Foreign earnings management of U.S. multinational companies –

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Final version: Master Thesis

Foreign earnings management of U.S. multinational companies

– The influence of parent CEO equity-based compensation and parent board independence on financial reporting quality of subsidiaries

Michiel Buitelaar S3056775 Group 7 De Taxushaag 5, Zutphen 06-38624799 m.t.buitelaar@student.rug.nl Supervisor: Simona Rusanescu Date: June 20, 2020.

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Abstract

The international expansion of U.S. multinational corporations (MNCs) has increased their complexity. Furthermore, it has led to an increase in the opportunities of MNC-parent executives to engage in earnings management through their foreign subsidiaries by making discretionary accounting choices in the consolidated financial statements. MNC-parents might prefer to engage in earnings management through their foreign subsidiaries because of a lower chance of reputational damage and less scrutiny from auditors, investors and regulators. Given the role of corporate governance (CG) in mitigating earnings management, an important question is whether these mechanisms are able to curb earnings management conducted through foreign subsidiaries and thereby improve subsidiary financial reporting quality (FRQ) and ultimately the reporting quality of consolidated reports. Therefore, using the agency theory, this paper examines the effect of two parent-level CG mechanisms, namely the CEO equity-based compensation and board independence, on the FRQ of subsidiaries, proxied by earnings management. I use the performance-adjusted modified Jones model to measure earnings management. Based on data of private subsidiaries from 22 European countries and their U.S. MNC-parents, I find that equity-based compensation of the parent´s CEO is not associated with subsidiary FRQ. However, an additional test shows that the proportion of option-based compensation is negatively associated with subsidiary FRQ. These findings indicate that stock options incentivize executives to engage in earnings management at the subsidiary-level. Therefore, equity-based compensation may not be an effective mechanism to align the interests of executives with the interests of the shareholders. Furthermore, in contrast to my prediction the results show that MNC-parent board independence is negatively associated with subsidiary FRQ. This finding challenges prevailing viewsby providing evidence that board independence is not always an effective monitoring mechanism that mitigates earnings management and that it in fact increases the extent of subsidiary earnings management. This effect might be explained by several factors that lower the independence of non-executive directors, among which dependence on the CEO and the managers to obtain information about the company, tenure, and the number of directorships. Another explanation might be that the parent board may reduce the opportunities for earnings management at the parent-level, which is why there might be higher levels of earnings management in foreign subsidiaries, where the board has more difficulties to monitor.

Keywords: accrual earnings management; board independence; equity-based compensation;

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1. Introduction

In the last decades, U.S. multinational corporations (MNCs) have significantly expanded their operations in foreign subsidiaries (Huang, 2018). The investments of U.S. MNCs in assets of foreign subsidiaries increased from $27,630 billion in 2009 to $42,143 billion in 2017 (Bureau of Economic Analysis, 2020). This international expansion has increased the organizational complexity of U.S. MNCs (Durnev et al., 2017). Furthermore, the expansion of foreign operations has created opportunities for parent executives to make discretionary accounting choices in the consolidated financial statements (Fan, 2012). In other words, complex corporate structures create opportunities for MNC-parents to engage in earnings management through their foreign subsidiaries (Chin et al., 2009; Beuselinck et al., 2019). The increased organizational complexity also resulted in larger information asymmetry between the MNC and its stakeholders (Fan, 2012). Therefore, in order to lower the information asymmetry, MNCs have tried to improve the quality of their financial reports, in the last decades, (Xie et al., 2003; Chin et al., 2009). Investors use this financial information to decide whether to invest in the company (Xie et al., 2003). So, when the financial statements give a fair view of the performance of the MNC, the information is useful for the investors, which results in a high financial reporting quality (FRQ) (Xie et al., 2003; Al-Haddad & Whittington, 2019). However, when MNC-parent executives engage in earnings management, they alter the information in the financial statements and the numbers may be reported in such a way that they give an improper view of the firm’s current performance (Meek et al., 2007; Al-Haddad & Whittington, 2019). This lowers the usefulness of the information for investors, because based on this altered financial information the investors cannot correctly determine the value of the MNC (Xie et al., 2003). Hence, earnings management negatively affects the FRQ of MNCs (Meek et al., 2007; Al-Haddad & Whittington, 2019). Therefore, various studies use earnings management as an indirect measure of FRQ (Martínez-Ferrero, 2014; Ianniello, 2015).

