excluded from the real situation.
A founding family will also be concerned with the reputation of their product/services, firmname, and family name to sustain family socioemotional wealth although this requires a level ofsacrifice in economic performance. 1 Thus, in this case, we infer that the level of earnings
management will be lower for family firms compared to non-family firms for reputational
purposes, and we investigate the level of earnings management identifying which method is morecostly for family firms. Family firms may conduct cosmetic earnings management and conceal bad
news (Gomes-Mejia et al., 2014).
We consider that the level of accruals and cost (Zang, 2012) may also vary among the type offamily firm; that is, whether or not shareholdings are large and whether the CEO is from thefounding family. We conduct empirical analyses using correlation analysis, portfolio analysis,
univariate analysis, and cross-section regressions and find evidence to test these assertions.
Section 2 explains the motivation for our study, and Section 3 reviews previous studies.
Section 4 establishes our hypotheses. Section 5 explains the data and reports basic statistics.
Section 6 reports empirical results in detail, and Section 7 concludes.

2. Motivation for the Study
Family firms are typically fortified by management that is compatible with a family norm
and/or value regardless of whether the CEO is a family member (Ward, 2004). Accordingly, we
expect that management possesses stronger real authority inside firm organization, according to
the definition of Aghion and Tirole (1997). However, this force can function in one of two ways.
First, family firms may suffer less from agency cost problems that arise between managers
and share owners ( Jensen and Meckling, 1976) because a large portion of shares are owned byfounding families, and the family CEO holds authority from the family. These factors provide
greater efficiency with less agency cost. Anderson et al. (2009) note that family firms can provide
stronger control and oversight with less agency cost and deliver direct control over corporatesocial activity decisions to managers. The authors call this strong tendency the “control in-place”
hypothesis.
However, stronger authority may be counterproductive, and entrenchment may increase
within the firm. Stronger authority with less agency cost may increase opaqueness in disclosures
because management and the owner have less concern for other stakeholders. Thus, family firms
1

See Berrone et al. (2010, 2012) and Gomez-Mejia et al. (2007, 2011) for the definition of socioemotional wealth(SEW) used in family firm research literature. Gomez-Mejia et al. (2014) discuss the impact of the family control andinfluence dimension and the family identity dimension on the extent of earnings management.

Chen, Gu, Kubota and Takehara:
Accrual-Based and Real Activities Based Earnings Management Behavior of Family Firms in Japan25

may fall into a state of autarky, and non-family managers and employees in fear of losing theirjobs may be defenseless against the firm. For example, both Dyer and Whetten (2006) andAnderson et al. (2009) state that families can be self-centered and more interested in protecting
their well-being, and Anderson et al. (2009) calls this tendency the “entrenchment hypothesis.”
Stockmans et al. (2010) uses Flemish private firm data to conclude that socioemotional wealthmotivates upward earnings management. Gomez-Mejia et al. (2014) present a similar argument
and establish their alternative hypotheses that are comparable to the hypotheses in thisstudy. We also present the entrenchment hypothesis as an alternative hypothesis, which implies
lower earnings quality against the null hypothesis. This set constitutes our null and alternative
hypotheses.
Additionally, from the perspective of preserving a family firm’s socioemotional wealth (SEW),
which is a new concept in family firm research literature, Gomez-Mejia et al. (2007, 2011) argue
that family firms are willing to yield financial performance to attain and preserve greatersocioemotional wealth. The authors suggest that family firms are concerned with persistentpositive profit, but do not necessarily maximize profits and may spend on social causes such as
museum, charity and/or educational institution donations at the same time as investing in thewell-being of company employees. In this case, net profit is not the ultimate goal.
Enforcing these management actions requires a stronger real authority (Aghion and Tirole,2007) with lower agency cost, which might allow the quality of earnings to better maintain the
reputation of the firm and the family or vice versa.2 This can be a significant implication of ourresearch framework. We establish our first null hypothesis to determine which story is consistentin Section 4.
To test our first hypothesis that compares the lower agency cost argument with theentrenchment effect, we focus on earnings quality. Earnings quality is one of the major properties
that accounting reports ought to reflect (Ronen and Yarri, 2008 and Francis et al., 2006), and theevidence for Japanese family business data is less known except in Ebihara et al. (2012). To
investigate the level of AEM, we use abnormal accruals as presented by Dechow et al. (1995) andother standard earnings quality measures from the accounting literature. We also investigate thelevel of REM as devised by Roychowdhury (2006).
In our second hypothesis and the subsequent sub-hypothesis in Section 4, we compare family
and non-family firms by highlighting various cost measures accompanied by both AEM and
REM, which was first proposed and tested by Zang (2012) on US data. The authors’ method
compares the relative cost of earnings management. Achleitner et al. (2014) apply the same
method to German family business data. The study sample is composed of 99 to 291 listed family
firms spanning 11 years, and the authors find that family firms in Germany choose to employ
AEM more than REM. Because the sample is composed of public firms, the results arecomparable to ours. However, as the introduction suggested, Japanese family firms tend to have
longer history, and the management culture may be unique (Bennedsen and Fan, 2014; Itami,2002); thus, their behavior may be different from that of European family firms.3

2
3

This corresponds to the family control and influence dimension (Gomez-Mejia et al., 2014, Berrone et al., 2012).
We thank Sasson Bar-Yosef and Annalisa Prencipe for their discussion that posits that Italian firms have the longest
history among European family firms, but Japanese firms have longer history and differ significantly in terms ofcorporate culture.

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The Japanese Accounting Review, 5 (2015), 21-47

In this paper, with minor modifications on the cost measures used by Zang (2012) in thecontext of Japanese firms, we compare the relative cost of two earnings management methods forfamily and non-family firms in Japan. This leads us to establish the second hypothesis and the
sub-hypothesis defined in Section 4. We review previous studies related to this current study inthe next section.

