Association between independent non-executive directors, family control and financial disclosures in Hong Kong

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Abstract

Our study examines whether comprehensive financial disclosures, used as a proxy for corporate board’s responsiveness, are positively associated with the proportion of independent non-executive directors (INDs) on corporate boards, and whether family control of the firm has an impact on this association. The findings suggest that the ratio of INDs to the total number of directors on corporate boards is positively associated with the comprehensiveness of financial disclosures, and this association appears to be weaker for family controlled firms compared to non-family controlled firms.

Introduction

In the 1980s, inclusion of independent non-executive directors (INDs) on corporate boards started to receive increasing attention (e.g., Fama, 1980; Williamson, 1985). Two main arguments have been advanced in support of INDs. First, INDs provide advice to corporate boards on strategic decisions, which may improve the firm’s economic and financial performance (Fama, 1980, pp. 293–295). Several studies (e.g., Brickley and James, 1987, Rosenstein and Wyatt, 1990, Baysinger and Hoskisson, 1990, Byrd and Hickman, 1992) empirically tested the association between INDs and economic and financial performance of firms, but found mixed evidence.1

The second argument for inclusion of INDs on corporate boards relates to better monitoring of management decisions and activities by corporate boards (Fama, 1980, pp. 293–295). In his analysis of a political theory of American corporate finance, Roe (1991, p. 10) argues that because of fragmentation of institutional capital, owners’ powers have shifted to managers. Managers are considered to be less identifiable targets of legislation than financial institutions because they are dispersed and they can exert political influence to retain powers (Roe, 1991, p. 65). Roe’s (1991, pp. 54–56) argument suggests that managers’ activities need to be properly monitored to avoid abuse of power, such as maximization of their own wealth. Fama (1980, pp. 296–302) in his analysis of ownership and control provides a theoretical explanation in support of the INDs’ role in the monitoring activities. Later, Fama and Jensen (1983, pp. 314, 315, 323) expanded on Fama’s explanation and argued that a higher proportion of INDs on corporate boards would result in more effective monitoring of boards and limit the managerial opportunism.

Monitoring of corporate boards by INDs suggests that corporate boards will become more responsive to investors, and inclusion of INDs on boards will improve the firm's compliance with the disclosure requirements which in turn will enhance the comprehensiveness and quality of disclosures (e.g., Forker, 1992, pp. 112, 113, who frequently refers to INDs as non-executive directors). In his analysis of transaction costs, Williamson (1985, pp. 1544–1546, 1550) provides a framework which also links disclosure quality to corporate governance. Following Williamson arguments, Forker (1992, p. 116) hypothesizes that the disclosure quality would improve if information about the proportion of non-executive directors on corporate boards is disclosed in financial reports. Forker (1992, p. 117) tested the association between disclosure of information on non-executive directors and disclosure quality by defining it in terms of fineness of details relating to stock option plans disclosed in the firms’ financial statements. Forker's (1992, p. 123) findings, however, did not fully support the positive association between non-executive directors and disclosure quality. Forker (1992, p. 123) attributed this lack of support to measurement errors resulting from the firms not disclosing information on non-executive directors.

Among other roles, in Hong Kong INDs are expected to monitor compliance with the board’s policies and applicable laws and regulations, and they are also expected to ensure accuracy of information provided by management SEHK, 1992, SEHK, 1996. In order to improve the effectiveness of Hong Kong corporate boards, the SEHK required listed companies to have at least two INDs on their boards by 31 December 1994 (SEHK, 1996, Section 3.15, pp. 3, 4). The improvement in accuracy was expected to enhance the reliability of financial information (e.g., refer to FASB, 1980 for qualitative characteristics of financial information). Furthermore, disclosure of more detailed information should provide a better understanding of the firm’s disclosure policies and practices to investors and will enable them to make better investment decisions. Disclosure of detailed information assumes even greater importance in Hong Kong and other countries in the Asian Pacific region because of the reasons discussed below.

First, globalization of capital markets and harmonization of accounting standards (Levitt, 1998, pp. 80, 81) demand that comprehensive information is disclosed for proper evaluation of the firm's economic performance by investors, especially foreign investors. Second, the 1996–1997 Asian financial crises have underlined the importance of openness and disclosure of detailed information (Tripathi, 1998, p. 49). Third, disclosure of detailed information deserves special attention in the East Asian countries because firms in these countries have less incentives for “transparency” than Anglo-American firms (Ball et al., 1999, p. 3).2 Disclosure orientation of firms in these countries is greatly influenced by the cultural environment in which they operate (e.g., refer to Hofstede, 1983) and also by the form of their ownership and management structure (e.g. Lam et al., 1994; Mok et al., 1992).

