Impact of corporate diversification on earnings management

Abstract

PurposeThe purpose of this research is to examine the effects of corporate diversification on earnings management.Design/methodology/approachBased on listed firms regarding non-financial sector of Pakistan, the study runs mean comparison test along with panel least squares regression analysis.FindingsThe results of the study suggested that locally diversified firms and combination of industrial and geographical diversified firms mitigate earnings management. In support of the earnings equalizing hypothesis, managers of diversified firms have less need for accruals management because diversified firms had more free cash flows which naturally reduces earnings variability. This study also found that diversified firms had no informational asymmetry problems which reject the asymmetric information hypothesis. In addition, debt ratios are also associated with large organizations, but it shows that the more debt ratios are negatively associated with earnings management. Mean comparison test is also conducted, but the results are same as the regression results which does not confirm asymmetric information hypothesis.Research limitations/implicationsDifferent business segments are affected by the world financial crisis in 2008. Because of those financial shocks, the diversified firms are affected more. In future studies, results will become more favorable in context of diversified firms.Practical/implicationsThe main function of earnings management is to make up the company for investors point of view to look healthier than it really is. But it may cause to disappointment for investors regarding loss of investment. It shows future projections of the company and has vital importance for investor’s perspective.Social/implicationsThe misallocation of resources caused by earnings management refers to the value loss for society. Because the misallocation of funds will make that particular segment or division more vulnerable which ultimately make shareholders to go for entrenchment or liquidation. At the end, un-employment rises after entrenchment or liquidation and the society suffers.Originality/valueThis research makes an important contribution to the accounting and management literature by providing new and significantly different evidences on the relative roles of corporate diversification and earnings management.