J. Account.

Public Policy 33 (2014) 391–400

Contents lists available at ScienceDirect

J. Account. Public Policy

journal homepage: www.elsevier.com/locate/jaccpubpol

Independent director cash compensation

and earnings management
Kangtao Ye ⇑
Department of Accounting, School of Business, Renmin University of China, Beijing 100872, China

a b s t r a c t

This study examines the impact of independent directors’ cash

compensation on firms’ financial reporting quality using a sample
of Chinese listed companies from 2002 to 2008. Unlike in the U.S.
where most listed firms provide stock-related compensations to
outside directors, Chinese listed companies compensate indepen-
dent directors with cash only. This context offers a cleaner setting
for examining the effects of independent director cash pay on earn-
ings management. Our study documents a positive association
between independent director cash compensation and the magni-
tude of earnings management. This suggests that compensating
independent directors with higher cash pay compromises their
independence and reduces their effectiveness in financial reporting
oversight. Our results are robust to an array of sensitivity checks.
These findings have important implications for both investors
and policy makers by showing that independent directors’ cash
compensation is also a significant determinant of financial report-
ing quality.
Ó 2014 Elsevier Inc. All rights reserved.

1. Introduction

The earnings management by public companies has attracted considerable attention in the wake of
several large accounting scandals involving Enron, WorldCom, and other firms. The revelation of these
accounting frauds raises concerns regarding the effectiveness of independent directors’ oversight of
companies’ financial reporting process. Prior studies examining the impact of board independence

⇑ Tel.: +86 10 8250 0435.

E-mail address: yekangtao@rbs.org.cn

http://dx.doi.org/10.1016/j.jaccpubpol.2014.04.001
0278-4254/Ó 2014 Elsevier Inc. All rights reserved.
392 K. Ye / J. Account. Public Policy 33 (2014) 391–400

on earnings management have yielded mixed results (e.g., Beasley, 1996; Vafeas, 2000a, 2005; Klein,
2002; Jaggi et al., 2009; Faleye et al., 2011). We contend that independent director monitoring is a
function of both the competency and incentives of independent directors (Fama and Jensen, 1983;
Yermack, 2004). The latter includes both pecuniary (directors’ compensation) and non-pecuniary (rep-
utation, status) incentives. Anecdote evidences suggest that the pecuniary incentives for independent
directors exert a significant impact on directors’ behavior. For instance, The Global Principles of
Accountable Corporate Governance released by CalPERS stated that ‘‘[a]lthough non-employee director
compensation is generally immaterial to a company’s bottom line and small relative to executive pay,
director compensation is an important piece of a company’s governance (CalPERS, 2011: p. 52)’’. The
AFL-CIO Proxy Voting Guidelines also claimed that ‘‘[e]xcessively large compensation packages may
also make directors less willing to challenge management out of fear of not being re-nominated
(AFL-CIO, 2003: p. 16)’’. It therefore remains an interesting question whether and how independent
director compensation affects financial reporting quality.
The extant research has examined the impacts of independent directors’ stock-based compensation
on financial reporting quality, and yields mixed results (Beasley, 1996; Vafeas, 2005; Ronen et al., 2006;
Cullinan et al., 2008). Little research however has explored the correlation between independent direc-
tors’ cash compensation and financial reporting quality. The distinct differences between cash and
stock-based compensations justify this study. Stock compensation is a performance-based pay, while
cash compensation for outside directors are typically not closely tied to firm performance. As a result
stock compensation can provide better alignment of directors’ and shareholders’ interests (Fich and
Shivdasani, 2005; Ahmed and Duellman, 2007). However, stock-based compensation may also provide
misaligned incentives in earnings management by closely tying directors’ wealth to equity price. If the
market cannot see through earnings manipulation in financial statements and values the company
incorrectly, directors compensated with stocks and options may benefit from earnings manipulation
by engaging in insider trading. This provides misaligned incentives for directors to engage in earnings
manipulation (Ronen et al., 2006; Cullinan et al., 2008). On the other hand, cash compensation for inde-
pendent directors is not sensitive to equity price, and therefore results in less motivation to inflate
earnings. The different impacts of cash and stocks on director incentives suggest that the implications
from research on stock-based compensation are not applicable to cash compensation.
There are two mechanisms however relating independent director cash compensation to earnings
management. The incentive hypothesis posits that high cash compensation will provide independent
directors with monetary incentives to effectively monitor management (Adams and Ferreira, 2008)
and thus curb the level of earnings management. On the other hand, the reciprocity hypothesis posits
that high cash compensation for independent directors may compromise their independence because
well-compensated directors may reciprocate high cash compensation by reducing oversight of insid-
ers (Vafeas, 2000b; Brick et al., 2006). The net effect of independent directors’ cash compensation on
earnings management is accordingly an empirical issue.
The Chinese stock market provides an appropriate setting for investigating this issue. Unlike in the
U.S. where most listed companies grant stocks and options to their outside directors (Yermack, 2004;
Farrell et al., 2008), Chinese listed companies do not grant stocks and options to their independent
directors and instead compensate independent directors with cash only. This context provides a clea-
ner setting for examining the impact of independent directors’ cash compensation on earnings man-
agement. In contrast, over 93% of U.S. listed firms grant equity-based compensation to outside
directors; cash pay merely accounts for 38% of outside directors’ total compensation during the period
from 1998 to 2004 in Farrell et al. (2008) sample. Outside directors in U.S. listed firms on average hold
0.9% of the firm’s equity (Ertugrul and Hegde, 2008). Accordingly, it is difficult to disentangle the impact
of cash compensation from that of stock-based compensation on earnings quality in U.S. listed firms.
Using a sample of 1407 Chinese listed firms during the period from 2002 to 2008, we find that inde-
pendent directors’ cash compensation is positively associated with the level of earnings management.
This suggests that the reciprocity effect dominates the incentive effect in China. We further document
that the positive relationship is weaker for female directors. Our results are robust to an array of sen-
sitivity tests, including endogeneity concern.
This study contributes to the extant literature in several ways. First, we complement the prior liter-
ature by examining the relationship between independent directors’ cash compensation and earnings
 K. Ye / J. Account. Public Policy 33 (2014) 391–400 393