Given the role of corporate governance (CG) in mitigating earnings management in stand-alone companies, an important question is whether these mechanisms are able to curb earnings management conducted through foreign subsidiaries (Adut et al., 2013; Al-Haddad & Whittington, 2019). In this paper I examine the effect of two U.S. MNC-parent-level CG mechanisms, namely the CEO equity-based compensation and board independence. Therefore, the goal of this paper is to answer the following research question: How are parent CEO equity-based compensation and parent board independence related to the FRQ of foreign subsidiaries? I use earnings management at the subsidiary-level as a proxy for subsidiary FRQ. Schipper (1989) divides earnings management into accrual earnings management and real earnings management. Accrual earnings management consists of accounting choices within the U.S. GAAP, whereas real earnings management consists of managers altering the timing or structure of transactions (Chen et al., 2015; Al-Haddad & Whittington, 2019). According to prior research executives prefer to use accrual earnings management instead of real earnings management (Gunny, 2010; Chen et al., 2015)1. That is why I focus on the management of accruals in this paper (from now on referred to as earnings management). Accruals are the part of earnings that is not paid or received in cash (Healy & Wahlen, 1999). In particular, I examine

1_{In the year after a firm has used real earnings management, the firm has to catch up on the expenses that are related to the}

real earnings management activities of managers (Chen et al., 2015). So, real earnings management directly leads to an unfavourable effect on the future cash flow of the firm and may negatively impact the firm’s value in the eyes of investors (Gunny, 2010; Chen et al., 2015). Accrual earnings management in contrast to real earnings management, does not directly change the firm’s cash flow (Gunny, 2010). Hence, the costs of real earnings management for the future value of the firm can be higher than those of accrual earnings management (Gunny, 2010).

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5 the discretionary accruals, as these are primarily used for the purpose of earnings management (Healy & Wahlen, 1999; Al-Haddad & Whittington, 2019).

According to Robinson & Stocken (2013), MNC-parents have a strong influence on the financial reporting decisions of their subsidiaries, because the subsidiaries are obligated to follow the reporting guidelines that are set by the parent, in order to enable the MNC-parent to draw up the consolidated financial statements (Prencipe, 2012). In addition, there are several incentives for MNC-parents to engage in earnings management through their foreign subsidiaries. Firstly, it is harder for the MNC-parent auditor to monitor the financial reporting process of the subsidiary, because there is usually a big geographical distance between the parent auditor and the subsidiary (Dyreng et al., 2012; Prencipe, 2012). Furthermore, a big geographical distance between the parent and the subsidiary leads to a lower probability that the subsidiary is subject to scrutiny of the investors and regulators of the MNC-parent, because it is harder for them to investigate activities at the subsidiary-level (Kedia & Rajgopal, 2011; Beuselinck et al., 2019). Secondly, earnings management at the subsidiary-level may lead to less reputational damage and lower fines for the parent, because the parent can claim in court that it was not aware of the earnings management activities of the subsidiary (Dearborn, 2009; Beuselinck et al., 2019). Thirdly, when the subsidiary earnings increase, this directly increases the MNC-parent consolidated earnings (net of intercompany transactions) (Bonacchi et al., 2018). Lastly, the U.S. government does not always have sufficient knowledge of foreign subsidiary country regulations, to be able to apply legislative control over these subsidiaries (Kedia & Rajgopal, 2011). In this regard, a few studies provided evidence that MNCs engage in earnings management through their foreign subsidiaries (Dyreng et al., 2012; Fan, 2012; Durnev et al., 2017; Beuselinck et al., 2019). The findings of these studies and why the four incentives that I described exist, are discussed in more detail in section 2.1. Based on this evidence, I assume that MNC-parents primarily engage in earnings management through their foreign subsidiaries.

The first CG mechanism that I examine is equity-based compensation of the MNC-parent CEO. Agency theory argues that the CEO may have his or her own goals and these goals are not always in the best interests of the shareholders (Alam et al., 2015; Harris et al., 2019). Equity-based compensation can be used to align the executives’ interests with the interests of the shareholders (Alam et al., 2015; Almadi & Lazic, 2016). Therefore, the board has increased the proportion of equity-based compensation of the CEO, in the last decade (Schneider, 2013; Almadi & Lazic, 2016). According to the Economic Policy Institute (2019), the average U.S. MNC-parent CEO equity-based compensation has increased from $11.3 million in 2009, to $17.2 million in 2018. The idea behind equity-based compensation is that it can incentivize the CEO to create firm value for the shareholders, because an increase in firm value (the stock price) will also increase the value of the CEO’s stock- and option-holdings (Harris et al., 2019). Several studies have provided evidence of this positive association between equity-based executive compensation and the creation of firm value (Mehran, 1995; Hanlon et al., 2003; Ittner et al., 2003).

