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This paper examines the relationship between managerial ownership and opportunistic managerial behavior relating to earnings management. Economics theory identifies two apparently conflicting effects of managerial ownership on managers' incentives: the incentive alignment effect and the management entrenchment effect. We construct a theoretical model demonstrating the two effects. This model suggests that as managerial ownership increases, earnings management decreases for both high and low levels of managerial ownership, while it increases for intermediate levels of managerial ownership if the sensitivity of the probability of managerial dismissal to the corporate performance is high enough and/or the manager's private benefit derived from managerial position is high enough. In a sample of Japanese firms, we find a significant nonmonotonic relationship between managerial ownership and discretionary accruals, consistent with our model.

We examine the effect of managerial ownership on the demand for accounting conservatism in Japan. We find that within the low and high levels of managerial ownership, managerial ownership is significantly negatively related to the asymmetric timeliness of earnings, which is consistent with the implication of the incentive alignment effect. We also find a significant positive relationship between managerial ownership and the asymmetric timeliness of earnings for the intermediate levels of managerial ownership, as suggested by the management entrenchment effect. These evidences suggest the possibility that accounting conservatism contributes to addressing the agency problem between managers and shareholders. Copyright (c) 2010 Blackwell Publishing Ltd.

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