management, while the prior literature has primarily focused on independent directors’ stock-based
compensation (e.g., Beasley, 1996; Vafeas, 2005; Ronen et al., 2006; Cullinan et al., 2008). In a related
study Persons (2012) examines how director stock-based and cash compensation affect the likelihood
of financial fraud using a sample of 222 U.S. listed firms, and find that the likelihood of financial fraud is
positively associated with director options, and is unrelated to director cash pay. However, the preva-
lence of stock-based compensation for directors in the U.S. suggests that the U.S. listed firms primarily
use stock-based compensation rather than cash pay to motivate or reciprocate outside directors. This
partially explains why Persons (2012) does not document a significant relationship between director
cash pay and financial fraud in the U.S. Furthermore, it is difficult to disentangle the impact of director
cash compensation from that of stock-based compensation on financial reporting quality when outside
directors receive both cash and stock-based compensations. In contrast, the Chinese context provides a
cleaner setting for examining the consequences of independent directors’ cash pay. In addition, listed
firms worldwide typically compensate independent directors with cash only.1 Hence, relative to
Persons (2012), our findings are more applicable for a vast majority of listed firms worldwide that do
not offer stock-based compensation to their independent directors.
Second, the AFL-CIO Proxy Voting Guidelines claims that ‘‘[e]xcessively large compensation packages
may also make directors less willing to challenge management out of fear of not being re-nominated
(AFL-CIO, 2003)’’. Our findings that the magnitude of earnings management is positively related to
independent director cash pay lends support to this argument. Third, we provide additional evidence
that the relationship between director compensation and earnings management is conditioned by
director gender. Forth, we extend the literature on director compensation from mature markets to
China, the largest emerging market.