However, an increase in the proportion of equity-based compensation also leads to an increase in the compensation risk for the CEO, because the compensation is directly linked to the firm’s stock price (Cheng & Warfield, 2005; Chen et al., 2015). So, when the stock price drops this directly lowers the value of the equity-based compensation (Cheng & Warfield, 2005; Chen et al., 2015). This might incentivize the CEO to use earnings management in order to increase the value of earnings, because then the stock price will probably rise and thereby also the value of his equity-based compensation (Cheng & Warfield, 2005; Alam et al., 2015; Chen et al., 2015).

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6 I focus on CEO compensation, because the SEC stated that in about 89% of the cases of earnings management the CEO is involved (Dyreng et al., 2012). Furthermore, the CEO has a strong influence on the organizational-wide financial reporting choices of the company and thereby is likely to influence earnings management (Alam et al., 2015; Essen et al., 2015). The international expansion of MNCs has created opportunities for parent executives to engage in earnings management (Chin et al., 2009; Fan, 2012). Due to the operations in many different countries, the complexity of the financial reporting process of MNCs has increased (Chin et al., 2009). This increased complexity resulted in opportunities for parent executives to make discretionary accounting choices in the consolidated financial statements (Fan, 2012). According to Chin et al. (2009), MNC-parent executives use these opportunities to engage in foreign earnings management. The parent CEO can then manage the subsidiary earnings upwards in order to increase the value of consolidated earnings (Bonacchi et al., 2018). This can result in an increase in the stock price of the MNC and can thereby lead to an increase in the value of the equity-based compensation of the parent CEO (Chen et al., 2015). Furthermore, the CEO might prefer to manage earnings through its foreign subsidiaries, because it may lead to less scrutiny from the auditors, investors and regulators of the MNC (Kedia & Rajgopal, 2011; Beuselinck et al., 2019). There are two ways in which the MNC-parent CEO can engage in earnings management through its foreign subsidiaries. The first way is that, as the MNC-parent CEO has a strong influence on the financial reporting choices of the company, the MNC-parent CEO can for example coordinate earnings management through the subsidiary by putting pressure on the parent CFO to change the financial reporting guidelines of the subsidiary (Feng et al., 2011; Prencipe, 2012; Alam et al., 2015). The subsidiary is obligated to follow these guidelines, because otherwise the MNC-parent can not consolidate the financial statements (Prencipe, 2012). As a second way, the MNC-parent CEO can use budgets to influence earnings management at the subsidiary-level (Huang, 2018). Leone & Rock (2002) provided evidence that when the managers’ compensation is linked to the performance with respect to budgets, which is usually the case, the managers make decisions about the reporting of discretionary accruals based on budget incentives (Leone & Rock, 2002). Therefore, by increasing the income budget target of certain subsidiaries, the MNC-parent CEO can for instance put pressure on the managers of these subsidiaries to engage in income increasing earnings management (Huang, 2018). Based on these arguments, I predict that MNC-parent CEO equity-based compensation has a positive effect on the extent of earnings management at the subsidiary-level. This increase in the extent of earnings management, can lower the information usefulness of the subsidiary financial reports and therefore can lower the FRQ of the subsidiary and that of the MNC as a whole (Al-Haddad & Whittington, 2019).

Prior research has found extensive evidence of a positive relation between CEO equity-based compensation and earnings management in stand-alone companies (Cheng & Warfield, 2005; Johnson et al., 2009; Alam et al., 2015; Chen et al., 2015; Harris et al., 2019). The little research that has been done for subsidiary FRQ examined the relation between earnings management and consolidated loss prevention (Fan, 2012); tax havens (Dyreng et al., 2012); and institutional quality (Dyreng et al., 2012; Durnev et al., 2017; Beuselinck et al., 2019), among others. To the best of my knowledge the association between MNC-parent CEO equity-based compensation and the extent of earnings management at the subsidiary-level has not yet been studied. It is important to examine this relation, because there is already extensive evidence for the association in stand-alone companies. Furthermore, according to an auditor from a Big 4 accounting firm: “the argument that MNC-parent CEOs engage in earnings management through their foreign subsidiaries is very plausible, because there have been multiple examples in practice”. This statement reinforces the relevance of my research question, from a practical

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7 standpoint. Existing literature also poses the need for further research on the determinants of earnings management at the subsidiary-level and policy makers have indicated their concern about subsidiary FRQ of MNCs (Dyreng et al., 2012; Pathak & Sun, 2013; Beuselinck et al., 2019). Therefore, in this paper I attempt to address this gap in the literature on the relation between CEO equity-based compensation of the MNC-parent and the extent of earnings management at the subsidiary-level.

