Earnings Management via Not-wholly-owned Subsidiaries

45 Pages Posted: 14 Jun 2019

See all articles by Mei Luo

Mei Luo

Tsinghua University - School of Economics & Management

Frank Zhang

Yale School of Management

Xinyi Zhang

Tsinghua University - School of Economics & Management

Date Written: May 30, 2019

Abstract

We explore a new mechanism of earnings management whereby a parent company shifts income from not-wholly-owned subsidiaries to itself to avoid losses. Consolidated net income attributable to the parent company increases if earnings are 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. In general, net income and noncontrolling interest in subsidiary earnings exhibit a strong positive correlation, suggesting that a firm’s earnings performance tends to co-move with its subsidiaries’ earnings. 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 to avoid losses. Income shifting from subsidiaries to the parent firm is mainly driven by firms with a very large percentage of noncontrolling ownership. In addition, related-party transactions and concurrent appointment of a parent’s top management member to subsidiaries’ management team play a complementary role in facilitating such income shifting. Overall, our evidence not only demonstrates a new mechanism of earnings management via not-wholly-owned subsidiaries, but also highlights the negative consequences to minority investors of income shifting from subsidiaries to the publicly listed company.

Keywords: earnings management; income shifting; non-wholly-owned subsidiaries

JEL Classification: M40; M41; G12; G1

Suggested Citation

Luo, Mei and Zhang, Frank and Zhang, Xinyi, Earnings Management via Not-wholly-owned Subsidiaries (May 30, 2019). Available at SSRN: https://ssrn.com/abstract=3396796 or http://dx.doi.org/10.2139/ssrn.3396796

Mei Luo

Tsinghua University - School of Economics & Management ( email )

Weilun Building 201B
School of Economics and Management
Beijing, Beijing 100084
China
8610-62773185 (Phone)

Frank Zhang (Contact Author)

Yale School of Management ( email )

135 Prospect Street
P.O. Box 208200
New Haven, CT 06520-8200
United States

Xinyi Zhang

Tsinghua University - School of Economics & Management ( email )

Beijing, 100084
China

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