Earnings Management Contagion in 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, whereas decreases with the degree of subsidiary independence. Most importantly, we provide evidence that MNCs exploit regulatory arbitrage opportunities arising from cross-country differences in institutional quality. We document that MNCs headquartered in jurisdictions with more restrictive regulation manage earnings through subsidiaries domiciled in countries where regulation is weaker. A difference-in-differences estimation reveals that, in response to exogenous improvements in the quality of their home countries’ 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.