The second CG mechanism that I examine is independence of the MNC-parent board. According to agency theory, the board is an important mechanism that monitors executive behaviour and that monitors the financial reporting process (Fama, 1980; Pathak & Sun, 2013; Benkraiem et al., 2017). Several studies have provided evidence that a higher proportion of independent directors on the board enhances the monitoring effectiveness and decision-making of the board (Jaggi et al., 2009; Pathak & Sun, 2013; Singh et al., 2017). Yang et al. (2009) define board independence as the appearance of non-executive independent directors (also referred to as outside-directors) on the board, that do not hold any social or financial connections to the firm. Board independence enhances the board’s monitoring effectiveness for the following reasons. Firstly, independent directors are incentivised to monitor the actions of management, because they risk losing their reputation when earnings management is discovered (Pathak & Sun, 2013). Secondly, independent directors usually have relevant skills and experience for supervising executives (Benkraiem et al., 2017). Thirdly, independent directors do not have financial or social ties to the company and consequently have less conflicts of interest in their decision-making than other directors (Essen et al., 2015). A high proportion of independent directors on the board therefore results in more effective monitoring of the behaviour of executives (Sanchez-Marin et al., 2010; Pathak & Sun, 2013). This lowers the opportunities of the executives to engage in earnings management (Pathak & Sun, 2013). Prior research has found extensive evidence of this negative association between board independence and earnings management in stand-alone companies (Vafeas, 2005; Firth et al., 2007; Pathak & Sun, 2013; Singh et al., 2017).

On the other hand, according to Essen et al. (2015), boards will not always act in the best interests of shareholders, because there are several factors that lower the monitoring effectiveness of the outside-directors (Bebchuk & Fried, 2004; O’Reilly & Main, 2010; Essen et al., 2015). Firstly, the directors do not want to develop a reputation of continually arguing against the CEO, because the CEO nominates the directors that can be elected for the board (Schneider, 2013). So, arguing against the CEO might decrease the opportunity of the director to be nominated for other boards (Schneider, 2013). Secondly, long tenure of outside-directors may lead to the development of friendships with management and with other board members (O’Reilly & Main, 2010; Essen et al., 2015). This could result in conflict avoidance of outside-directors (O’Reilly & Main, 2010; Essen et al., 2015). Thirdly, the independent outside-directors depend on information from managers to be able to make effective decisions (Essen et al., 2015). These factors lower the independence of the board members and thereby lower their monitoring effectiveness (Ryan & Wiggins, 2004; Schneider, 2013). This can create opportunities for executives to engage in earnings management (Pathak & Sun, 2013; Bonacchi et al., 2018).

Nevertheless, the largest part of prior literature found a negative relation between board independence and earnings management in stand-alone companies (Vafeas, 2005; Firth et al., 2007; Jaggi et al., 2009; Pathak & Sun, 2013; Singh et al., 2017). In MNCs the parent board focuses on the reporting quality of the consolidated financial statements, which is based on the quality of the financial statements of the subsidiaries (Bonacchi et al., 2018; Al-Haddad &

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8 Whittington, 2019). Therefore, the independent directors of the parent board are concerned with subsidiary FRQ and are incentivized to curb earnings management at the subsidiary-level, because this can increase the information usefulness of the subsidiary financial statements and thereby can improve subsidiary FRQ and the FRQ of the consolidated financial statements (Pathak & Sun, 2013; Bonacchi et al., 2018; Al-Haddad & Whittington, 2019). Based on these arguments, I argue in this paper that the effective monitoring of parent executive behaviour by independent parent board members could lower the opportunities of parent executives to make discretionary accounting choices in the consolidated financial statements. Therefore, parent board independence could lower the opportunities of the parent executives to engage in earnings management through their subsidiaries. Hence, I predict that independence of the MNC-parent board has a negative effect on the extent of earnings management at the subsidiary-level, because curbing earnings management of foreign subsidiaries is likely to improve the reporting quality of the consolidated financial statements. To the best of my knowledge the association between MNC-parent board independence and subsidiary FRQ has not yet been examined. It is important to address this research gap, as there is extensive evidence of the association in stand-alone companies (Pathak & Sun, 2013). Furthermore, existing literature indicates the need for further research on the CG factors influencing earnings management at the subsidiary-level (Dyreng et al., 2012; Beuselinck et al., 2019).

