“The association between foreign directors and opportunistic financial reporting”

This study examines the effect of foreign directors in the board of directors on the monitoring function by analyzing the association between foreign directors and opportunistic financial reporting. The authors address this question by examining the effect of the foreign directors in the board on firms’ discretionary accruals and book-tax difference. The researchers analyze by using Korean firm data for the years 2001–2014 as Korea is one of the few countries that nepotism is strong within the board, providing the ideal setting to analyze the effect of foreign directors on the monitoring function of the board. The authors find that foreign directors have a positive effect on the monitoring function of the board, as discretionary accruals and book-tax differences of firms with foreign directors are lower than those without foreign directors. Further, the researchers find that the posi- tive effect of foreign directors on the monitoring function is more pronounced if foreign directors are independent directors or expertise in accounting or finance. Overall, the findings support the view that foreign directors in the board increase the board diversity, which increases the independence of the board and so the monitoring function.


INTRODUCTION
IBM, the multinational firm, organized a Task Force (TF) team of executives -divided into eight groups including Asian, Black, Hispanic, Native American, LGBT, Men, Disabled, and Women -and set environment and policy to engage in business without any discrimination in every part such as recruitment and project (The Economic Daily, 2015). 2 It is no longer surprising that major Korean corporations are making higher sales in overseas markets than in the domestic market. With the globalization of their businesses, major Korean firms are actively hiring foreign directors, Peter Schreyer, the former chief designer at Hyundai-Kia, is a typical example (Yeonhap News, 2016).
As global management and multinational corporations are becoming common, many Korean firms are expanding their businesses to overseas markets, and the rapid development of the internet, communication technologies, and distribution channels are accelerating the growth of international trade. Therefore, corporations today require to design their business strategies on a global basis and develop their products and services that work across borders, so today's multinational firms need to have directors or leaders who can develop business strategies that work effectively outside of their own territory.
The demand for foreign directors, therefore, is increasing because of the pace and nature of globalization. Recently, Korean firms are actively appointing foreigners as members of board of directors to reyspond to the rapidly changing foreign markets and to seek new business opportunities 1,2 . Prior researches offer that foreign directors bring the variety of backgrounds, experiences, and knowledge to the boardroom that enhances the firm performance and the value (Oxelheim & Randoy, 2003;Masulis et al., 2012;Byoun et al., 2016). Therefore, firms are actively appointing foreigners as members of board of directors with the expectation that they will help business expansion by bringing diverse perspectives and viewpoints to the boardroom.
Prior studies show that strong governance helps firms to improve monitoring function, restricting managers' opportunistic behaviors (Denies & McConnell, 2003;Bhagt & Bolton, 2008;Chen et al., 2009). According to the prior literature, the benefit of including foreigners in the boardroom is not only the increase in the value of the company, but also the enhancement of the corporate governance. According to Fama and Jensen (1983), from the perspective of the board of directors, the good corporate governance is the governance that reduces dissensus among stakeholders and that effectively overwatches managers' activities. These major functions of the boardroom are strengthened with board's independence (Dechow et al., 1996;Beasley, 1996), and the research by Carter et al. (2008) suggests that the independence of the board increases with the board diversity. Bhagat and Bolton (2008) also suggest that the board independence is required to discipline management of poorly performing firms. Thus, the inclusion of the foreign directors in the firm helps firms to form an effective board of directors by increasing the independence of the boardroom.
While firms benefit from including foreigners in the boardroom, on the other hand, there could be cost incurred from board diversity due to greater communication and coordination problems among board members. Diverse directors with different background and characteristics can increase the conflicts among members of the board and impede the decision-making process 3 . Also, since the main purpose of including foreign directors in the board is to develop the business strategies to expand the businesses to the foreign market or to make efficient decisions, the positive effects of foreign directors may be limited only to the business operation.
The effect of foreign directors in the board and board diversity are one of the major areas of interest in the corporate governance literature. Thus, most of the extant literature has explored the relationship between the board diversity or foreign directors and the firm performance. However, the effect of foreign directors or board diversity on the specific functions of boardroom has not been explored. Therefore, our research focuses on the monitoring function of foreign directors in the boardroom.
As mentioned above, there are two general conflicting views regarding the monitoring function of foreign directors in the boardroom. Some researchers suggest that diversity leads to greater independence, improving the monitoring function of the boardroom. On the other hand, some other researchers assert that there can be the negative effect of board diversity on monitoring function, because the different or disparate background and characteristics cause the coordination and communication problems, which reduce the efficiency of monitoring function (Masulis et al., 2012).
In this research, we hypothesize that the board diversity enhances the monitoring function of the board, as diversity increases the board independence by preventing or restricting nepotism that reduces the monitoring function. To examine the effect of foreign directors on the monitoring function, we analyzed the influence of foreign directors on the opportunistic financial reporting by examining how the existence of foreign directors in the board of directors affects the firms' discretionary accruals and book-tax difference.
Our study has several contributions to the literature. First, this study clarifies ongoing disputes on the effectiveness of foreigners in the board of directors by analyzing the monitoring functions of foreign directors. This study provides useful implications for such stakeholders as regulators and investors to 3 In 2007, LG Electronics filled all senior vice president positions in with foreigners. However, all of them were either replaced or fired three years later.
LG was criticized for appointing foreigners to top positions without concerning cultural differences (Hankyung Biz, 2010).

