Joseph Fan, TJ Wong, and Tianyu Zhang

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Asset Specificity, Accounting Quality and Family
Succession

• Joseph Fan, TJ Wong, and Tianyu Zhang

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Broad Research Questions

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

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Motivation

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

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Definition of Succession

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

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Succession and Accounting
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1. Family firms and their accounting system

• Accounting The familys and/or founders control
  in the company will lead to an insider access
  accounting system that relies heavily on private
  channels rather than external financial
  reporting, increasing its accounting opacity to
  the public.
• Reduction in control leads to more external
  access accounting system

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2. Specific Assets and Accounting

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

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2. Specific Assets and Accounting

• Many of these specific assets are not fully
  transferable, not even to ones children
• This disruption during family succession allows
  us to examine if the reduction in asset
  specificity is associated with increase in
  accounting quality around succession
• Succession --gt higher accounting quality
• Interaction Reduction in family / founder
  control, further increase in accounting quality

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3. Predecessors Entrenchment

• Founder or departing chairman tries to hang on to
  power
• Asset specificity can be highly correlated with
  entrenchment (hard to separate)
• Firm experiences poor performance prior to
  succession and tries to cover up
• Firm performance and accounting quality improves
  after the succession

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Measuring Accounting Quality

• How to measure quality in literature?
• Accruals (unsigned discretionary accruals) Leuz
  et al.
• Timely loss recognition Bushman et al.
• Earnings-return relations Fan and Wong, 2002

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Discretionary Accruals Estimation

• Modified Jones Model with contemporaneous ROA
• Total Acc / TA 1/TA b1 (?Sales-?AR) / TA b2
  PPE / TA e
• NI Total Acc CF, so higher Total Acc, higher
  NI
• Residual e is the unexpected change in
  accruals. Manipulated level
• Unsigned discretionary accruals measure how much
  firms smooth earnings

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Timely Loss Recognition

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

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Table 1 Sample
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Table 1 Sample
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Accounting quality before and after
successionQuestion 1 We expect lower quality
before and higher quality after
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Table 3 Level of discretionary accruals--Univaria
te analysis
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Table 3 Level of discretionary accruals--multivar
iate analysis
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Table 4 Timely loss recognitionPanel A
Descriptive statistics
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Table 4 Timely loss recognitionPanel B
Succession v.s. non-succession
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Table 4 Timely loss recognitionPanel C Before
v.s. after succession
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Table 5 Earnings persistence
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Family/Founder control and accounting
qualityQuestion 2 Family/founder control is
associated bigger change in Discretionary
Accruals and TLR before and after succession
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Proxies for Family/Founder Control

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

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Table 6 Change is DA
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Table 7 Change in TLR
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Asset specificity and accounting qualityTLR
and Discretionary Accruals prior to succession
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Table 8 Discretionary accruals prior to succession
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Table 9 TLR prior to succession
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Need further analysis

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

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Further analysis

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

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Conclusion

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

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Future Directions

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