Earnings Management within Multinational Corporations

Abstract

Using a large sample of multinational corporations (MNCs), we examine the location of earnings management within the firm. We posit and find that MNCs manage their consolidated earnings through an orchestrated reporting strategy across subsidiaries over which they exert significant influence. Specifically, we find that headquarters' influence on subsidiary earnings management increases with the degree of subsidiary integration and the extent of earnings management opportunities. Most importantly, we provide evidence that MNCs exploit regulatory arbitrage opportunities arising from cross-country differences in institutional quality. We document that, in response to exogenous improvements in the quality of their home-country institutions, MNCs rebalance their reporting strategies by clustering earnings management in subsidiaries from countries with more lenient regulations. Taken together, our findings yield important insights on the drivers of earnings management location within the firm and highlight the need for better cross-country coordination in regulatory design. JEL Classifications: F23; G15; G34; G38; M41; M48.

Parents’ Use of Subsidiaries to “Push Down” Earnings Management: Evidence from Italy

“…), their ownership structure (Gopalan and Jayaraman ; Kim and Yi ), their parents’ governance characteristics (Beuselinck et al. ), and their tax minimization incentives (Beuselinck and Deloof ).…”

“…The first strand of literature attempts to find what drives the subsidiaries' earnings management, in particular their location (in terms of rule of law and tax-haven status) (Dyreng et al 2012), their ownership structure (Gopalan and Jayaraman 2012;Kim and Yi 2006), their parents' governance characteristics (Beuselinck et al 2016), and their tax minimization incentives (Beuselinck and Deloof 2014). Dyreng et al (2012) examine the geographical location of earnings management within U.S. multinationals and show that firms with extensive foreign subsidiaries located in weak rule-of-law countries or tax havens manage earnings more than other firms and that the difference in earnings management is concentrated in foreign income.…”

“…Moreover, because the nonlisted firms' financial statements are unavailable in the United States, Dyreng et al (2012) cannot directly examine the earnings management of domestic subsidiaries. Beuselinck et al (2016) also look at multinational firms and show that the corporate governance characteristics of the parent firm (ownership structure and analyst coverage) and the institutional features of the subsidiary's country affect the reporting quality of the subsidiary. However, they do not examine whether the subsidiaries' earnings are managed to optimize the reporting outcomes of the parent's consolidated financial statements (i.e., earnings management of the subsidiary as a function of the incentives of the consolidated group).…”

“…This is consistent with a parent using its subsidiaries to manage its own (i.e., parents') earnings to meet or beat a benchmark. Prior research has examined several drivers of earnings management of subsidiaries, such as the subsidiary's location in terms of the rule of law and the location's tax-haven status (Dyreng, Hanlon, and Maydew 2012) and its ownership structure (Gopalan and Jayaraman 2012;Kim and Yi 2006) as well as the parent's governance characteristics (Beuselinck, Cascino, Deloof, and Vanstraelen 2016) and its tax minimization incentives (Beuselinck and Deloof 2014). However, as Prencipe (2012) suggests, these analyses fail to examine whether the parent manages its earnings through its subsidiary or the subsidiary is managing its earnings based on its own incentives.…”

Foreign ownership and financial reporting quality in private subsidiaries

“…Assuming a significant influence of parent companies in their subsidiaries' accounting policies, financial reporting quality at the subsidiary level depends on the incentives and opportunities of the parent company (Beuselinck, Cascino, Deloof, & Vanstraelen, 2017). The incentives relate to both the benefits and costs of producing poor (or good) quality accounting information at the subsidiary level; and the opportunities mainly depend on the subsidiaries' institutional framework, including accounting standards and enforcement mechanisms.…”