Board diversity and foreign directors
Extant researches are usually focused on the relationship between the board diversity and firm performance. Most of the researches related to board diversity examine the effect of gender and ethnic diversity, but the researches on the effect of foreigners themselves on the functions of board-room have not been conducted sufficiently. Jeon et al. (2017) analyzed the relationship between board diversity and earnings management. In particular, they used gender, former bureaucrats, and foreign director as proxies for the board diversity and examine the effect of diversity on the real earnings management. The result of the study offers that board diversity is negatively associated with the real earnings management. However, they could not find any significant relationship between foreign director and real earnings management. They concluded that communication problems that arise from the difference in backgrounds may undermine the monitoring function of the board. Gwak et al. (2011), in respect of resource dependency theory, examined the factors that determine the appointment of the foreign directors in the Korean manufacturing firms. In their research, they classified the foreign directors in the boardroom as a type of resources, and they suggest that the percentage of the foreign directors in the board of directors increases as firms are younger, smaller or more dependent on the overseas sales. However, the possibilities of appointing foreign directors decrease as the competitive pressure in market increases.
The research by Carter et al. (2008), which examines the relationship between the gender and ethnic minority diversity of the board of directors and the financial performance of the firm shows that board diversity has a positive effect on financial performance. They argue that board diversity enhances the strategic decision-making process by providing various perspectives and viewpoints.
In addition, they also assert that diverse directors increase the quality of communication by broadening the topics of the conversation among board members. Oxelheim and Randoy (2003) also examine the effects of foreign directors from the UK or U.S. on corporate performance measured in terms of firm value, and they also found that foreign directors have positive effect on the firm value.
Unlike other researches that examined the effects of board diversity or foreign directors on the firm value or performance, the research by Winfried et al. (2007) investigates how the directors' nationality and gender interact with the directors' level of independence. The result of the research suggests that foreign directors are more likely to be independent, while female directors are more likely to be affiliated to firm management through family ties.
While many numbers of researchers assert that the board diversity has a positive effect on the firm performance, the research by Masulis et al. (2012) shows that foreign directors are more likely to have negative effect on the firm performance. In their research, they explored the financial costs and benefits of board diversity and assert that the diversity brings various perspectives and talents to the boardroom, enhancing managerial monitoring. However, the result of the research shows that foreign independent directors decrease the firm performance as they are more likely to miss board meetings, and are more likely to engage in intentional misreporting. These findings in their research indicate that the board with foreign independent directors weakens the monitoring functions of the boardroom.
As mentioned previously, researches on the effect of board diversity and foreign directors show conflicting views. Some researchers assert that diversity and foreign directors have positive effect on the firm overall, because they bring diverse perspectives and viewpoints that increase the firm performance and independence of the board. On the other hand, some argue that there can be negative effect of board diversity because they have different backgrounds and characteristics that may impede decision-making process and hinder communication among board members. In this study, we examine the effect of foreign directors on the monitoring functions of the board by investigating whether the foreign directors have a significant effect on the opportunistic financial reporting.

HYPOTHESES DEVELOPMENT
The main purpose of this study is to analyze the effect of foreign directors on opportunistic financial reporting, which represents the monitoring function of the board, by examining whether the inclusion of foreign directors in the board has any significant influence on the discretionary accruals and book-tax difference (BTD Overall, the prior researches on the effect of foreign directors on the board independence and monitoring function show the positive results. Therefore, we set the first hypothesis with the expectation that foreign directors increase the board diversity, which increases the board independence and so the monitoring function of the board.

