Foreign Capital and Earnings Management: International Evidence from Equity Market Openings
60 Pages Posted: 30 May 2019
Date Written: May 7, 2019
The opening of equity markets to foreign investors provides financing opportunities and disrupts the stock ownership structure of the firms in these markets. In this paper, we study how this affects firms’ earnings management in the opening’s immediate aftermath. Using a broad set of countries that opened their equity markets, we find a significantly positive effect on firms’ income-increasing earnings management in the year of opening. We show that there are substantial heterogeneous effects across industries and firms. The positive effect is more pronounced in industries that are more dependent on external financing and for firms that are financially constrained, suggesting that firms’ intrinsic need for equity finance contributes to income-increasing earnings management behaviors. In addition, the effect is weaker when the firm is audited by a Big N auditor, consistent with the monitoring effect of relatively more reputable auditors. We find that income-increasing earnings management is less pronounced in countries with better funded securities regulators and that it is more pronounced in countries with greater corruption. Overall, our results suggest that incentives to attract financing when a country opens its equity market to foreign investors affects firms’ reporting bias.
Keywords: equity market opening, earnings management, equity finance dependence
JEL Classification: G15, G18, M41, M43
Suggested Citation: Suggested Citation