Does the board of directors as Fat Cats exert more earnings management? Evidence from Benford’s law

The co-existence of an unbridled self-interested board of directors with weak corporate governance provides firms with a strong incentive to exert more earnings management. Since directors form the core of corporate governance, once they act as Fat Cats (board members who are both in charge of a company and have the power to increase their own pay substantially) to connive in earnings management, this in turn will incur substantial damage to the quality of the firm’s financial information. First, thus, this study investigates whether these directors guide executives to perform more earnings manipulation. Next, to examine the impact of regulatory reforms in Taiwan on Fat Cat firms’ earnings management, we probe whether these firms exert less earnings management after they were denoted as being Fat Cats. This study employs Benford’s law to overcome the shortcomings of accrual models’ insufficient explanatory power on the detection of earnings management, because Benford’s law uses the first or the second digit of holistic data to identify if the distribution of whole numbers deviates from the theoretical distribution. The test results present solid evidence that Fat Cat firms do exert more earnings manipulation than non-Fat Cat firms do, and further find that these firms still perform a certain degree of earnings management after they were announced as being Fat Cats. The results suggest that legislative authorities and investors may re-examine whether the competent authorities have created a suitable environment to enhance the quality of listed firms’ financial statements.