H1-1:
The presence of foreign directors in the board of directors is negatively associated with discretionary accruals.
Most of the recent studies analyzed the booktax difference (BTD) in the perspective of agents (Chen et al., 2009;Desai & Dharmapala, 2006). Tax avoidance in the perspective of agents has negative effects on the firm as it increases the uncertainty of future profits for investors, lowers the corporate transparency, and increases the information asymmetry. Also, it serves as an element that discounts the firm value in the capital market. Kang and Ko (2014) argue that tax avoidance has negative effect on the firm value, and strong corporate governance is one of the most effective solutions that reduce such negative effect.
The prior researches on the effect of foreign directors clearly show that the presence of the foreign directors in the board increases the board diversity, which also increases the board independence.
Therefore, based on the fact that board diversity increases the independence of the board, which mitigates the negative effect of tax avoidance, we set the following hypothesis.
H1-2: The presence of foreign directors in the board of directors is negatively associated with the book-tax difference.
Sarbanes-Oxley Act requires independent directors to become the leaders of board of directors to strengthen the role of the boardroom. Song (2014) argues that the inclusion of independent directors enhances the managerial monitoring, which helps firms to decentralize the power of corporate governance and improves the investors' rights.
If the inclusion of independent directors is the effective way of enhancing the monitoring function of the board, recruiting foreigners as independent directors would have greater positive effect on the monitoring function of the boardroom. Therefore, we set the second hypothesis as follows.
H2-1: The inclusion of foreign independent directors is negatively associated with discretionary accruals.
H2-2: The inclusion of foreign independent directors is negatively associated with the booktax difference.
The monitoring function of the board could be influenced by the expertise of the directors. If directors on the board of directors have expertise in accounting or finance, the monitoring function of the boardroom will be strengthened. The professional knowledge on accounting or finance also helps directors to resolve the conflicts between executives and the board of directors. According to Lee and Moon (2004), the quality of reported earnings increases if directors in the board possess the expertise in accounting or finance. The research by Seo et al. (2010) also shows that there is a positive relationship between the number of accounting or finance specialists in the board and the firm performance. Therefore, based on these results, we expect that foreign directors with an expertise in accounting or finance are more effective in managerial monitoring, and we set the following hypothesis.
H3-1: The inclusion of foreign directors with expertise in accounting and finance is negatively associated with discretionary accruals.
H3-2: The inclusion of foreign directors with expertise in accounting and finance is negatively associated with the book-tax difference.

Measuring discretionary accrual
Jones (1991) discovered through empirical research that American firms adjust their accruals discretionarily to lower the profit and receive government support. Therefore, he developed the following model to measure the discretionary accruals: , 01 ,

Measuring book-tax difference (BTD)
The book-tax difference (BTD) is earnings before tax minus taxable income divided by beginning total asset. Since the real taxable income is not disclosed in public, it is difficult to separate the in-formation that related to tax avoidance. However, the following models are widely used, because they can predict the difference between accounting income and taxable income without collecting actual tax data.
Afterward, Dharmapala (2006, 2009) separated the "earnings management" measured by discretionary accruals from the elements that constitute BTD, and used its residuals as a proxy for tax sheltering behavior (DD_BTD). Both BTD and discretionary BTD (DD_BTD) have been used as proxies for "tax sheltering behavior" (Mills et al., 1998;Wilson, 2009). The following equations (2) and (3) are used in this study to measure BTD and DD_ BTD, and it is interpreted that as the related value increases, the "tax sheltering behavior" increases. In this study, we assume that the foreign directors have positive effect on the monitoring function of the boardroom, lowering discretionary accruals (DA) and book-tax difference (BTD). Thus, this study set the following models by including discretionary accruals (DA), book-tax difference (BTD), and discretionary book-tax difference (DD_BTD) as dependent variables. Also, the dummy variable, FOREIGN, is used as an independent variable to indicate whether there is a foreign director in the boardroom.
Model 1 -Hypothesis 1-1 , 01 ,       , 1998). BM is a price-to-book ratio of net asset at year t-1 and the GROWTH represents the change in sales divided by the lagged total assets. SIZE is calculated as natural logarithm of total assets. INTAN is the intangible assets divided by lagged total assets. INVEN is calculated by dividing the total inventories by lagged total assets. LEV is a total debt divided by total asset. OCFS is the operating cash flow divided by beginning total assets and ROA is the return on asset.
BIG4 is the indicator variable that is equal to one if the external auditor of a firm is one of Big 4 accounting firms and zero otherwise. OPIN is also the indicator variable, and it is equal to one if the audit opinion is unqualified, zero otherwise.   Table 2 shows descriptive statistics of variables used in the hypotheses tests. Each mean of dis-cretionary accrual, BTD, and DD_BTD is 0.000, 0.018, and 0.018, respectively. There were no abnormal values for standard deviation, minimum, and maximum value for the proxies of tax avoidance. Since the variable FOREIGN is calculated through 1:2 propensity score matching, the mean value shows exactly 0.333. Table 3 shows the correlation matrix. BTD and DD_ BTD shows significant and positive correlations. Also, the correlation coefficient between BTD and DA is 0.067, and that between DD_BTD and DA is 0.075, which are also significant at one percent level. The correlations among FOREIGN, BTD, DD_BTD, and DA shows the value of -0.002, -0.004, and -0.006, respectively, but they are not statistically significant. However, the level of significance is not reliable without considering the control variables. Thus, we ran the following regression analysis.   positive effects on the boards' monitoring function, 1 β is expected to be negative.