2. Institutional background and hypothesis development

2.1. Institutional background

Chinese listed firms are characterized by a highly concentrated ownership structure. Controlling
shareholders accordingly have stronger incentives to directly monitor management, reducing the tra-
ditional Type I agency problem (conflict between managers and shareholders). However, this concen-
trated ownership structure leads to the Type II agency problem (conflict between majority and
minority shareholders), where controlling shareholders tend to divert resources out of firms at the
expense of minority shareholders (Shleifer and Vishny, 1997). Both academic research and anecdotal
evidences suggest that minority investors are severely expropriated by controlling shareholders in
Chinese stock markets (e.g., Jiang et al., 2010; Firth et al., 2011).
In order to improve corporate governance in China, the Chinese Security Regulation Committee
(CSRC) introduced the independent director system as a potential solution. The CSRC required that
independent directors should constitute no less than one-third of the board by June 30, 2003. By
the end of 2007 approximately 36% of all board directors were independent directors. Independent
directors in China generally receive a fixed annual cash retainer. Unlike in the U.S., Chinese listed com-
panies do not grant stocks and options to independent directors. The primarily role for independent
directors in China is to protect minority shareholders from expropriation by controlling shareholders
and management as well as preventing corporate scandals (Clarke, 2006). Independent directors have
the rights to recommend the hiring and dismissal of auditing firms, as well as retain independent
counsel such as auditors and lawyers at the company’s expense.

2.2. Independent director cash compensation and earnings management

Effective monitoring of management requires both time and effort. Independent directors generally
are busy people with higher time opportunity costs, and may therefore demand higher pecuniary and
non-pecuniary rewards for their efforts. High compensation can also attract highly-reputed and more

1
Source: S&P CAPITAL IQ.
394 K. Ye / J. Account. Public Policy 33 (2014) 391–400

able directors (Adams and Ferreira, 2008). These arguments suggest that cash compensation for inde-
pendent directors will be positively related to monitoring effectiveness and negatively associated with
the level of earnings management. We term this effect the ‘‘incentive hypothesis’’. Consistent with the
incentive hypothesis, Adams and Ferreira (2008) find that high cash compensation for outside direc-
tors reduces board meeting attendance problems.
However, high compensation for independent directors may also compromise their independence
in oversight of management because well-compensated directors may reciprocate for higher compen-
sation by reducing monitoring (Brick et al., 2006). Vafeas (2000b) shows that directors with higher
compensation will become more tolerant toward management. Brick et al. (2006) document that CEOs
receive more generous compensation when outside director compensations are high, and that this
excess compensation for CEOs has an adverse effect on firm performance. This suggests that high cash
compensation for independent directors may compromise their monitoring effectiveness. We term
this effect the ‘‘reciprocity hypothesis’’.
As discussed in the preceding section, controlling shareholders with higher ownership have greater
incentives to directly monitor management (Ke et al., 1999). This reduces the reliance on external
monitoring mechanisms such as independent directors to limit managerial opportunism. It is there-
fore unlikely that controlling shareholders will utilize cash compensation to incentivize independent
directors in oversight of management. Accordingly, the incentive hypothesis may not be applicable for
Chinese listed firms.
On the other hand, Chinese listed firms are more likely to suffer from the Type II agency problem.
The conflict between majority and minority shareholders indicates that controlling shareholders tend
to expropriate firm resources at the expense of minority shareholders. This motivates controlling
shareholders to engage in earnings management in order to camouflage their rent-seeking activities
and facilitate the diversion of firm resources (Fan and Wong, 2002; Chung et al., 2005). Furthermore,
the China Securities Regulatory Commission (CSRC) typically uses profitability criteria to determine
which companies are eligible for initial public offering and/or seasoned equity offering. Prior studies
suggest that those regulations induce rampant earnings management in Chinese listed firms (Aharony
et al., 2010; Chen and Yuan, 2004). Controlling shareholders in China therefore have motivation to use
pecuniary benefits to compromise outside director effectiveness in financial reporting oversight.
Taken together, we expect that the reciprocity hypothesis will better characterize the impact of
independent directors’ cash pay on earnings management than the incentive hypothesis in China.
As a result, we should observe a positive relationship between independent director cash compensa-
tion and the level of earnings management. This leads to the following hypothesis:
H1. Cash compensation for independent directors is positively associated with the magnitude of
earnings management in Chinese listed firms.

3. Data and research design

3.1. Data

Our sample contains all Chinese companies listed on the Shanghai and Shenzhen Stock Exchanges
during the period from 2002 to 2008. Our sample begins in 2002 because few Chinese firms had
appointed independent directors before 2002. We obtained financial and corporate governance infor-
mation from the CSMAR (China Stock Market and Accounting Research) database, and obtained own-
ership structure information from the CCER China Stock Database. After excluding observations with
missing information we obtained a sample of 6139 observations representing 1407 companies.