3. Previous Evidence on Family Firms’ Earnings Management
Among the literature on earnings quality (Sloan, 1996; Xie, 2001; Desai et al., 2004;
Richardson et al., 2005), few studies use US family firm data. Ali et al. (2007) find that
US family firms show better quality financial disclosures, are followed by more analysts,
and trade their stocks with smaller bid-ask spreads. Wang (2006) finds that earnings
quality is higher for US family firms versus non-family firms. Similarly, Jiraporn and
DeDalt (2009) find that stronger control by the founding family leads family firms to alower level of earnings management by US firms and emphasize the role of family
reputation, which we use to construct our hypotheses in Section 4.
For evidence on other countries, Stockmans et al. (2010) find family firms have greater
incentive to engage in upward earnings management to preserve their socioemotional wealth anduse Finnish data from their own questionnaires. Cascino et al. (2010) use Italian listed firm data
and find that family firms have a higher quality of financial information disclosure than
non-family firms. Achleitner et al. (2014) use a sample of 402 German listed family firms andfind that family firms in Germany use less REM and adopt earning-decreasing accruals-based
earnings management. Using Taiwan family firm data, Yang (2010) finds the greater the share of
insider ownership, the higher the level of earnings management. With respect to Korean data,
Kim and Yi (2006) find that the greater the disparity between control (voting rights) andownership (cash flow rights), the greater the extent of earnings management.4
The previous studies investigated only AEM, except Achleitner et al. (2014). In the current
paper, we explore both AEM and REM (Roychowdhurry, 2006 and Zang, 2012) and compare
relative costs for three types of family firms, which we define in Section 5. For the former
earnings management measure, we decompose total accruals into normal and abnormalcomponents using the CFO-modified Jones model proposed by Kasznik (1999), and for the lattermeasure we use the method by Roychowdhury (2006).
In one of the most widely cited research articles on Asian family business, Claessens et al.
(2000) investigated ownership structure among East Asian countries for evidence onmanagement behavior and financial performance of Japanese family firms. The authors include
1,240 Japanese listed firms (op. cit., p.104) and note that 13.1% of firms are controlled by families
with a 10% shareholding cutoff level for founding families, and 9.7% of firms are controlled byfamilies with a 20% cutoff level. Saito (2008) finds that family firms slightly outperformed
non-family firms from the year 1990 to the year 1998, but their superiority was limited to thefounders’ reign. Allouche et al. (2008) find that family firms outperform the matched sample ofnon-family firms with a smaller sample. More recently, Asaba (2013) investigates the investment
behavior of the electric machinery industry in Japan. The author’s sample of 184 family firms
from the year 1995 to the year 2006 demonstrates aggressive investment behavior during a boom
and persistent investment behavior during a recession. Mehrotra et al. (2013) investigate Japanese
4

The Companies Act in Japan contains a clause that states one voting right for one unit share.

Chen, Gu, Kubota and Takehara:
Accrual-Based and Real Activities Based Earnings Management Behavior of Family Firms in Japan27

family business succession problems and demonstrate that adopted heirs can avoid the succession
problem. The authors studied Japanese firms between 1949 and 1970 and followed the data up to2000.
In the accounting literature investigating Japanese firm earnings quality, Kubota andTakehara (2013) find that family firms adopt more conservative earnings reporting compared to
non-family firms and report losses earlier using the Basu (1995) conditional conservatism
regression model. Ebihara et al. (2012) find that earnings quality is lower for family firms than
non-family firms with univariate analysis, but the quality is higher for founding-family
shareholdings of up to 33% using multivariate analysis. However, this prior research is limited by
the length of the sampling period (only three years) and the measurement of accruals-based
earnings only.

4. Hypotheses
Based on the reasoning in Sections 2 and 3, we establish two hypotheses and one
sub-hypothesis in this section. First, considering the robust real authority (Aghion and Tirole,1997) and lower agency cost in family firms because of the close relationship between
management and owners, we predict that family firms will be unwilling to boost their reported
earnings and will have strong executing power not to do. Given real authority, management andowners are not concerned with manager compensation geared towards firm performance and will
not engage in income-boosting strategies. Given lower agency cost, the founding family andmanagement with greater firm share may be more concerned with long-run value appreciation
than non-family firms and may be less concerned with earnings performance in the short run.
Additionally, with respect to the preservation motive to maintain socioemotional wealth(Gomez-Mejia et al., 2007, 2011; Berrone 2010, 2012) of family firms, we predict that managers
of family firms will not choose income-increasing earnings management practices because it will
reduce the founding family firm reputation and, consequently, detract from the accumulation offamily specific socioemotional wealth.
However, there may be a greater entrenchment effect by owners, management, and internal
auditors from collusion. This can lead to a higher level of earnings management and exhibits
strong real authority that is functioning in the opposite direction.
As a null hypothesis, we predict that the amount of earnings management in family firms islower than that of non-family firms. We call this reasoning “founding family’s reputation
hypothesis” and establish our first hypothesis. 5 We call the alternative hypothesis the“entrenchment hypothesis.”
Hypothesis 1: Family firms will conduct a lower level of income-increasing earnings management
than non-family firms.
If the alternative hypothesis is supported, the cause may be the entrenchment effect arisingfrom the collusion of management, family owners, and an internal auditor, and this phenomenon
can be explained by a particular Japanese governance style. In such a case, managers and thefounding family may extract more cash by compensating a family CEO and/or paying out higher
dividends with inflated earnings. Management may incur higher expenditures for perks ( Jensen
5This corresponds to the family identity dimension (Gomez-Mejia et al., 2014, Berrone et al., 2012).

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The Japanese Accounting Review, 5 (2015), 21-47

and Meckling, 1976). Outside shareholders, both current and future, may suffer from theincome-boosting efforts of family firms. Stockmans et al. (2010) find such behavior in Flemish
private family firms, and Kim and Yi (2006) find similar behavior in Korean private family firms
versus public family firms. Our sample is composed of public firms in Japan, and our evidence willcomplement these prior findings whatever the direction.
The second hypothesis addresses the type of earnings management method that family firms
in Japan pursue: AEM or REM.
Subsequent to Hypothesis 1, we predict that family firms sacrifice cost for earnings
management because owners and/or family CEOs are (is) insider(s), do (does) not want to incur
cost, and would rather conduct earnings management. Outside shareholders may place a highlevel of confidence on family management if the CEO is a family member. Family firms may
consider that a family-member CEO avoids unnecessary expenditure to boost earnings unlike a
non-family-member CEO, who may conduct earnings management to enhance their professional
reputation.6
We call this hypothesis the “earnings management cost hypothesis” for family firms because
family firms avoid incurring real economic cost solely for income-boosting purposes.
Hypothesis 2: Family firms will sacrifice less economic cost through real earnings management toincrease earnings than non-family firms
Then, given that Hypothesis 2 is accepted for family firms in Japan, we establish an
additional sub-hypothesis as a corollary to Hypothesis 2 using the same reasoning that family
firms do not want to sacrifice economic cost even in cases where they want to conduct earnings
management. We call this the “accrual method choice hypothesis. “Hypothesis 2.A: Family firms prefer accruals-based earnings management to real earnings
management.
From the two hypotheses and sub-hypothesis, we explore the extent of earnings management
and the cost differences for Japanese family firms.

5. Data and Variables Construction
5.1 Data
Our primary observation period is from the year 2004 to the year 2011, and the sample
includes all listed firms on the Tokyo Stock Exchange. The numbers of firm types in the sample
are listed in Table 1. We construct unbalanced panel data without survivorship and new firm bias.
We classify family firms into three types in Table 1: Type 1: firms with more than 10% of
shares owned by a founding family and the CEO is a family member; Type 2: firms with morethan 10% of shares owned by a founding family, but the CEO is not a family member, and Type

6The CEO of Toyota Motor Company, Mr. Akio Toyoda, is a grandson of the founder, and the family owns less than
2% of the shares and voting rights unlike the family of Ford Motor Company. See also Bennedesen and Fan (2014)
for a related discussion on the uniqueness of family firm CEO postings in Japan.

