Business group opportunism: the difference in real earnings management between parent firms and nonparent firms

Glenny Alawag

doi:10.1108/ajar-07-2020-0046

Abstract

PurposeThis paper aims to understand real earnings management behavior in the context of a parent–subsidiary relationship. It explores the differences between business groups and firms that do not have controlled subsidiaries and provides potential explanations for any measured difference.Design/methodology/approachThe study uses the random-effects generalized least squares (GLS) estimation to find the difference between the real earnings management behavior of business groups, represented by the ultimate parent firms and the nonparent firms from 73 countries.FindingsThe results show that ultimate parent firms have lower abnormal production costs and abnormal discretionary expenses than nonparent firms. In contrast, parent firms have higher abnormal cash flow from operations (CFO) than nonparent firms. The results are unexpected because abnormal production costs usually have a dominant direct relationship with abnormal CFO. The results indicate that business groups use a route different from manipulating production costs and discretionary expenses.Research limitations/implicationsThe results reveal that parent firms use a route different from manipulating production costs and discretionary expenses. The results can be used to extend the discussion to specific business group cases, such as tracing the route or allocation of real earnings management (REM) pressure from a parent firm to its listed and private subsidiaries, and if the consolidation of minority voting rights and the transitivity of control affect the behavior in its subsidiaries.Originality/valueInstead of the degree of diversification or affiliation, this paper investigates REM behavior based on the parent firm's control of its subsidiaries. With this approach, the study argues that business groups prefer a route other than manipulating production costs and discretionary expenses. The results may redirect the attention of regulators to the activities of parent firms that need more policing.

Highlights

The earnings management behavior in business groups is traditionally explored based on the entity’s size and the degree of diversification, which is usually measured by the reporting entity’s number of segments
The results show that debt size is positively associated with all real earnings management (REM) proxies, which means that debt may motivate firms to manage earnings before the existing debt covenants tighten due to weak performance, say a net loss
Instead of diversification within groups, I focused the analysis on parent– subsidiary control, and instead of accrual-based earnings management, I argued that real earnings management has more applicability

Summary

Introduction

The earnings management behavior in business groups is traditionally explored based on the entity’s size and the degree of diversification, which is usually measured by the reporting entity’s number of segments. The discussion revolves around the use of segments as a mechanism of managers to pursue while, at the same time, hiding traces of earnings management. Despite the continuous improvement in reporting standards, segment reporting remains vague. Business groups can still harness this management discretion to manage earnings, but detection models may not effectively measure the relationship. A common approach in the literature is to use accrual-based earnings management, hereafter referred to as AEM. Prior studies argue that AEM has been in decline because recent regulations have a more intensified focus on preventing and detecting

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