3.2. Research design

3.2.1. Measuring earnings management

We measure the level of earnings management (EM) as the absolute value of the discretionary
accruals derived from the modified Jones (1991) model (Dechow et al., 1995). The modified Jones
(1991) model is estimated cross-sectionally by each industry-year group. Since earnings manipulation
 K. Ye / J. Account. Public Policy 33 (2014) 391–400 395

involves both extremely positive and negative values of discretionary accruals (Klein, 2002;
Bergstresser and Philippon, 2006), we use the absolute value of discretionary accruals as our proxy
for earnings management.

3.2.2. Independent variable and control variables

We measure independent directors’ cash compensation (PAY) as the logarithm of the average
annual cash retainer paid to the independent directors of company i at year t. We also control other
factors that may affect the level of earnings management. Prior research suggests that board indepen-
dence can effectively curb earnings management (Beasley, 1996; Klein, 2002; Jaggi et al., 2009; Faleye
et al., 2011). We therefore include two measurements of board independence: the fraction of indepen-
dent directors on the board (IDRATIO), and the duality of the CEO and Chair of the board (DUALITY). We
also control for board size (BSIZE) as Yermack (1996) suggests that small boards of directors can dis-
cipline management more effectively.
We also include the ownership by controlling shareholders (CSOWN) because Jaggi et al. (2009)
suggest that controlling shareholder ownership is inversely related to the magnitude of earnings man-
agement. Chen et al. (2011) contend that state-owned companies have weaker incentives to engage in
earnings management than private-owned companies. We therefore include a dummy variable (SOE)
denoting state ownership. We also include a dummy variable (AUDIT) denoting audit quality that is
equal to one if the company is audited by a Big-10 audit company, and zero otherwise. We further con-
trol SIZE (the logarithm of total assets), ROA (return on total assets), and LEVERAGE (the ratio of debts
to total assets) in the regressions. All of continuous variables are winsorized at 1% for each tail.

4. Results

4.1. Summary statistics and correlations

The summary statistics in Table 1 illustrate that the mean (median) cash retainer for independent
directors in our sample is 42,258 (37,500) RMB (approximately US$ 6501 (5769)). This is quite large
compared to the per capita income of urban residents in China (15,781 RMB in 2008), and is approx-
imately one-third of the average top executive compensation in Chinese listed firms (the mean (med-
ian) is 121,666 (90,903) RMB for our sample firms).
Table 2 reports the correlation matrix. Independent director pay is positively associated with the
magnitude of earnings management, consistent with the reciprocity hypothesis. The level of earnings

Table 1
Summary statistics.

Variable Mean Median Std. dev. Min Max

PAY 42,258 37,500 27,838 2000 293,867
EM 0.066 0.046 0.067 0.001 0.381
DUALITY 0.099 0 0.298 0 1
IDRATIO 0.346 0.333 0.054 0.071 0.750
BSIZE 9.770 9 2.200 4 21
SOE 0.697 1 0.460 0 1
AUDIT 0.254 0 0.436 0 1
CSOWN 0.391 0.369 0.162 0.081 0.786
Total assets (in millions RMB) 3847 1772 10,295 93 319,390
ROA 0.020 0.026 0.090 0.774 0.357
LEVERAGE 0.539 0.522 0.300 0.074 3.805

Note: PAY is the average annual cash retainer paid to the independent directors of firm i at year t; EM is the level of earnings
management measured as the absolute value of discretionary accruals; DUALITY is a dummy variable equal to one if CEO is also
the Chair of the board and zero otherwise; IDRATIO is the fraction of independent directors on the board; BSIZE is the number of
directors on the board. SOE is a dummy variable equal to one if the company is controlled by the government and zero
otherwise; AUDIT is a dummy variable equal to one if the company is audited by a Big-10 audit firm and zero otherwise; CSOWN
is the percentage of equity held by the controlling shareholder; ROA is return on total assets; and LEVERAGE is the ratio of debt
over total assets.
396 K. Ye / J. Account. Public Policy 33 (2014) 391–400

Table 2
Correlation matrix.