Chen, Gu, Kubota and Takehara:
Accrual-Based and Real Activities Based Earnings Management Behavior of Family Firms in Japan

29

TABLE 1. SUMMARY OF FIRM-YEAR OBSERVATIONS
2004
2005
2006
2007
2008
2009
2010
2011
TSE First Section (TSE1)
TSE Second Section (TSE2)
Other than TSE1 and TSE2
Consumption Goods
Investment Goods
Services
Transportion
Utility
Real Estate%Family Firms

Non Family
921
928
960
1,035
1,018
991
975
998
821
208
301
303
603
250
62
20
55
57.852Type 1
304
317
340
379
393
406
417
426
209
104
261
131
145
236
13
1
22
24.519Type 2
58
59
67
85
88
96
102
104
73
29
82
46
51
73
4
0
5
8.009

Type 3
131
136
144
165
165
164
159
152
154
25
38
51
105
42
10
1
6
9.620

Total
1,414
1,440
1,511
1,664
1,664
1,657
1,653
1,680
1,257
366
682
531
904
601
89
22
88
100.000

Note: Type 1, more than 10% shareholdings and CEO from family, Type 2, more than 10%
shareholdings, but CEO not from founding family, Type 3, less than 10% shareholdings, CEOfrom the founding family. The observation period is from 2004 through 2011.

3: less than 10% of shares are owned by a founding family and the CEO is a family member.7
Based on these classifications, and using a sample of non-family firms, we investigate thehypotheses 2 and 2A based on cost differences for these four types of firms (Zang, 2012).
The differences in family firm types may reveal distinct management and financial reporting
behavior. The differences may depend on the size of the shareholding of the founding family
and/or whether the CEO is a family member. The finding will provide new insight into thequality of earnings of Japanese family firms.
The first subpanel reports the number of observations for each year followed by the stock
exchange listings and the sector-wise observations. This sector classification scheme follows thatof Kubota and Takehara (2007), who investigate the cost of capital in Japan. The details of thisscheme are shown in Appendix 1. The first column lists the number of non-family firms; thesecond column, Type 1 firms (more than 10%, and a CEO from the founding family); the thirdcolumn, Type 2 firms (more than 10%, and a CEO not from the founding family); the fourthcolumn, Type 3 firms (less than 10%, and a CEO from the founding family); and the fifth, the7

The non-family firm group includes family firms with a shareholding percentage of less than 10%, and family firms
with a CEO who is not a family member. When we established our own database, this group was classified as
non-family firms.

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The Japanese Accounting Review, 5 (2015), 21-47

total number of firms. For example, for 2011, there are 998, 426, 104, 152, and 1,680 firms.
The CEOs of Japanese family firms are often members of the founding family, even if thefamily shareholding is less than 10%. The data reveals that 9.62% of the firms conform to thisType 3, and we determine that there are more large firms (Toyota, for example) than small firms
from the listings on different stock markets. This represents a unique phenomenon not foundanywhere else in the world (Bennedsen and Fan, 2014). The phenomenon may come from a
corporate culture whereby the employees respect that the descendant may have inherited theoriginal entrepreneur’s spirit, a reflection of historical traditions dating from medieval times, or acharacteristic of Japanese management culture. However, this paper does not identify the reason
because it may be a sociological paradigm.
We find that the number of family firms of all types increases over the years with a pace more
rapid than that of non-family firms. For stock exchange listings, we find the largest listing is fromother emerging stock markets in Japan with 261 firms and 82 firms for Type 1 and Type 2 firms,
respectively. For Type 3 firms, we find the largest listing on the Tokyo Stock Exchange, with
Toyota Motor Company and Panasonic in this category. For sector-wise observations, for Type 1
and Type 2 firms, the largest listing is from the service industry, whereas for Type 3 firms thelargest listing is from the investment goods industry. Overall, we find that 42% of the firms areclassified as listed family firms in Japan.

5.2 Measures of Earnings Management
For the sample firms, we use financial statement and stock price data from the Nikkei
NEEDS Database and compute earnings numbers and managed numbers.
In this study, we define accruals (ACC) as the difference between earnings before
extraordinary items (EBEI) and cash flow from operations (CFO).8 First, we compute EBEI fromthe corresponding items on the income statement and obtain CFO directly from the cash flow
statement. Because EBEI is equal to (CFO + ACC) by definition, accruals in this study arecomputed as EBEI - CFO.
We decompose total accruals into normal and abnormal components using the modified
Jones model proposed by Dechow et al. (1995). We estimate the following cross-section
regression equation separately by each industry for each sample year.9

ACC j ,t / TA j ,t 1   0  1 1 / TA j ,t 1 1ADJREV j ,t / TA j ,t 1   2 PPE j ,t / TA j ,t 1   j ,t .

(1)

In equation (1), ΔADJREV is the difference between changes in sales and accounts receivables,
PPE is property, plant, and equipment measured at net book value, and νj,t is a residual term. The
fitted values from OLS estimation were used to construct normal accruals (NAC) components,
and their residual terms were used as abnormal accruals (ABNAC). The abnormal accruals
components represent firm-specific accrual components in excess of industry averages.
8

Based on the observation by Hribar and Collins (2002), we use the data from the cash flow statement instead of thebalance sheet. The authors thank an anonymous referee for this suggestion.
9
Based on the original 33 industry classifications of the Tokyo Stock Exchange, we classified all non-financial firms
into 24 industries.

Chen, Gu, Kubota and Takehara:
Accrual-Based and Real Activities Based Earnings Management Behavior of Family Firms in Japan31

In addition to abnormal accruals, we use two other measures of accounting-based earnings
quality measures - measures of variability and smoothness of earnings. Variability of earnings(EBEISD) in this study is defined as the past five-year standard deviation of earnings before
extraordinary items (EBEI). The “smoothness” measure is the ratio of the standard deviation of
EBEI to the standard deviation of CFO.
For measures to assess the level of REM, we follow the method employed by Roychowdhury(2006), and the data construction method is almost identical. First, by conducting cross-sectional
regressions for every industry and year, we compute abnormal cash-flows from operations,
ABNCFO, which is defined as a residual term from the following regression model (2).

CFO j ,t / TA j ,t 1   0   1  1 / TA j ,t 1  1 SLS j ,t / TA j ,t 1   2 SLS j ,t / TA j ,t 1   j ,t . (2)We also compute two additional measures of REM, abnormal production (ABNPROD) andabnormal expenditures (ABNEXP), by employing the following regression models (3) and (4)proposed by Roychowdhury (2006).10 Roychowdhury (2006) hypothesizes that ABNPROD will
be higher and ABNEXP will be lower for the suspect firm sample with unusually low profit.

PRODj ,t 

 0  1 1/ TAj ,t 1

 1SLSt / TAj ,t 1   2 SLS j ,t / TAj ,t 1  3 SLSt 1 / TAj ,t 1   j ,t .
DISEXPj ,t / TA j ,t 1   0   1  1 / TA j ,t 1  1 SLS t 1 / TA j ,t 1   j ,t .

