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10-08-2022

Growth opportunities and earnings management by cross-listed and U.S. firms

Authors: Shrikant P. Jategaonkar, Linda M. Lovata, Xiaoxiao Song

Published in: Journal of Economics and Finance

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Abstract

Using a sample of cross-listed and U.S. firms, we examine whether firms’ growth opportunities are associated with discretionary accruals and/or real activities management. While existing papers have reported mixed evidence for U.S. firms, we are the first to explicitly compare earnings management of cross-listed growth versus cross-listed value firms. Using the Tobin’s Q ratio as our proxy for growth opportunities, we compare earnings management by: (i) cross-listed growth versus cross-listed value firms, (ii) cross-listed growth versus U.S. growth firms, and (iii) cross-listed value versus U.S. value firms. We find significantly more management of discretionary accruals and real activities for cross-listed growth firms than the cross-listed value firms. In addition, the difference in earnings management between cross-listed and U.S. firms is concentrated in the growth firms, as there are no significant differences in earnings management between the cross-listed and U.S. value firms. Our findings have implications for analysts and investors interested in cross-listed firms. A better understanding of earnings management by firms with high or low growth opportunities can enable them to better assess the quality of earnings of these companies.
Appendix
Available only for authorised users
Footnotes
1
While some studies show how a firm’s earnings management behavior can be motivated by an event such as equity issuances (Teoh, Welch, and Wong (1998a, 1998b), Cohen and Zarowin (2010), Kothari, Mizik, and Roychowdhury (2016), Sletten, Ertimur, Sunder, and Weber (2018)), share repurchases (Gong, Louis, and Sun 2008), mergers and acquisitions (Louis (2004), Louis and Sun (2016)), reversed leveraged buyouts (Chou, Gombola, and Liu 2006), management buyouts (Francis, Hasan, and Li 2016b) etc., others suggest that firms tend to manage earnings to achieve a specific goal, such as meet or beat earnings estimates (Bartov, Givoly, and Hayn (2002), Byun and Roland-Luttecke (2014)), avoid reporting earnings decreases and losses (Burgstahler and Dichev 1997), avoid debt covenant violations (Dyreng, Hillegeist, and Penalva 2020), maintain a string of meeting or beating analyst expectations (Zhang, Perols, Robinson, and Smith 2018), avoid credit rating downgrades (Hill, Korczak, and Wang 2018), among others.
 
2
Examining a sample of U.S. firms, Charitou et al. (2011) find that while distressed firms have a low level of earnings timeliness, growth firms have greater earnings timeliness for bad news and manage earnings less frequently.
 
3
Also see Dichev and Li (2013) and Krishnan, Myllymaki, and Nagar (2021). Dichev and Li (2013) conclude that there is no reliable relation between growth and a firm’s aggressiveness of accounting choices. While Dichev and Li (2013) do not use AEM or REM, it is relevant to this discussion because they examine whether growth opportunities are associated with firms’ accounting choices. Specifically, they use growth as the dependent variable and test for a positive relation between growth and the aggressiveness of accounting choices. Krishnan, Myllymaki, and Nagar (2021) examine how firms’ life-cycle stages are associated with financial reporting quality and find that firms in introduction, growth, and decline stages are significantly more likely to have misstatements in their financial statements compared to firms in the mature stage.
 
4
Lang et al. (2006) investigate the reconciliations required by international companies reporting under non-U.S. GAAP prior to 2008, finding more earnings management by non-U.S. firms. Srinivasan et al. (2015) conclude that firms from countries with weak rule of law exhibit higher opportunistic reporting in the U.S.
 
5
For studies that use absolute value of AEM or REM, please see Becker, DeFond, Jiambalvo, and Subramanyam (1998), Bartov, Gul, and Tsui (2000), Klein (2002), Chung and Kallapur (2003), Leuz, Nanda, and Wysocki (2003), Bergstresser and Philippon (2006), Cohen, Dey, and Lys (2008), Francis, Hasan, and Li (2016a), Yung and Root (2019), among others.
 