Variable (1) (2) (3) (4) (5) (6) (7) (8) (9) (10)
(1) EM 1.00
(2) Ln(PAY) 0.02 1.00
(3) DUALITY 0.03 0.00 1.00
(4) IDRATIO 0.04 0.12 0.06 1.00
(5) Ln(BSIZE) 0.07 0.06 0.06 0.23 1.00
(6) SOE 0.10 0.04 0.07 0.09 0.17 1.00
(7) AUDIT 0.05 0.18 0.02 0.01 0.08 0.09 1.00
(8) CSOWN 0.04 0.04 0.07 0.06 0.00 0.30 0.09 1.00
(9) Ln(ASSET) 0.09 0.32 0.07 0.03 0.24 0.25 0.27 0.23 1.00
(10) ROA 0.25 0.12 0.03 0.01 0.04 0.07 0.10 0.13 0.23 1.00
(11) LEVERAGE 0.21 0.02 0.03 0.02 0.01 0.11 0.04 0.14 0.09 -0.39

Note: Correlations greater than 0.02 are significant at p < 0.10. The variables are defined as in Table 1.

Table 3
Independent director cash compensation and earnings management: OLS regression results.

Variable Regression 1 Regression 2 Regression 3

Dependent variable: Dependent variable: Dependent variable:
absolute value of income-increasing income-decreasing
discretionary accruals discretionary accruals discretionary accruals
Ln(PAY) 0.007*** 0.006*** 0.004
(3.049) (3.606) (0.954)
DUALITY 0.005** 0.004 0.005***
(2.256) (1.060) (3.741)
IDRATIO 0.022 0.005 0.026
(1.547) (0.308) (0.964)
Ln(BSIZE) 0.007* 0.004 0.008
( 1.650) ( 1.205) ( 1.396)
SOE 0.007*** 0.007* 0.005*
( 2.976) ( 1.920) ( 1.897)
AUDIT 0.004** 0.008*** 0.001
( 1.988) ( 2.970) ( 0.492)
CSOWN 0.023*** 0.016** 0.020*
(2.798) (2.310) (1.789)
Ln(ASSET) 0.003*** 0.003 0.000
( 2.583) ( 1.637) (0.212)
ROA 0.158*** 0.223*** 0.285***
( 4.731) (5.118) ( 20.27)
LEVERAGE 0.023*** 0.017** 0.012**
(3.054) (2.385) (2.416)
Constant 0.055 0.072* 0.012
(1.134) (1.679) (0.140)
Industry and year dummies Controlled Controlled Controlled
Observations 6139 3252 2887
Adjusted R-squared 0.128 0.107 0.265

Note: Variables are defined as in Table 1. The heteroskedastically consistent t-statistics, adjusted for clustering by firm and year,
are in parentheses.
*
Significance level at 10%.
**
Significance level at 5%.
***
Significance level at 1%.

management also positively correlates with leverage and the duality of the CEO and Chair, and nega-
tively correlates with state ownership, firm size, and audit quality as expected. All correlation coeffi-
cients are less than 0.40 and the variance inflation factors are less than 2, suggesting that potential
multicollinearity is not a major concern.
 K. Ye / J. Account. Public Policy 33 (2014) 391–400 397

4.2. Main regression results

Table 3 presents the empirical results. Regression 1 shows that independent directors’ cash pay is
significantly and positively associated with earnings management (a = 0.007, p < 0.01), suggesting that
the reciprocity effect of independent directors’ cash compensation on earnings management domi-
nates the incentive effect. The results are consistent with Higgs (2003) survey contending that excess
pay may compromise outside directors’ independence.
The coefficients on control variables are largely consistent with prior research. The magnitude of
earnings management is negatively related to audit quality, state ownership, firm size, and financial
performance, while positively related to leverage and the duality of the CEO and Chair. We also find
that controlling shareholder ownership is positively related to earnings management, consistent with
Fan and Wong (2002).
We further partition our sample into two subsamples based on the sign of discretionary accruals.
Regressions 2 and 3 of Table 3 report the regression results. We find that the positive effect of
independent directors’ pay on earnings management exists in the subsample of income-increasing
earnings management, and unsurprisingly does not hold for the subsample of income-decreasing
earnings management.
Overall, the results in Table 3 provide evidence that high cash compensation for independent direc-
tors compromises their monitoring of financial reporting process. Firms paying larger cash retainers to
independent directors exhibit a higher level of earnings management.