(3)

(4)

Table 2 reports the means of the various measures of earnings management as well as
financial characteristics and p-values of the differences for each category of family and non-family
firms.11
To measure accrual-based earnings quality (Francis et al., 2008), we choose three variables,
abnormal accruals (ABNAC), earnings variability (EBEISD), and smoothness. Reported in thefirst row are the percentage of shares owned by the founding family, and the differences are all
significant.
For abnormal accruals, the smallest is Type 3 firms at -0.053, although the difference with
non-family firms is not significant. ABNAC for Type 1 family firms is also negative at -0.019.
These results imply that the type of firms in which CEOs are founding-family members (Types 1
and 3) tend to decrease their earnings among all firm types, supporting Hypothesis 1 for thesetypes of family firms.
However, for variability (EBEISD), non-family firms show the smallest value at 2.108
defined as the past five-year volatility of earnings, although the differences are not significant.
10

Using equations (2) and (3) of Roychowdhury (2006), we computed two additional measures of REM: abnormal
cost of goods sold and abnormal inventory growth. However, the Pearson correlation between abnormal production(ABNPROD) and abnormal cost of goods sold in our pooled sample is high at 0.916. Thus, we decided not to use
abnormal cost of goods sold and abnormal inventory growth in the analysis and to focus on abnormal production(ABNPROD).
11
Appendix 2 shows the descriptive statistics for these earnings management measures.

32

The Japanese Accounting Review, 5 (2015), 21-47

TABLE 2. DIFFERENCES BETWEEN FAMILY FIRMS AND NON-FAMILY FIRMS
FFO
ABNAC
EBEISD
Smoothness
ABNCFOABNPRODABNEXP
lnTA
ROA
LEV
SLSG
LP

Non-FB
0.570
0.026
2.108
0.649
-0.0010.010-0.00911.0821.453
18.3291.045
23.887

Type 131.509-0.019
2.130
0.599
0.002
-0.0180.016
10.1561.787
14.4551.018
16.212p-value
0.000
0.671
0.572
0.000
0.006
0.000
0.000
0.000
0.006
0.000
0.224
0.000

Type 224.102
0.005
2.363
0.615
0.002
-0.0070.002
10.221
1.378
12.584
1.106
20.313p-value
0.000
0.930
0.003
0.114
0.237
0.002
0.029
0.000
0.777
0.000
0.491
0.048

Type 34.011-0.0532.186
0.719-0.0020.009-0.007
11.1751.637
16.0121.010
19.428p-value
0.000
0.577
0.226
0.000
0.457
0.790
0.521
0.017
0.308
0.000
0.116
0.000

Note: FFO: percentage of shares held by the founding family (in %). ABNAC: abnormal
accruals to total assets (in %), Persistence: Persistency measure of earnings which is defined as
first order autocorrelation of earnings, EBEISD: Past 5 year S.D. of earnings before
extraordinary items (in %), Smoothness: Smoothness measure defined as S.D. of earnings to
S.D. of cash-flows from operations, ABNCFO: Abnormal cash-flows from operations to total
assets (in %), ABNCOGS: Abnormal cost of goods sold (in %), ABNPROD: Abnormal
product to total assets (in %), ABNEXP: Abnormal R&D expenditures to total assets, lnTA:
Natural logarithm of total asset, ROA: Past 5 year average return on assets (in%), LEV: Firm’s
financial leverage defined as non-current liabilities to total asset, SLSG: Past 5 year growth rateof sales (in %), LP: Labor productivity defined as value added per employee (in million Yen).
Numbers shown in the third, fifth and seventh columns are the p-values corresponding totwo-sided Student t-test on the differences for each category of family (Type 1, Type 2 andType 3) and non-family firms (non-FB).

Smoothness is measured by the ratio of variability to the standard deviation of cash flows fromoperations, and Type 3 firms have the highest number at 0.719, which shows the lowest earnings
quality. However, we find that Type 2 firms show a lower number than other types of firms at
0.599, which implies higher earnings quality. For Type 2 firms, the managers are hired managers
and perhaps more concerned with their own reputation as capable managers and/or their own
empire building (Berk and DeMarzo, 2011). We infer that Type 2 firms without family CEOs
may be more concerned with stable earnings patterns to secure a stable and higher salary.
Overall, for the various measures of AEM for different types of family firms, we find that thelevel of earnings management is somewhat higher for family firms although not significant in allcases. Therefore, the evidence for AEM supports Hypothesis 1 at least for ABNAC.
For the measures of REM, the means of abnormal cash flows from operations (ABNCFO) of
Type 1 family firms are higher than those of non-family firms, and the difference is statisticallysignificant. In the case of abnormal production (ABNPROD), the means are lowest (negative) for
both Type 1 and Type 2 firms at -0.018 and -0.007, respectively, and significantly. These results
imply that Type 1 and Type 2 family firms utilize less REM.

Chen, Gu, Kubota and Takehara:
Accrual-Based and Real Activities Based Earnings Management Behavior of Family Firms in Japan

33

Abnormal expenditures (ABNEXP) for these two types of firms are larger at 0.016 and 0.002,
which implies that family firms expend more and do not conduct upward earnings management.
The stronger real authority of family firms (Aghion and Tirole, 1997) may allow management tospend on necessary investment expenditure and employee compensations even to the extent ofsacrificing profit.
Overall, except for abnormal expenditures, we find that Type 1 and Type 2 family firms use
less REM than non-family firms and Type 3 firms. From the univariate analysis result for REM,
we support Hypothesis 1, similar to the cases for AEM. Because the size of Type 3 firms is large
at 11.175 (see the rows of lnTA below) and these are listed firms, it is reasonable that Type 3 firms
show a similar tendency to non-family firms as far as accrual-based and real activities-based
earnings management are concerned.
In the lowest subpanels, we report the basic financial characteristics of our sample. Size(lnTA: Natural logarithm of total assets) is used as a dummy variable in cross-section regressions,and the other four variables are also used as control variables. That is, ROA: Past five-year average
return on equity, LEV: A firm’s financial leverage defined as non-current liabilities to total assets,
SLSG: Past five-year growth rate of sales, and LP: Labor productivity defined as value added per
employee. The return on assets (ROA) is highest for Type 1 family firms at 1.787% followed byType 3 firms at 1.637%. Leverage is lowest for Type 2 firms at 12.584%. Sales growth (SLSG) is
higher for Type 2 family firms at 1.106%, but the difference is not significant. Labor productivity(LP) for non-family firms is higher than all types of family firms at 23.887 million yen and is aninteresting result.

