Disclosure relevance and earnings management in business group: evidence from UK private subsidiaries

Zhu, Keying (2020) Disclosure relevance and earnings management in business group: evidence from UK private subsidiaries. PhD thesis, University of Nottingham.

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Abstract

Corporate financial disclosure is widely agreed to be important to the general stakeholders as it reduces information asymmetries between managers and investors (Marquardt and Wiedman, 1998; Lang and Lundholm, 2000), arguably improves the information precision in financial statements (Lambert et al., 2012; Hughes and Pae, 2004), provides more financial and non-financial information for valuation and thus mitigates mispricing (Jegadeesh and Livnat, 2006). However, such disclosure requirements are made only to publicly traded companies (business group). Privately held companies do not often have public disclosure requirements from either regulators or standards setters. Only when these private companies engage in related party transactions with a publicly traded business group, such transactions are sometimes required to be disclosed. This may lead to manipulation that could be concealed by a parent company through their private subsidiaries - if manipulated items are excluded from related party transactions. Supported by the evidence that companies do often hide and manipulate information that should be disclosed (Kim and Yi, 2006; Beuselinck and Deloof, 2014; Beatty and Harris, 2001; Weil, 1980), this area can potentially be a grey area where public companies avoid disclosure responsibility and benefit privileged few at the expense of the investing public.

The objective of this dissertation is to examine whether disclosure of private subsidiaries matters and to what extent such disclosure matters. Test is done through an investigation of publicly traded companies’ earnings management activity via their private subsidiaries. Earnings management is selected because it often represents reporting quality and also reflects companies’ motivations under different scenarios (Ball and Shivakumar, 2005; Burgstahler et al., 2006). On the one side, companies hope to manage earnings so that their aimed targets can be achieved. On the other side, they also do not want to show a high level of earnings management which is perceived as bad reporting quality. From such conflicted interests, this becomes important to test how company would moderate different interests to balance and maximize the overall utility.

Empirical results in this dissertation show subsidiary information disclosure is relevant to group reporting quality, as proxied by earnings management. That is, business group shows a lower level of earnings management and hence better reporting quality when they have qualifying subsidiaries. Qualifying subsidiaries are defined as subsidiaries that are controlled by the group (i.e. a business group having more than 50% of the voting rights), not in regulated industries and non-foreign (i.e. domestic subsidiaries only). Further, there is a substitute effect between group level of earnings management and subsidiary level of earnings management. That is, when group shows a lower level of earnings management, their subsidiaries show a higher level of earnings management. This proves that group firms shift their earnings management needs at subsidiary level, especially private subsidiaries. By taking the cover of being private and being a subsidiary, they are far away from auditor scrutiny and public attention, and hence are the safest channel to satisfy earnings management needs.

Further analysis shows that subsidiary number, subsidiary size, subsidiary industry and subsidiary revenue is relevant to group level of earnings management. From that, group firm selection preference may be snooped when they are considering using private subsidiaries to shift the pressure of earnings management and hence improve the reporting quality of themselves. One interesting finding in this dissertation is that auditor is not effective in detecting earnings management at subsidiary level. Although most of the existing literature reveals that Big4 auditors mitigate earnings management, finding in this dissertation shows that such mitigation influence is only effective at business group level but not at subsidiary level. More specifically, there is a positive relationship between subsidiary earnings management and Big4 auditors. That is, subsidiaries audited by Big4 show a higher level of earnings management. This further enhances the assertation that business groups push down their earnings management needs at their subsidiary level.

The contributions of this dissertation are threefold. First, as private subsidiaries face substantively minimum disclosure requirements, this dissertation provides evidence and insights to regulators and standard setters on why and how to set up high quality disclosure requirements to better protect stakeholders’ benefits. Second, it contributes to the general stakeholders that existing and potential investors should use the information more cautiously when a private subsidiary is involved. Third, this dissertation also contributes to the literature of earnings management in different ways.

While most of the literature on earnings management looks at the final output of the consolidation process with an extensive focus on public companies, this dissertation tries to shed light on earnings management at private companies given their economic importance. I further trace down the earnings management practice at private subsidiaries’ level, which is a relatively new perspective and a new way that has rarely been examined and filed in the past (Bonacchi et al., 2018; Beuselinck et al., 2019). To our best knowledge, this method is the first work in earnings management with a focus of improving disclosure quality. The ongoing debate of the financial reporting quality (FRQ) between public and private companies may also be shaped if private subsidiary plays a role. It may then suggest that debate of FRQ between public and private companies is not that debatable unless the effect of private subsidiary is completely removed, which provides space for future research. Finally, this dissertation provides further insights in terms of auditor effectiveness. In particular, the effectiveness of auditor depends on the level of a firm in a business group. Auditor is more effective at business group level as most of literature shows, but not effective at private subsidiary level. This not only refines the past cognition on auditor role in detecting and preventing earnings management, but also provides spaces for further research in examining overall auditor role at different levels in business groups.

Item Type: Thesis (University of Nottingham only) (PhD)
Supervisors: Liu, Weimin
Dow, Kevin
Leung, WK
Chen, Jing
Keywords: Corporate financial disclosure ; earnings management
Subjects: H Social sciences > HG Finance
Faculties/Schools: UNNC Ningbo, China Campus > Faculty of Business > Nottingham University Business School China
Item ID: 60039
Depositing User: Zhu, Keying
Date Deposited: 30 Mar 2020 08:54
Last Modified: 06 May 2020 09:18
URI: http://eprints.nottingham.ac.uk/id/eprint/60039

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