In this study I focus on a sample of 1,608 private subsidiaries of US MNCs that are domiciled in 22 European countries for the period 2011-2017. I use the performance-adjusted modified Jones modelproposed by Kothari et al. (2005), to measure earnings management. I find that equity-based compensation of the parent´s CEO is not associated with subsidiary FRQ. However, the results of an additional test show that the proportion of option-based compensation is negatively associated with subsidiary FRQ. These results suggest that stock options incentivize the parent CEO to engage in earnings management at the subsidiary-level. Therefore, equity-based compensation may not be an effective mechanism to align the interests of the CEO with the interests of the shareholders. Furthermore, in contrast to my prediction the results show that MNC-parent board independence is negatively associated with subsidiary FRQ. This finding contradicts prevailing viewsby providing evidence that board independence is not always an effective monitoring mechanism that mitigates earnings management and that the presence of independent directors on the MNC-parent board in fact increases the extent of earnings management at the subsidiary-level. This might be explained by several factors that lower the monitoring effectiveness of the non-executive directors, among which dependence on the CEO to be nominated for boards, tenure, dependence on the managers to obtain information about the company, and the number of directorships. Another explanation might be that the parent board can reduce the opportunities to manage earnings at the parent-level, which is why parent executives might engage to a higher extent in earnings management through their foreign subsidiaries, where the parent board has more difficulties to monitor, due to the complexity and the geographical distance.

This study contributes to several strands of literature. First, I contribute to the limited literature on earnings management within MNCs, by examining the effect of parent-CG mechanisms on earnings management at the subsidiary-level. The little research that has been done examined the relation between earnings management and consolidated loss prevention (Fan, 2012); tax havens (Dyreng et al., 2012); and institutional quality (Dyreng et al., 2012; Beuselinck et al., 2019). Given the role of CG mechanisms in mitigating earnings management in stand-alone companies, an important question is whether parent-CG mechanisms are able to limit earnings management conducted through foreign subsidiaries. In this paper I provide evidence that it is not the case that parent-CG mechanisms curb earnings management at the subsidiary-level. I

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9 also contribute to this strand of literature, by providing evidence that independence of the MNC-parent board increases the extent of earnings management at the subsidiary-level and thereby lowers subsidiary FRQ, which ultimately impairs the quality of consolidated financial statements. These contributions are relevant, because according to Dyreng et al. (2012), further research is needed on earnings management within MNCs, to get a better understanding of why MNCs engage in earnings management through their subsidiaries.

Second, I contribute to the compensation literature by challenging prevailing views (Mehran, 1995; Hanlon et al., 2003; Ittner et al., 2003), because I provide evidence that stock option compensation may not be an effective mechanism to align the interests of executives with the interests of the shareholders.

Third, I contribute to the corporate governance literature by showing that board independence is not always an effective monitoring mechanism that mitigates earnings management, thereby challenging prevailing views (Jaggi et al., 2009; Pathak & Sun, 2013; Singh et al., 2017). My finding that option-based compensation can have a negative effect on subsidiary FRQ and ultimately on the quality of consolidated financial statements, has implications for investors and MNC-parent boards. They should consider this potential negative effect, when making their decisions. Furthermore, my findings have implications for regulators and for shareholders of U.S. MNCs when designing board regulations and making decisions about the board composition, respectively. They should consider that board characteristics like tenure andthe number of directorships of independent board members could lower their monitoring effectiveness. Furthermore, they should consider that the monitoring effectiveness of independent directors might be limited to parent-level earnings management.

The rest of the paper is organized as follows: In section 2, I provide an overview of the theory around earnings management within MNCs and develop the hypotheses. In section 3, I describe the research method and the data I used for this study. In section 4, I report the results. Lastly, a conclusion based on the results is formed in section 5.

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2. Theoretical framework and hypothesis development

2.1 Theoretical background of earnings management within MNCs

The agency problem of executives not acting in the best interests of shareholders and maximizing personal wealth, has been a longstanding issue in corporations (Jensen & Meckling, 1976; Harris et al., 2019). One way to mitigate information asymmetry between shareholders and top executives, is financial reporting (Xie et al., 2003). Investors use financial statement information to make decisions about whether to sell, buy or hold shares (Xie et al., 2003). In addition, creditors use financial statement information to decide whether to provide a loan to the company (Alexander & Christina, 2017). A high FRQ exists when the information in the financial statements is useful for the stakeholders of the MNC (Xie et al., 2003). This is the case when the financial statements give a fair view of the performance of the MNC (Xie et al., 2003; Al-Haddad & Whittington, 2019). However, when MNC-parent executives engage in earnings management the information in the financial statements is altered and may therefore not give a fair view of the MNC’s current performance (Meek et al., 2007; Al-Haddad & Whittington, 2019). When the information is altered, this will negatively affect the decisions of the MNC’s stakeholders, because they cannot correctly determine the value of the company (Xie et al., 2003). So, earnings management lowers the decision usefulness of the financial statements and thereby lowers the FRQ of the MNC (Xie et al., 2003; Al-Haddad & Whittington, 2019). This interpretation of earnings management is defined by Healy & Wahlen (1999, p. 368) as: “Managers using judgment in financial reporting and in structuring transactions to alter financial reports to either mislead some stakeholders about the underlying economic performance of the company or to influence contractual outcomes that depend on reported accounting numbers”.