Our study examines whether a higher proportion of INDs on corporate boards is associated with more comprehensive disclosures within the mandatory disclosure framework. Our study also examines whether family ownership and control of firms has an impact on the association between INDs and financial disclosures because a substantial number of Hong Kong firms are family owned and controlled (e.g., Mok et al., 1992, p. 282; Lam et al., 1994, p. 727). Because of family ownership and control structure, the appointment of INDs in family controlled companies is likely to be influenced by the management's close relationship with prospective INDs and the likelihood of their support for the management's philosophy and policies. Consequently, in the presence of family ownership and control INDs' independence may be compromised and their contribution to improve the management's responsiveness to investors might be reduced. Thus, these factors may reduce the INDs' effectiveness in family owned and controlled firms.

Our results suggest a positive association between the proportion of INDs on corporate boards of Hong Kong firms and comprehensiveness of financial disclosures. This in turn suggests that inclusion of INDs on corporate boards has a positive influence on the management’s decisions to disclose financial information. The results also suggest that the positive association between the proportion of INDs on corporate boards and financial disclosures is stronger for non-family owned and controlled firms than for family owned and controlled firms. This result in turn suggests that family ownership and control may reduce the INDs' effectiveness in convincing management to disclose more comprehensive financial information. The findings of our study have policy implications for Hong Kong as well as other countries in the Asian Pacific Basin region because of similarities in the institutional and cultural environments and also in the Asian Pacific Basin region because of similarities in the institutional and cultural environments and also in the corporate ownership structure of firms from different countries in the region (see, for example, Lam et al., 1994, p. 727).

The remainder of our paper is organized as follows: Section 2 provides the background for the study and contains a brief review of the relevant literature. In Section 3, the research methodology, data selection procedures and development of hypotheses are presented. Section 4 discusses the results and Section 5 contains the conclusion.

Section snippets

Hong Kong business and accounting environment

As Hong Kong developed into an industrialized region under British governance, its business practices have been influenced both by British value systems and indigenous Chinese cultural values (Bond and King, 1985, pp. 353–356). Accounting, which played an important role in the economic growth and the development of capital markets in Hong Kong, among other factors, has also been influenced by British accounting practices (Phenix, 1994, pp. 164, 165). The Hong Kong Companies Ordinance, similar

Independent non-executive directors and financial disclosures

Forker (1992, pp. 112, 113) argued that inclusion of non-executive directors on corporate boards would improve the quality of financial disclosures. This argument suggests that INDs could encourage better management’s compliance with the mandatory disclosure requirements, which would enable investors to have a better insight into the working of corporate boards (e.g., Baysinger and Hoskisson, 1990, pp. 73–75).

Based on Fama and Jensen’s (1983, pp. 314, 315) argument that higher proportion of

Descriptive statistics

Descriptive statistics for the total sample are contained in panel A of Table 2. The results on disclosure index (SCORE) indicate that the highest raw score achieved by a firm is 116 out of 142 points (83.1%) and the lowest raw score is 75 points (52.8%). The mean and median values are 72.0% and 73.0%, respectively, and the standard deviation is 6.0%. These results suggest that the sample firms are widely distributed with regard to financial disclosures and that the distribution is not skewed.

Conclusion

Our study has examined the association between comprehensiveness of financial disclosures and INDs on corporate boards. The study has been conducted on a sample of 87 large Hong Kong firms and on a disclosure index based on the measurement instrument developed by Wallace and Naser (1995). The classification of firms into family owned and controlled and non-family owned and controlled has been based on criteria used by prior studies (Mok et al., 1992; Lam et al., 1994).

The results suggest that

Acknowledgements

This research study was made possible by a research grant provided by the City University of Hong Kong, and the authors thank the University for its research support. The authors are grateful to Ferdinald A. Gul, Judy Tsui, John Courtis, and participants in the seminar at the Department of Accountancy, City University of Hong Kong for their helpful comments and suggestions. Anonymous referees’ comments and suggestions are also gratefully acknowledged.

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