5.3 Costs of Earnings Management
We analyze the costs of earnings management in Section 6 and use the following variables assurrogates for the cost of earnings management. We follow Zang (2012) and, particularly, threevariables each for AEM and REM. We use similar variables as Zang because US and Japanese
GAAP and their disclosure regulations based on Sarbanes and Oxley type laws are more similar
to each other than to European country ones with IFRS standards.
That is, we use a dummy variable for the selection of a large auditing firm (Big Four in theJapanese case) or not, the number of following analysts (Athanasakou et al., 2011), and the lengthof operating cycle as a cost of AEM. The rationale is as follows: 1) The larger the auditors, themore difficult it is to avoid adhering to Japanese GAAP to conduct earnings management, 2) The
greater the attention the firm receives from analysts and the media, the more difficult it is toconduct earnings management, and 3) The longer the operating cycle as measured by the turnoverof accounts receivables, the easier it is to use less stringent credit policy for sales.
To measure the cost of REM, the latter, we use market share (Harris, 1998) distance todefault (Merton, 1974 and Gray et al., 2006) using the Merton European option pricing modelby measuring the distance to the default boundary (standard deviations divided by the means of
the geometric Brownian motions) at the end of one year and the effective marginal tax rates(Graham, 1996 and Scholes et al., 2002). We use the weight of firm sales figures over industry
sales to compute market shares based on Nikkei mid-industry classifications. To estimate thedistance to default for individual firms, we employ the method proposed by Vassalou and Xing
(2004). The method to compute the effective tax rates follows Graham (1996) and Kubota andTakehara (2007) and is computed using 10,000 simulation paths for 20 years. We use these proxyvariables for cost because 1) the larger the market share, the stronger the market-leader power of a

34

The Japanese Accounting Review, 5 (2015), 21-47

TABLE 3. EARNINGS MANAGEMENT VERSUS
FOUNDING FAMILY ’S OWNERSHIP AND CEO POSITIONS
Panel A. Correlation between FFO and Earnings Management Measures
Pearsonp-value
Spearmanp-value

ABNAC-0.004
0.612
0.008
0.387

EBEISD
0.028
0.002
0.063
0.000

Smoothness-0.0420.000-0.0080.364

ABNCFO
0.033
0.000
0.025
0.004

ABNPROD-0.1020.000-0.0750.000

ABNEXP
0.096
0.000
0.065
0.000

Panel B. Effects of Family CEO on Earnings Management Measures
DCEO=1
DCEO=0p-value

ABNAC-0.0290.024
0.566

EBEISD
2.147
2.128
0.607

Smoothness
0.634
0.646
0.198

ABNCFO
0.001-0.001
0.095

ABNPROD-0.0100.009
0.000

ABNEXP
0.010-0.0080.000

Note: DCEO is a dummy variable which is equal to 1 if the CEO is from the founding family
or at least one executive who has a representative right of the firm from the founding family.
Definitions of other firms’ earnings management measures are the same as Table 2.

firm and its ability to boost sales; 2) the closer the boundary of bankruptcy, the more difficult it isto overproduce or oversell, and 3) the higher the effective tax rate, the higher the extra marginal
tax cost to boost earnings.

6. Empirical Results
6.1 Analysis of Family Shares and CEO Positions
In this sub-section, we investigate how ownership affects earnings management behavior andwhether it matters if the CEO is a founding-family member.
Table 3 reports Pearson and Spearman rank correlations between the extent of earnings
management and the shares owned by a founding family (shown in Panel A). The difference inearnings management depending on whether the CEO is a founding-family member (DCEO =1) or not (DCEO = 0) is shown in Panel B.
The Pearson and Spearman correlations between the percentage of shares held by founding
families, FFO and earnings variability (EBEISD) are 0.028 and 0.063, respectively, and both aresignificant at the 1% level. This implies that the more shares a family owns, the higher theearnings variability. Both for ANBAC and smoothness, the Pearson correlations with FFO are
negative, and the Pearson correlation is significant at the 5% level for smoothness. This result
implies that larger family shareholdings lead to less AEM and a smoother earnings stream. We
consider this an example of long-term orientation among family firms.
For REM, we find that abnormal production (ABNPROD) is negatively correlated withfamily shares at -0.102 for Pearson and -0.075 for Spearman. Additionally, abnormal expenditures(ABNEXP) are positively correlated with family shares at 0.096 for Pearson and 0.065 forSpearman, and this augments our previous findings. That is, a founding family does not conduct

Chen, Gu, Kubota and Takehara:
Accrual-Based and Real Activities Based Earnings Management Behavior of Family Firms in Japan

35

TABLE 4. FIVE PORTFOLIOS RANKED BY PERCENTAGE OF SHARES HELDBY FOUNDING FAMILIES#FirmsFFO
ABNAC
EBEISD
Smoothness
ABNCFOABNPRODABNEXP
lnTA
ROA
LEV
SLSG
LP

P1

P2

395
57.812-0.433
2.438
0.634
0.001
-0.017
0.022
9.857
0.668
17.6521.000
16.721980
41.494
0.293
2.209
0.585
0.005
-0.033
0.025
9.936
1.892
13.5311.014
14.210P3
1113
26.630-0.143
2.116
0.580
0.005
-0.0170.012
10.236
2.216
13.8371.029
19.726P41153
14.487-0.0092.105
0.627-0.0020.001
0.003
10.4071.433
13.6731.067
16.689

P5
9042
1.033
0.015
2.118
0.658
-0.0010.010-0.00911.0941.478
18.0171.040
23.288(P1-P5)----56.780-0.4480.320-0.0240.002-0.0270.030-1.237-0.810-0.365-0.041-6.566p-value----0.000
0.077
0.002
0.260
0.533
0.002
0.001
0.000
0.006
0.655
0.057
0.000

Note: FFO denotes percentage of shares held by the founding family. P1 is a portfolio of firms
whose FFO is equal or greater than 50%. P2 is a portfolio of firms whose FFO is less than 50%
but equal to or greater than 1/3. P3 is a portfolio of firms whose FFO is less than 1/3 but equal
to or greater than 20%. P4 is a portfolio of firms whose FFO is less than 20% but equal to or
greater than 10%. P5 is a portfolio of firms whose FFO is less than 10%. We test the differenceof mean of variables between P1 and P5 by Welch’s two-sample t-test. Probability values fromt-tests are shown in the ‘p-value’ column.

overproduction to generate extra profits or does not mind incurring extra necessary expenditures,
which is consistent with Hypothesis 1. However, it is a pair-wise analysis, and we do not control
for other factors that may affect these variables. Therefore, the evidence is temporary.
In the case of the CEO dummy variable shown in Panel B, we do not find significant
differences in AEM. However, for REM, we find the abnormal production cost (ABNPROD) islower at -0.010 when the CEO is a family member. We suggest that family-member CEOs do
not execute overproduction to increase profit. Abnormal expenditures (ABNEXP) are higher incases where the CEO is a family member (0.010 versus -0.008), and this augments the previous
finding. So far, the evidence is consistent with Hypothesis 1.
Table 4 classifies firms into five portfolios based on the percentage of shares owned by the
FFO and compares the same variables as those in Table 3.
The second to the upper-most right column reports the difference between the highest
share-owned group (P1) with more than 50% minus the lowest group (P5) with less than 10%
owned, and the upper-most right column shows the corresponding p-values.
For this difference in variable (P1 to P5), the values are -0.448, 0.320, and -0.024 forabnormal accruals (ABNAC), earnings variability (EBEISD), and smoothness, respectively. Thus,earnings are decreased to a greater extent and earnings variability becomes higher as more shares
are owned by founding families. This finding is consistent with our previous findings in Tables 2
and 3.

