An Investigation of Earnings Management Through Investments In Associated Companies: An Australian Perspective

Abstract

Until recently, Australian companies have been precluded from adopting equity accounting for investments in associated companies in the consolidated accounts. As reported profits were based on the cost method (albeit with note disclosures utilizing equity accounting procedures), this paper investigates the incentives of Australian firms to manage earnings in a reporting environment which facilitated opportunism. It is argued that the higher the ex ante probability of managing accounting earnings from investments in associates, parties will contract to remove those incentives by restricting the accepted set of accounting procedures to equity accounting. Opportunism is more likely to be observed for firms for which it is inefficient to specify ex ante the method of accounting for associates. The ability to act opportunistically is defined as the degree of influence which an investor exercises over the financial and/or operating policies of its investees. The results are confirmatory. For firms which have a lower ex ante probability of managing earnings, use of the cost method significantly improves consolidated return on investment compared with returns calculated using the equity method. Firms which are more likely to choose the equity method for efficiency reasons have an insignificant difference between cost and equity returns.