The increased complexity of MNCs in the past decade, due to the expansion into new countries, has put pressure on the FRQ of MNCs (Durnev et al., 2017). This is because due to the increased complexity and due to international differences in accounting standards, it is harder for parent country regulators and for MNC investors to oversee the activities of the MNC-parent and its subsidiaries, including their financial reporting process (Chin et al., 2009; Huang, 2018). This leads to information asymmetry between the MNC and its stakeholders (Chin et al., 2009; Fan, 2012). In addition, the international expansion led to an increase for MNC-parent executives in the opportunities to make discretionary accounting choices in the consolidated financial statements, because it is harder for the parent auditor to monitor the MNC’s financial reporting process (Dyreng et al., 2012; Fan, 2012). According to prior research, MNC-parent executives can use these circumstances to make suboptimal decisions for private gain2 (Chin et al., 2009; Fan, 2012). However, when this creation of private gain is discovered, it will harm the MNC’s reputation and it will likely increase external scrutiny (Chin et al., 2009). Therefore, according to Chin et al. (2009), MNC-parent executives have incentives to engage in earnings management in order to conceal the negative effects of exploiting the increased firm complexity.

2_{For instance, Hope and Thomas (2008) provide evidence that increased firm complexity leads managers to engage more in}

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11 On the other hand, earnings management can sometimes be beneficial for stakeholders (Al-Haddad & Whittington, 2019). This is the case when executives use earnings management to communicate private information3 to the stakeholders about the true performance of the MNC (Adut et al., 2013; Harris et al., 2019). However, in most cases earnings management is not in the best interests of the stakeholders (Chin et al., 2009; Fan, 2012). Earnings management is then used by parent executives for the creation of private gain (Harris et al., 2019). As discussed in section 1, I follow prior research by using earnings management as a proxy for FRQ in this paper (Martínez-Ferrero, 2014; Ianniello, 2015). Specifically, I focus on the discretionary accruals of subsidiaries.

In order to engage in earnings management, there have to be opportunities for it (Dyreng et al., 2012). According to Robinson & Stocken (2013), MNC-parents have substantial power over the financial reporting decisions of their subsidiaries, because they can change the subsidiaries’ financial reporting guidelines. The subsidiaries must follow these guidelines of the MNC-parent to make it possible for the MNC-parent to draw up the consolidated financial statements (Prencipe, 2012). Furthermore, a few studies have provided evidence that MNCs use their foreign subsidiaries to engage in earnings management. Fan (2012) finds that U.S. MNCs make more use of foreign earnings for earnings management than domestic earnings, when trying to prevent a loss in the consolidated financial statements. Furthermore, Fan (2012) shows that the complexity of foreign operations provides greater discretion for MNC managers to use foreign earnings for earnings management. Furthermore, Dyreng et al. (2012) document that U.S. MNC-parents with a substantial number of foreign subsidiaries in tax havens or countries with a weak rule-of-law, use more foreign earnings management than MNC-parents with subsidiaries in strong rule-of-law countries. Thirdly, Durnev et al. (2017) use a sample of parent companies with subsidiaries located in offshore financial centres, to provide evidence that these firms have lower FRQ than firms that do not have subsidiaries in offshore financial centres. Lastly, Beuselinck et al. (2019), use a sample of subsidiaries that are situated in 89 countries, to provide evidence that MNC-parents that are established in countries with high institutional quality, engage in earnings management through their subsidiaries that are located in institutional environments of low quality.

In addition, there are several other motives for MNC-parents to engage in earnings management through their foreign subsidiaries. For instance, the MNC-parent auditor usually delegates the audit of the foreign subsidiaries to local auditors (Prencipe, 2012). These local auditors may be affiliates of the MNC-parent audit firm, but sometimes the MNC-parent auditor does not have an office in the specific foreign country, which means that the subsidiary has to hire an unrelated local firm to do the audit of its financial statements (Dyreng et al., 2012). These local audit firms do not always follow the same strict rules and principles as the MNC-parent audit firm, for auditing the prepared accounts (Dyreng et al., 2012). Therefore, the MNC-parent executives may have less probability of being questioned by the auditor if they manage the earnings through the foreign subsidiaries (Dyreng et al., 2012; Prencipe, 2012). Moreover, a big geographical distance between the MNC-parent and the subsidiary reduces the probability that the subsidiary is subject to scrutiny of the investors and regulators of the MNC-parent, because it is harder for these stakeholders to investigate the activities at the subsidiary-level (Kedia & Rajgopal, 2011; Beuselinck et al., 2019). Furthermore, engaging

3_{For example, the parent executive may know that the lower cash flow of the year is due to a new investment and that there}

is a high probability that this investment will generate earnings in the coming years (Tucker & Zarowin, 2006). He can then use earnings management to smooth the value of the earnings in the current year, in order to signal to investors that the drop in the cash flow is temporary (Tucker & Zarowin, 2006). Based on this information, investors can better determine the value of the company and can make better investment decisions (Chaney et al., 1998; Adut et al., 2013).