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The Japanese Accounting Review, 5 (2015), 21-47

In case of REM, abnormal production costs (ABNPROD) is smallest at -0.017 in P1 inwhich FFO is greater than 50% while abnormal expenditures (ABNEXP) are positively correlated.
In sum, the result from the ranked portfolio test is consistent with the previous result shownin Tables 2 and 3 both for AEM and REM. Also, note that the shares owned by the founding
family are negatively related with all financial characteristics variables, but the result for leverage is
not significant.

6.2 Cross-sectional Regressions
In this sub-section, we report the results from cross-section regressions of the following
specification in equation (6). EQ is an earnings management variable. FFO and DCEO are thepercentages of shares owned by the founding family and CEO dummy. CVs are control variables,
composed of ROA, leverage, sales growth, and labor productivity. DSize are firm size dummies(large-cap, mid-cap, and small-cap) defined based on the ranking in each year by book value of
total assets, DSector is as defined in the Appendix 1, and DYear is the year dummies.

EQ jt     1 FFO jt   2 DCEO jt   3 ( FFO jt  DCEO jt )
4

3

6

2010

i 1

i2

i2

t  2004   i CV ijt    i 1 DSize ijt    i 1 DSectorijt    t  2003 DYearijt   jt

(5)

Table 5 reports the results of OLS regressions, where p-values are computed with White’s(1980) heteroskedasticity corrections.
For the level of AEM, when we look at the family share value FFO, we find the slope for theabnormal accruals (ABNAC) is positive at 0.006. The slope for DCEO is negative at -0.013.
However, insignificant slopes for FFO and DCEO suggest that the characteristic variables tohighlight family firms do not contribute to higher earnings management. Because the alternative
hypothesis is that the income is boosted upward by earnings management, we do not findevidence of this either. Hence, given the result from the previous univariate analysis, Hypothesis 1
is still maintained. As for the cross-term between FFO and DCEO, it is negative and shows somesynergy effects of these variables concerning a decrease in earnings management, but it is not
significant.
As for earnings variability (EBEISD), the slopes of FFO and DECO are positive at 0.012 and
0.086 and significant at the 5% level, which implies that the more shares owned by the family or,if the CEO is from the family, the higher the earnings variability. The cross-term between FFO
and DCEO is negative at -0.012 and may make earnings smoother. The result is significant.
As for smoothness, the slope of DCEO is positive, 0.065, and significant at the 1% level,
which implies that if the CEO is from the family, the level of smoothness is lower, which issomewhat counterintuitive. For the cross-term between FFO and DCEO, it is negative at -0.002,
and the result is significant.
In the case of REM, the magnitude of coefficients for both FFO and DCEO become muchsmaller. We find that the coefficient of family shares (FFO) explains the abnormal production
cost (ABNPROD), which is negative and significant at -0.001. Additionally, the coefficient on
abnormal expenditures (ABNEXP) is positive at 0.0004 and significant. Again, family firms do
not conduct overproduction and are willing to spend necessary expenditures and do not boost
earnings. The coefficient for abnormal expenditures of DCEO variable is positive at 0.005 and2.204EBEISD

0.648-0.001-3.141

0.000

2.819

-0.797

0.003

0.815

0.000

-0.050t-value

ABNPROD

t-value

ABNEXPt-value

***

***

*

***

2.131

0.005

-0.883-0.003-1.293-0.002

5.219

0.065

2.101

0.086

-0.121-0.013

DCEO

**

***

**

1.102

0.000

-1.041

0.000

0.981

0.000

-3.542-0.002-3.618-0.012-1.106-0.008******

FFO×DCEO-3.814-0.001-7.520-0.00215.6870.002-7.424-0.006-5.398-0.026

6.948

0.063

ROA

***

***

***

***

***

***

0.240

0.000

4.002

0.000

-5.931

0.000

9.420

0.003

0.341

0.000

3.125

0.010

LEV

***

***

***

***

0.213

0.000

-0.2140.000-0.5710.000-2.466-0.002

0.567

0.004

0.142

0.003

SLSG

Note: Definition of variables are the same as Tables 2 and 3 and t-values are computed withWhite heteroskedasticity corrections. *** p-value < .01; ** p-value < .05; * p-value < .10(two-tailed test.)

0.000-0.001

1.789

0.001

ABNCFO

***

3.821

0.012

0.958

42.936

0.672

***

**

0.006

FFO

t-value

Smoothness

38.654-2.286t-valuet-value-0.315ABNAC

Intercept

TABLE 5. RESULTS FROM REGRESSION ANALYSIS

1.014

0.000

-5.106

0.000

5.550

0.000

3.869

0.000

5.898

0.002

-2.738-0.002

LP

***

***

***

***

**

0.027

0.046

0.083

0.059

0.085

0.010

Adj. R2

Chen, Gu, Kubota and Takehara:
Accrual-Based and Real Activities Based Earnings Management Behavior of Family Firms in Japan37

38

The Japanese Accounting Review, 5 (2015), 21-47

significant at the 5% level. As for the cross-terms between FFO and DCEO, these are all zero forreal earnings management variables and are insignificant.
Overall, we find a tendency that CEOs from the founding family play a positive role toimprove the earnings quality both on AEM and REM. The results support Hypothesis 1 overall.
It means the family CEO is concerned with the reputation of the firm as reliable in terms of
disclosure effort leading at the same time to increased socioemotional wealth. The latter may
mean that the more shares held by founding families, the less attention will be paid toshareholders outside the family.

6.3 Further Analysis of Costs of Earnings Management
We have confirmed in Tables 2 to 5 that family firms have a general tendency to decrease
their reported earnings by utilizing both AEM and REM strategies. These findings support our
Hypothesis 1 and suggest that family firms are more concerned with the reputation of investors.
Additionally, the magnitude of the income decrease using AEM strategies is greater than thatusing REM strategies, which supports Hypothesis 2 and Hypothesis 2.A.
The reason family firms utilize accruals-based strategies to a large extent to manage theirearnings is worth exploring. One of the possible reasons to explain such family firm earnings
management behavior is the ease in managing earnings. The potential cost of managing earnings
using an AEM strategy is lower than the cost of an REM strategy. More importantly, family firms
may not want to incur economic cost by conducting REM strategies that will deter them fromaccumulating family socioemotional wealth (Gomez-Mejia et al., 2014). This prediction led toHypothesis 2 and Hypothesis 2.A.
In this subsection, we further compare the relative cost of earnings management: AEM
versus REM, for which variables were defined in Section 5.2
Table 6 reports the cost of earnings management classified by three types of family andnon-family firms.
The results for AEM reveal that the choice of auditors is significantly less for all types of family
firms at the 10% level, the number of analysts is significantly less for Type 1 and Type 2 firms at
the 1% level, and the operating cycle is significantly less for Type 2 firms at the 10% level, but islonger for Type 1 and Type 3 firms although not significant. Accordingly, we conclude thatearnings management will be easier for family firms from these three cost comparisons, except fora shorter operating cycle for Type 2 firms. For the number of analyst variables, Type 3 firms
attract more analysts on average (2.644) versus non-family firms (2.541), although the difference
is not significant. Moreover, Type 3 and Type 1 firms show a longer operating cycle than
non-family firms but, again, the results are not significant.
For REM, market shares (MShare) are significantly lower for all types of family firms and, forType 2, MShare is the lowest with 1.503% while the market share for Type 3 firms is 5.040%,
comparable to 6.829% of non-family firms, although the difference is not significant. This implies
that the cost of earnings management is higher for family firms. For the distance to default (DD)threshold point, all family firms have a significantly smaller likelihood of defaulting.12 The largest
likelihood of default is among Type 1 firms with a distance of 3.754. Type 2 and Type 3 firms
12

Table 2 shows that family firms are less leveraged. However, this is only one factor, and variability of operating profit
is also a consideration. One of the co-authors of this paper has already confirmed that the variability of profit forfamily firms is lower than that of non-family firms. The result is available upon request from the authors.

