Earnings Management via Not-wholly-owned Subsidiaries

Abstract

We investigate a new mechanism of earnings management: Income shifting from not-wholly-owned subsidiaries to help the parent company avoid losses at the expense of subsidiaries. Consolidated net income attributable to the parent company increases if income is shifted from not-wholly-owned subsidiaries to the parent, as the parent company enjoys the full amount of earnings shifted rather than sharing earnings with minority investors. We find that in general, net income and noncontrolling interest in subsidiary earnings exhibit a strong positive correlation, reflecting a co-movement between a firm’s earnings performance and its subsidiaries’ earnings owing to industry- or economy-wide factors. However, this positive relation turns significantly negative for firms just meeting or beating zero earnings, indicating that firms opportunistically decrease earnings of not-wholly-owned subsidiaries to manage consolidated net income upward to avoid losses. Income shifting from subsidiaries to the parent firm is mainly driven by firms with a very large percentage of noncontrolling ownership and by firms with strong influence over subsidiaries and occurs largely in the second half of the year. Our results are robust to alternative research designs, such as controls for within-firm variations, propensity score matching and entropy balancing techniques. Overall, our evidence not only demonstrates a new mechanism of earnings management via not-wholly-owned subsidiaries, but also suggests that tunneling from subsidiaries to the publicly listed company harms the interest of minority investors.

Keywords: earnings management, income shifting, tunneling, subsidiary, loss

JEL Classification: M40; M41; G12; G1