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12 in earnings management at the subsidiary-level, instead of at the parent-level, may also lead to less reputational damage and lower fines for the MNC-parent, when earnings management is detected (Beuselinck et al., 2019). An explanation for this is that according to Dearborn (2009) the MNC-parent can claim in court that it was not aware of the earnings management activities of the subsidiary. Also, it is not very difficult to prove in court that the MNC-parent and the subsidiary are both distinct legal entities, which leads to a small chance that the court holds the MNC-parent accountable for the actions of its subsidiary (Dearborn, 2009). In addition, according to Beuselinck et al. (2019) the MNC-parent consolidated earnings can be directly increased by increasing the subsidiary earnings (net of intercompany transactions4). Bonacchi et al. (2018) provide evidence that the accruals are not always effectively monitored by the auditor, for example when the value is below the materiality level, which leads to the situation that some discretionary accruals of the subsidiary transfer through to the MNC-parent consolidated earnings (Beuselinck et al., 2019). Lastly, the U.S. government is not always able to apply legislative control over the accounting of foreign U.S. MNC subsidiaries, because it does not always have sufficient knowledge of the local regulations (Kedia & Rajgopal, 2011). Therefore, based on this evidence, I assume that MNC-parents primarily engage in earnings management through their foreign subsidiaries.

In the last decades, several CG mechanisms have been implemented to mitigate earnings management (Adut et al., 2013; Al-Haddad & Whittington, 2019). Given this role of CG in mitigating earnings management, an important question is whether these mechanisms are able to curb earnings management conducted through foreign subsidiaries and thereby improve subsidiary FRQ and ultimately the reporting quality of consolidated reports. Therefore, in the next two sections I discuss the effect of two parent-level CG mechanisms, namely the CEO equity-based compensation and board independence, on the FRQ of subsidiaries.

4_{I mention net of intercompany transactions, because the transactions between the MNC-parent and the subsidiary and the}

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2.2 CEO equity-based compensation and earnings management

A common agency problem is that the interests of the CEO are not sufficiently aligned with the interests of the shareholders (Almadi & Lazic, 2016). Agency theory argues that the CEO may have his or her own goals, including empire building and the creation of private gain, which are not always in the best interests of the shareholders (Schneider, 2013; Alam et al., 2015; Harris et al., 2019). Therefore, to better align the CEO’s interests with the shareholders’ interests, the board has increased the proportion of equity-based compensation of the CEO, in the last decade (Schneider, 2013; Almadi & Lazic, 2016). The idea is that the equity-based compensation steers the activities of the CEO more to creating firm value for the shareholders (Harris et al., 2019). This is because an increase in firm value can result in a higher stock price and can thereby increase the value of the CEO’s stock- and option-holdings (Hanlon et al., 2003; Meek et al., 2007; Harris et al., 2019). Several studies have provided evidence that equity-based compensation indeed incentivises executives to create firm value and that it helps in mitigating agency problems (Mehran, 1995; Hanlon et al., 2003; Ittner et al., 2003).

However, a drawback of equity-based compensation, from the CEO’s point of view, is that it makes his compensation more dependent on firm performance (Cheng & Warfield, 2005; Chen et al., 2015). This dependency creates uncertainty for the CEO about the future value of his compensation, because when the stock price drops this directly lowers the value of his equity-based compensation (Alam et al., 2015; Chen et al., 2015). Therefore, the CEO might be incentivised to engage in earnings management in order to increase the value of his current compensation and equity holdings (Cheng & Warfield, 2005; Alam et al., 2015). In that case the CEO can manage the earnings upwards, because then the stock price is likely to increase, as the capital market uses the value of consolidated earnings to predict the future value of stock (Cheng & Warfield, 2005; Alam et al., 2015; Chen et al., 2015). The increased stock price in turn results in a higher value of equity-based compensation for the CEO (Chen et al., 2015). For example, Cheng & Warfield (2005) provided evidence that equity-based compensation incentivises CEOs to use earnings management to beat analyst earnings forecasts, so that they can sell their shares at a high price in the following year.