Chen, Gu, Kubota and Takehara:
Accrual-Based and Real Activities Based Earnings Management Behavior of Family Firms in Japan

39

TABLE 6. DIFFERENCE OF THE COST OF EARNINGS MANAGEMENT
Audit4
NEst
Cycle
MShareDD
MTR

Non-FB
0.776
2.541
55.431
6.829
3.312
30.402Type 10.760
1.149
55.5941.610
3.754
33.431p-value
0.074
0.000
0.916
0.000
0.000
0.000

Type 20.736
1.351
50.6151.503
3.491
31.973

Type 30.731
2.644
58.1705.040
3.497
29.769p-value
0.025
0.000
0.038
0.000
0.039
0.011

p-value
0.001
0.455
0.359
0.000
0.003
0.176

Note: Audit4: Big 4 Audit firm dummy variable, NEst: Number of Analysts who follow thefirm, Cycle: Operation cycle (in days), MShare: Market share of the firm (in %), DD: Distanceto default, MTR: Marginal tax rate (in %). Numbers shown in the third, fifth and seventh
columns are the p-values corresponding to two-sided Student t-test on the differences for eachcategory of family (Type 1, Type 2 and Type 3) and non-family firms (Non-FB).

TABLE 7. COSTS OF EARNINGS MANAGEMENT,
FOUNDING FAMILY ’S OWNERSHIP, AND CEO POSITION
Panel A. Correlation between FFO and Cost Proxies
Audit4
NEst
Cycle
Pearson-0.025-0.1550.009
p-value
0.005
0.000
0.325
Spearman-0.052-0.152-0.041p-value
0.000
0.000
0.000

MShare-0.2230.000-0.388
0.000

DD
0.067
0.000
0.058
0.000

MTR
0.083
0.000
0.076
0.000

Panel B. Effects of Family CEO on Cost Proxies
Audit4
NEst
Cycle
DCEO=10.751
1.582
56.340
DCEO=00.773
2.449
55.057p-value
0.008
0.000
0.374

MShare
2.604
6.415
0.000

DD
3.680
3.326
0.000

MTR
32.37130.5240.000

Note: Definition of variables are the same as Tables 2 and 7.

show distances of 3.491 and 3.497, respectively, which is significantly larger than 3.312 fornon-family firms. We find family firms are safer and, for that reason, the cost for upward earnings
management will be less. Type 2 and Type 3 firms have higher effective tax rates, which showsthat the cost of earnings management is higher. Type 3 firms have lower effective marginal tax
rates (Graham, 1996) with 29.769% versus 30.402% for non-family firms. Accordingly, except forthe distance to default (DD), the cost of REM for family firms is larger than for non-family
firms.
Hence, for Hypothesis 2.A, we conclude that family firms choose AEM over REM. We
confirm this with a robustness check in the following two tables.

Table 7 reports Pearson and Spearman rank correlation numbers between the degreeof earnings management and shares owned by the founding family in Panel A. The
difference in earnings management depending on whether the CEO is a founding-family
member (DCEO = 1) or not (DCEO = 0) is shown in Panel B with corresponding p-values.

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The Japanese Accounting Review, 5 (2015), 21-47

Panel A shows that the percentage of shares owned by the family are negatively correlatedwith costs related to the choice of Big Four auditors (-0.025) and the number of analyst (-0.155)
variables in the direction of reducing the cost of AEM. The results for operating cycles are mixed;with the Pearson rank it is positive at 0.009 but negative and significant for Spearman at -0.041.
For the CEO dummy, again, for the auditor choice and number of analyst variables, CEOs fromthe founding family tend to reduce earnings management cost (0.751 firms versus 0.773 firms,
and 1.582 analysts versus 2.449 analysts, respectively).
For cost proxies for REM, the percentage of shares owned by the family are negatively
correlated with market shares at -0.223 and positively correlated with distance to default andeffective marginal tax rates at 0.067 and 0.083, respectively. The results for market share andmarginal tax rates imply that the costs rise as more shares are owned by families. However, theobservation for distance to default reveals that family firms for which a large proportion of stockis held by the founding family are more risk averse to avoid bankruptcy, which is consistent withthe theory that a family seeks long-term sustainability and preservation of socioemotional wealth.
Table 8 reports the results from regression analysis as in equation (6) and the logistic
regression model for the Big Four auditors (Audit4).

Cost jt     1 FFO jt   2 DCEO jt   3 ( FFO jt  DCEO jt )
4

3

6

2010

i 1

i2

i2

t  2004   i CV ijt    i 1 DSize ijt    i 1 DSector ijt    t  2003 DYearijt   jt

(6)

In (6), the dependent variables are replaced by the costs of two types of earnings management
methods instead of the various measures of earnings management tested in (5).
The results for AEM reveal that the choice of auditors with the logistic regression model is
not significant, but DCEO tends to hamper the choice of big auditors. When we consider the costof earnings management as in Zang (2012), other results for both FFO and DCEO variables
demonstrate that these variables reduce the cost of AEM because coefficients for the number ofanalysts are negative at -0.037 and -0.201, respectively, and those for operating cycles are positiveat 0.137 and 1.701, although the coefficients for DCEO variable are not significant.
For REM, with the exception of distance to default, the costs will be higher because thecoefficients for both FFO and DCEO variables for market shares are negative at -0.123 and-1.796, and the coefficients for effective marginal tax rates are positive at 0.004 and -0.543,
respectively.
In sum, from the analyses in this section, we conclude that family firms in Japan choose
AEM over REM (supporting Hypothesis 2 and Hypothesis 2.A) when more shares are owned by
the founding family with a family CEO. Moreover, family firms, particularly when the CEO is
not from the founding family (Type 2), tend to engage in a higher level of earnings management(rejecting Hypothesis 1) than non-family firms.

7. Summary and Conclusion
We investigated the degree of accrual-based earnings management and real activities-based
earnings management using data for all family and non-family firms listed on the Tokyo Stock
Exchange from the year 2004 to the year 2011.