The effect of the foreign directors in the board of directors on the discretionary accruals
The results of the regression analysis generally indicate that the variable of interest, FOREIGN, shows the negative association with the discretionary accruals (DA). The slope of FOREIGN is -0.011 at one percent significance level, meaning that foreign directors in the board of directors have positive effect on the monitoring function of the board by curbing the opportunistic financial reporting. We argue that foreign directors in the board increase the board diversity, and the diversity increases the independence of the board, which enhances the monitoring function.  Table 5 shows the results of the regression analysis for hypothesis 1-2. It examines the relationship between the independent variable, FOREIGN, and dependent variables, BT and DD_BTD. The results show the value of -0.006 and -0.007 with the one percent significance level, meaning that foreign directors in the boardroom have positive effect on the monitoring function of the board by reducing tax avoidance behavior of executives. The results suggest that board diversity enhances the independence of the board, which also improves the firm transparency.  Table 6 indicates the results for hypothesis 2-1.

The effect of foreign independent directors in the board on the discretionary accrual
FOREIGN_EXT, the independent variable, is the indicator variable, which is equal to one if the foreign director in the board is the independent director. The results show that FOREIGN_EXT is negatively associated with the discretionary accruals as it shows the coefficient of -0.019 at one percent significance level. The result of the analysis suggests that the foreign directors in the board have positive effect on the monitoring function of the board by reducing the discretionary accruals and that the positive effect of foreign directors is more pronounced when the foreign director is an independent director.  Table 7 is the result of hypothesis 2-2. The results show the association between FOREIGN_EXT and the book-tax difference, and DD_BTD, the dependent variables. The coefficient of each relationship shows the value of -0.004 and -0.007, which are consistent with the expectation but are not statistically significant.    Table 9 shows the results of the regression analysis for hypothesis 3-2. It analyzes the relationship between the independent variable, FOREIGN_PRO, and BT and DD_BTD. The results show the coef-ficient of -0.031 and -0.030 with the one percent significance level, meaning that foreign directors with the expertise in accounting or finance have positive effect on the monitoring function of the board by reducing tax avoidance behavior of executives. Also, the results suggest that the positive effect of foreign directors is more pronounced when they have expertise in accounting or finance.

CONCLUSION
This study examines the effect of foreign directors in the board of directors on the monitoring function by analyzing the association between foreign directors and opportunistic financial reporting. We address this question by utilizing discretionary accruals and book-tax difference, and by examining the relationship with the presence of the foreign directors in the board. Based on the prior literature, we hypothesize that foreign directors in the board have a positive effect on the monitoring function of the board as they increase the board diversity, which also increases the independence of the board.
We test our hypothesis by using Korean firm data for the years 2001-2014 as Korea is one of the few countries that Nepotism is strong within the board, providing the ideal setting to examine the effect of foreign directors on the monitoring function of the board. We find that foreign directors reduce the earnings management and tax avoidance behavior of executives. We also find that the positive effect of foreign directors on the monitoring function is more pronounced when they are an independent director and expertise in accounting or finance. Taken together, our findings suggest that not only the various perspectives and viewpoints, but also foreign directors bring the independence that improves the monitoring function of the board.  Notes: 1. This table presents results from OLS model. 2. ***, **, * denote significance at 1%, 5%, and 10% levels, respectively. All t-values are based on two-tailed tests using firm and year clustered standard errors. 3. Please refer to Appendix A for variable definitions.
Our research also supports the extant researches that suggest that board diversity has positive effect on the firm value and performance (Anderson et al., 2011;Carter et al., 2008;Jeon et al., 2017;Oxelheim & Randoy, 2003). Our results clearly show that foreign directors curb the opportunistic financial reporting behavior, and we argue that the inclusion of foreign directors could be the alternative way to enhance the corporate governance by improving the independence and the monitoring function of the board. By providing empirical evidence that foreign directors have significant positive effect on the monitoring function of the board, our study provides useful implications for such stakeholders as regulators, investors, and shareholders. Nonetheless, there are some limitations in our study. For instance, because of the limitations of the data collected manually, it is difficult to classify the foreign directors' expertise that may influence our results.