5. Robustness checks

A major concern with our results is the potential endogeneity problem. We address this problem by
employing the instrumental variable approach. Our instrumental variable is local managerial pay
(LocalPay), the average cash pay for top executives in the province where the listed company is
located. Many independent directors in Chinese listed firms are businessmen from local companies
or professors from local business schools. Hence the listed firms should offer independent directors
with a pay level that is comparable to local managerial pay. This suggests that independent director
cash pay should be correlated with local managerial pay. The magnitude of earnings management
in a firm however should be uncorrelated with local managerial cash pay. This suggests that local
managerial cash pay can be a valid instrument variable here.
The Regressions 1 and 2 in Table 4 report the instrumental variable regression results. We find that
independent director pay is significantly related to local managerial pay. The Sargan test of instrument
validity does not reject the null hypothesis that the instrumental variable is exogenous, implying that
local managerial pay is a valid instrumental for independent director pay. More importantly, we doc-
ument a positive correlation between the instrumented value of Ln(PAY) and the level of earnings
management, suggesting that our results are robust to the instrumental variable approach.
Another possible endogeneity source is the potential reverse causality issue. For instance, firms
with poor earnings quality may appoint more reputable independent directors in order to alleviate
the information asymmetry between firms and investors, and more reputable directors may ask for
higher compensation (Engel et al., 2010). We perform the Granger causality test to address the poten-
tial reverse causality issue. The Regressions 3 and 4 of Table 4 present the estimation results. We find
that past changes in director pay positively influences the current change in earnings management (F-
statistics = 2.71, p = 0.067), but document no relationship between past earning management changes
and the current change in director pay (F-statistics = 1.44, p = 0.237). These results confirm that higher
independent director pay leads to future earnings management and there appears to be no reverse
causality from earnings management to director pay.
Bergstresser and Philippon (2006) suggest that CEO stock compensation is positively related to
earnings management. Hribar and Nichols (2007) suggest that absolute discretionary accruals is asso-
ciated with operating volatility. We accordingly include the percentage of equity held by the CEO (CEO
Ownership), cash flow volatility (SDCFO), and cash-based revenues volatility (SDREV) into the regres-
398 K. Ye / J. Account. Public Policy 33 (2014) 391–400

Table 4
Independent director cash compensation and earnings management: Instrumental variable regression and Granger causality tests.

Variable Instrumental variable regression Granger causality tests

Regression 1 Regression 2 Regression 3 Regression 4
First stage Second stage Dependent variable: Dependent variable:
regression regression change in EM change in Ln(PAY)
dependent dependent at year t at year t
variable: Ln(PAY) variable: EM
Ln(LocalPay) 0.339***
(10.54)
Ln(PAY) 0.017**
(2.039)
Change in EM at year t 1 0.632*** 0.036
( 15.27) ( 0.402)
Change in EM at year t–2 0.362*** 0.076
( 11.04) ( 1.573)
Change in Ln(PAY) at year t 1 0.016* 0.170***
(1.712) ( 2.582)
Change in Ln(PAY) at year t 2 0.007 0.053**
(0.853) ( 2.189)
DUALITY 0.001 0.005* 0.006 0.015**
(0.0311) (1.669) (1.367) ( 2.345)
IDRATIO 0.282 0.018 0.073*** 0.270***
(1.513) (1.077) (11.82) (4.247)
Ln(BSIZE) 0.003 0.007* 0.003 0.018
(0.0512) ( 1.668) (0.374) (1.302)
SOE 0.079*** 0.007*** 0.003** 0.012
( 4.150) ( 3.231) ( 2.539) ( 0.856)
AUDIT 0.059*** 0.005** 0.004 0.012
(2.635) ( 2.239) ( 0.904) (0.785)
CSOWN 0.138** 0.025*** 0.006 0.030
( 2.134) (4.337) (0.485) (0.723)
Ln(ASSET) 0.134*** 0.004*** 0.001 0.012***
(14.24) ( 2.926) (0.401) (2.748)
ROA 0.125 0.159*** 0.179*** 0.112**
LEVERAGE (1.207) ( 15.65) ( 3.807) (2.530)
0.004 0.023*** 0.005 0.021
(0.124) (7.857) (0.572) (1.100)
Constant 4.363*** 0.016 0.066 0.342***
(11.53) ( 0.254) ( 0.889) ( 3.574)
Industry and year dummies Controlled Controlled Controlled Controlled
Observations 6139 6139 1906 1906
H0: The coefficients H0: The coefficients
on the past changes on the past changes
in Ln(PAY) are not in EM are not
different from zero. different from zero.
F-statistics = 2.71 F-statistics = 1.44
p-value = 0.067 p-value = 0.237
Adjusted R-squared 0.258 0.124 0.329 0.043