6
These proxies for growth opportunities are commonly used in the literature. See Fama and French (1992, 1998, 2012), Szewczyk, Tsetsekos, and Zantout (1996), Rouwenhorst (1999), Bagella, Becchetti, and Carpentieri (2000), Hovakimian, Opler, and Titman (2001), Skinner and Sloan (2002), Arisoy (2010), Bali, Demirtas, and Hovakimian (2010), Payne and Thomas (2011), among others.
 
7
For instance, see McNichols and Wilson (1988), Trueman and Titman (1988), Schipper (1989), Jones (1991), Louis (2004), among others. Also, see Healy and Wahlen (1999) for review of the literature.
 
8
For instance, Cohen et al. (2008) test AEM and REM by firms pre- and post-SOX. Cohen and Zarowin (2010) examine AEM and REM around seasoned equity offerings. Zang (2012) studies the factors that affect the trade-off between AEM and REM. Sohn (2016) tests the effect of accounting comparability on firms’ choices between AEM and REM.
 
9
Also, see Enomoto, Kimura, and Yamaguchi (2015) who report that outside investor rights are negatively correlated with AEM, but positively correlated to REM.
 
10
We use three measures of REM for our analysis: cash flow from operations, production costs, and discretionary expenditures. Detailed description of these measures is available in the Data and Methodology section.
 
11
Also, see Haw, Hu, Hwang, and Wu (2004) and Degeorge, Ding, Jeanjean, and Stolowy (2013).
 
12
Compustat exchange codes 11, 12, 14, and 17.
 
13
For additional studies that use Tobin’s Q ratio, please see Denis, Denis, and Sarin (1994), Loderer, Stulz, and Waelchli (2017), Badertscher, Shanthikumar, and Teoh (2019), among others.
 
14
Following Srinivasan et al. (2015), for each cross-listed firm, we obtain a U.S. firm by first matching on exact industry and year and then using a propensity score match based on firm size, leverage, and return on assets.
 
15
Please refer to Appendix B for details regarding the calculation of abnormal discretionary accruals.
 
16
For the expectation models, we used all firms traded on the three major U.S. Exchanges with complete information in Compustat.
 
17
For instance, Jha, Shankar, and Prakash (2015) argue that “Using the signed value as a proxy for earnings management over long periods violates the view that it is not possible for a firm to continuously have income-increasing earnings management. The signed value of discretionary accruals is used as a proxy for earnings management mainly when examining a particular circumstance where the incentives to manage earnings is only in a particular direction” (p.233). Also see Bergstresser and Philippon (2006), Cohen et al. (2008), Jiang, Petroni, and Wang (2010), Baker, Lopez, Reitenga, and Ruch (2019), among others.
 
18
Details regarding the calculation of REM measures are provided in Appendix B.
 
19
We follow Srinivasan et al. (2015) and use Year 2000 ROL median value. The relative ROL across countries is assumed to be stable over time.
 
20
See Cohen et al. (2008), Braam, Nandy, Weitzel, and Lodh (2015), Dhole et al. (2016), Shi et al. (2018).
 
21
Using only the U.S. firms, Nabar and Song (2017) define top 30 percentile firms as growth firms and the bottom 70 percentile as non-growth firms. Also, they only examine two of the three REM techniques and focus on earnings management by suspect firms (firms that just meet or beat earnings expectations/last year’s profits/avoid losses). This study, on the other hand, compares growth (top 30 percentile) versus value (bottom 30 percentile) firms and examines all three measures of REM.
 
22
These results are available upon request.
 
23
The consistency in results across the Tobin’s Q and the market-to-book ratios is expected as Perfect and Wiles (1994) report a high correlation between the two proxies.
 
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Metadata
Title
Growth opportunities and earnings management by cross-listed and U.S. firms
Authors
Shrikant P. Jategaonkar
Linda M. Lovata
Xiaoxiao Song
Publication date
10-08-2022
Publisher
Springer US
Published in
Journal of Economics and Finance
Print ISSN: 1055-0925
Electronic ISSN: 1938-9744
DOI
https://doi.org/10.1007/s12197-022-09599-3

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