1.804 *

0.004
0.169

49.23034.500 ***3.741

14.286

3.574

70.61328.77049.321 ***Cycle

t-value

MSharet-valueDDt-valueMTRt-value

2.748

0.006

-19.584-0.123***-1.104-0.543

3.578

0.149

-10.870-1.796

1.429

1.701

-1.123-0.201-2.261-0.153

DCEO

***

***

**

***

**

2.841 ***

0.080

-1.070-0.00311.3860.084-0.198-0.017-0.316-0.004

2.100

0.008

FFO×DCEO

***

***

***

***

7.992 ***

0.684

16.112

0.066

8.325

0.092

-6.848 ***-0.571

6.803

0.098

7.633

0.029

ROA

***

***

***

-13.268 ***-0.187-25.683-0.03114.1520.085

3.331 ***

0.129

6.369

0.034

0.361

0.001

LEV

-0.529-0.046-2.124-0.011

0.834

0.055

0.207

0.023

-2.658-0.035

0.071

0.001

SLSG

**

***

Note: Definition of variables are the same as Tables 7 and 8. The seven independent variables
are the same with Table 6 and t-values are computed with White heteroskedasticity corrections.
When Audit4 is used as a dependent variable, we run a logistic regression and Nagelkerke’s
pseudo R2 is reported in the table.
*** p-value < .01; ** p-value < .05; * p-value < .10 (two-tailed test.)

***

***

-3.198-0.037***0.137

21.151***t-value

***

5.354

NEst

-0.84515.823-0.003t-value

***

1.431

FFO

Audit4

Intercept

TABLE 8. FURTHER RESULTS FROM REGRESSION ANALYSIS***-0.589-0.002-1.668-0.001

7.385

0.023

*

***

-2.455 **-0.023

7.324

0.011

1.266

0.001

LP

0.144

0.332

0.144

0.135

0.110

0.063

Adj. R2

Chen, Gu, Kubota and Takehara:
Accrual-Based and Real Activities Based Earnings Management Behavior of Family Firms in Japan41

42

The Japanese Accounting Review, 5 (2015), 21-47

By employing univariate analysis, we found that the magnitude of income decrease using
accruals-based strategies is greater for family firms compared to non-family firms, and REM
measures are lower for family firms compared to non-family firms. From cross- section
regressions, we found that the shares owned by the founding family (FFO) and CEO dummy(DCEO) do not affect the incremental level of earnings management. For the level of real
activities-based earnings management, we found that family firm-related variables decrease levelsof earnings management.
When we introduced various economic measures that are related to costs of earnings
management, we found that family firms in Japan utilize more accrual-based earnings
management than real activities-based earnings management by comparing cost differences,which is a new finding and reinforces the findings of Achleitner et al. (2014) for German family
firms.
Our contribution is that this is the first study using Japanese data to investigate the level ofaccrual-based earnings management and real activities-based earnings management using thetesting methodology by Zang (2012) and, moreover, based on the real authority theory by Aghion
and Tirle (1997). In contrast to conventional family firm research, we tested the original
hypotheses by applying them to the three types of listed family firms in Japan and non-family
firms.
The limitation of this research is that we have not investigated the differences across industries
for three types of family firms, which is an avenue for future research.

Chen, Gu, Kubota and Takehara:
Accrual-Based and Real Activities Based Earnings Management Behavior of Family Firms in Japan

43

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The Japanese Accounting Review, 5 (2015), 21-47

APPENDIX1. SECTOR CLASSIFICATION FOR JAPAN
SectorConsumption
Goods

Investment
Goods

Industry
Fishery and Agriculture
Foods
Textiles and Apparels
Pharmaceutical
Electric Appliances
Other Products
MiningConstruction
Pulp and Paper
Chemicals
Oil and Coal Products
Rubber Products
Glass and Ceramics Products
Iron and Steel
Nonferrous Metals
Metal Products
MachineryTransportation Equipment
Precision Instruments

SectorServices

Industry
Communication
Wholesale Trade
Retail Trade
Services

Financial

Banks
Securities
Insurance
Other Financial BusinessTransportation

Land Transportation
Marine Transportation
Air Transportation

Utility

Electric Power and Gas

Real Estate

Warehousing
Real Estate

Note: Based on 33 industry classifications by the Tokyo Stock Exchange, we redefine sevensectors following Kubota and Takehara (2007) for Japanese firms.

Chen, Gu, Kubota and Takehara:
Accrual-Based and Real Activities Based Earnings Management Behavior of Family Firms in Japan

47

APPENDIX 2. DESCRIPTIVE STATISTICS OF ALL THE VARIABLES USED
RFO
ABNAC
EBEISD
Smoothness
ABNCFOABNPRODABNEXP
NEst
Cycle
MShare
DD
MTR
lnTA
ROA
LEV
SLSG
LP

Mean
9.397
0.007
2.134
0.642
0.000
0.002
-0.002
2.162
55.482
5.154
3.443
31.13510.8281.546
16.8971.039
21.469

S.D.
15.485
5.121
2.060
0.518
0.057
0.119
0.108
4.104
66.1709.955
2.094
14.9891.409
6.164
13.3761.582
47.98525%ile0.000-2.3220.926
0.306-0.028-0.045-0.0570.000
17.5260.420
2.044
20.386
9.858
0.539
6.428
0.941
10.079Median0.000-0.025
1.559
0.516
0.000
0.014
-0.0150.000
42.2851.355
3.102
40.57410.6721.801
13.8061.013
13.33475%ile13.345
2.213
2.693
0.829
0.028
0.068
0.029
2.000
76.371
4.975
4.426
40.78511.6503.629
23.9191.076
18.192

Note: Based on 33 industry classifications by the Tokyo Stock Exchange, we redefine sevensectors following Kubota and Takehara (2007) for Japanese firms. [Family Ownership] FFO
denotes the percentage of shares held by the founding family (in %).
[Earnings management measures] ABNAC: abnormal accruals to total assets estimated by themodified Jones model (in %), Persistence: Persistency measure of earnings which is defined as
first order autocorrelation of earnings, EBEISD: Past 5 year S.D. of earnings before
extraordinary items (in %), Smoothness: Smoothness measure defined as S.D. of earnings to S.D.
of cash-flows from operations, ABNCFO: Abnormal cash-flows from operations to total assets(in %), ABNCOGS: Abnormal cost of goods sold (in %), ABNPROD: Abnormal product tototal assets (in %), ABNEXP: Abnormal R&D expenditures to total assets. ABNCFO,ABNPROD and ABNEXP are estimated by Roychowdhury’s (2006) model.
[Cost proxies] Audit4: Big 4 Audit firm dummy variable, NEst: Number of Analysts who
follow the firm, Cycle: Operation cycle (in days), MShare: Market share of the firm (in %), DD:
Distance to default, MTR: Marginal tax rate (in %).
[Control variables] lnTA: Natural logarithm of total asset, ROA: Past 5 year average return on
assets (in%), LEV: Firm’s financial leverage defined as non-current liabilities to total asset,
SLSG: Past 5 year growth rate of sales (in %), LP: Labor productivity defined as value added per
employee (in million Yen).