Note: LocalPay is the average managerial cash pay in the province where the focal company locates. Change in EM is the change
in EM for year t, t 1, and t 2, respectively. Change in Ln(PAY) is the change in Ln(PAY) for year t, t 1, and t 2, respectively.
Other variables are defined as in Table 1. The heteroskedastically consistent t-statistics, adjusted for clustering by firm and year,
are in parentheses.
*
Significance level at 10%.
**
Significance level at 5%.
***
Significance level at 1%.

sions. We also include book-to-market ratio and sales growth to control for the growth effect. Un-tab-
ulated results indicate that our main inferences do not change.
As robustness checks, we further follow Dechow and Dichev (2002), McNichols (2002), and Kothari
et al. (2005) to incorporate cash flows and firm performance in the Jones model to estimate earnings
 K. Ye / J. Account. Public Policy 33 (2014) 391–400 399

management. We again document quantitatively similar results using those alternative measure-
ments of earnings management.
Prior research suggests that men are more interested in economic benefits and are more likely to
break rules in order to achieve career success, while women appear to be more ethically conscious
(Betz et al., 1989; Butz and Lewis, 1996). Hence we further examine the moderating effects of indepen-
dent directors’ gender. Using independent director-level data we find that the positive effect of direc-
tor cash compensation on earnings management is weaker for female directors, consistent with
prediction.
To further support the reciprocity argument, we examine whether or not independent director pay
is higher in firms with more likelihood of diversion by the controlling shareholder. Prior studies sug-
gest that the divergence between the controlling shareholder’s voting rights and cash flow rights leads
to more rent-seeking activities by the controlling shareholder (Claessens et al., 2002; Fan and Wong,
2002). The reciprocity hypothesis hence predicts a positive relationship between independent director
cash pay and the divergence between the controlling shareholder’s voting rights and cash flow rights if
the controlling shareholder uses pecuniary benefits to compromise independent directors’ effective-
ness in monitoring. Un-tabulated results are consistent with the prediction, further supporting the
reciprocity hypothesis.

6. Concluding remarks

Our study suggests that higher cash pay for independent directors impairs their independence and
makes them less effective in financial reporting oversight. The positive relation between director cash
pay and earnings management, coupled with the mixed results from prior research on stock-based
compensation, suggests that the current monetary rewards (cash or options) cannot appropriately
motivate independent directors in oversight of financial reporting process. We may need to rely on
non-monetary incentives (status or reputation) to enhance board effectiveness in financial reporting
oversight.
Our study contributes to the corporate governance literature by providing evidence on the associ-
ation between independent directors’ cash compensation and earnings management. Our findings are
of value to policy makers who seek to improve board independence and corporate governance in pub-
lic firms. Our findings suggest that cash compensation for independent directors is a significant deter-
minant of financial reporting quality in addition to board structure.
Although this study sheds light on the link between independent directors’ cash compensation and
earnings management, caution should be taken when generalizing our results. Our findings may be
generalized to other markets that exhibit similar ownership structure and director compensation
scheme as those in Chinese stock markets, but may not hold for markets with diffused ownership
structure or that primarily compensate directors with stocks or options. Further studies are warranted
in order to better understand the role of independent directors’ compensation in corporate
governance.

Acknowledgments

I appreciate the helpful comments and suggestions from Martin Loeb (editor), Lawrence Gordon
(editor), two anonymous reviewers, Oliver Z. Li, Wenjing Li, Xiumin Martin, Ning Zhang, Nan Zhou,
and workshop participants at Beijing Technology and Business University, Southwestern University
of Finance and Economics, and Xiamen University. This study is supported by the National Natural Sci-
ence Foundation of China (Project Nos.: 71072145 and 71132004).

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