As discussed in section 2.1, several studies have provided evidence that MNC-parents engage in earnings management through their foreign subsidiaries (Dyreng et al., 2012; Fan, 2012; Durnev et al., 2017; Beuselinck et al., 2019). Furthermore, I discussed two important implications of the international expansion of MNCs for their financial reporting process. Firstly, it has increased the complexity of the MNCs’ financial reporting process (Chin et al., 2009). Secondly, the international expansion has resulted in opportunities for parent executives to make discretionary accounting choices in the consolidated financial statements (Fan, 2012). According to Chin et al. (2009), MNC executives use this increased complexity and increased discretion opportunities to engage in foreign earnings management. The parent CEO can then manage the subsidiary earnings upwards in order to increase the value of consolidated earnings (Bonacchi et al., 2018). This can result in an increase in the stock price of the MNC and might thereby lead to an increase in the value of the equity-based compensation of the parent CEO, as this is based in the MNC’s overall performance (Chen et al., 2015). Furthermore, the CEO might prefer to manage earnings at the subsidiary-level, because it may lead to less scrutiny from the auditors, investors and regulators of the MNC (Kedia & Rajgopal, 2011; Beuselinck et al., 2019). There are two ways in which the MNC-parent CEO can engage in earnings management through its foreign subsidiaries. The first way the MNC-parent CEO can influence the financial reporting choices of the MNC is by putting pressure on the parent CFOto change the reporting guidelines of the subsidiary (Feng et al., 2011; Alam et al., 2015). According to

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14 Feng et al. (2011), the parent CEO can put pressure on the parent CFO by threatening to fire him or by developing a culture within the organization that focuses on meeting short-term earnings targets. The parent CEO can for instance coordinate earnings management through the subsidiary by putting pressure on the parent CFO to record discretionary accruals in one of the foreign subsidiaries (Huang, 2018). The subsidiary is then obligated to follow these reporting guidelines of the MNC-parent, in order to enable the MNC-parent to draw up the consolidated financial statements (Prencipe, 2012). A second way in which the MNC-parent CEO can influence earnings management at the subsidiary-level is by using budgets (Huang, 2018). Leone & Rock (2002) provided evidence that managers make decisions regarding the reporting of discretionary accruals based on budget incentives, because their bonus is usually linked to their performance with regard to budgets. Therefore, the MNC-parent CEO can for example set a high income-budget target for a certain subsidiary, to put pressure on the subsidiary managers to engage in income increasing earnings management (Huang, 2018). The largest part of prior literature finds a positive relation between equity-based compensation and earnings management in stand-alone companies (Cheng & Warfield, 2005; Johnson et al., 2009; Alam et al., 2015; Chen et al., 2015; Harris et al., 2019), a few other studies find a non-significant relation (Erickson et al., 2006; Armstrong et al., 2010) and the study of Laux & Laux (2009) finds a negative relation. Laux & Laux (2009) provide evidence that an increase in the proportion of equity-based compensation also increases the board’s commitment to engage in monitoring, because the board is aware of the CEO’s incentives for engaging in earnings management. This lowers the opportunities of the CEO to engage in earnings management (Laux & Laux, 2009).

Nevertheless, based on the arguments presented in this section and assuming that MNC-parents primarily engage in earnings management through their foreign subsidiaries (Durnev et al., 2017; Beuselinck et al., 2019), I expect that MNC-parent CEO equity-based compensation has a positive effect on the extent of earnings management at the subsidiary-level, because subsidiary earnings are included in the consolidated reports. This increase in the extent of earnings management, can lower the information usefulness of the subsidiary financial reports and therefore can lower the FRQ of the subsidiary and that of the MNC as a whole (Al-Haddad & Whittington, 2019). Based on these expectations, I state the following hypothesis:

H1: There is a negative association between CEO equity-based compensation of the MNC-parent and FRQ of the subsidiary.

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2.3 Board independence and earnings management

The board of directors has gained more and more attention from academic researchers in the past few years (Prencipe & Bar-Yosef, 2011; Pathak & Sun, 2013; Singh et al., 2017; Al-Haddad & Whittington, 2019). According to agency theory the board is an important CG mechanism that monitors the behavior of the executives, including their financial reporting decisions (Pathak & Sun, 2013; Benkraiem et al., 2017).

Previous research has provided evidence that the monitoring effectiveness and decision-making of the board is enhanced by increasing the proportion of independent members on the board (Jaggi et al., 2009; Pathak & Sun, 2013; Singh et al., 2017). This relation exists for several reasons. Firstly, because independent directors risk losing their reputation when earnings management is detected, they are incentivised to supervise the actions of management (Pathak & Sun, 2013). Secondly, independent directors often have extensive experience in supervising top management, which enhances their monitoring effectiveness (Benkraiem et al., 2017). Thirdly, independent directors have less conflicts of interest in their decision-making than other directors, because they do not have financial and social ties to the company (Essen et al., 2015). In addition, Sanchez-Marin et al. (2010) found that a high proportion of independent directors on the board leads to larger control over the behaviour of management and Benkraiem et al. (2017) state that independent directors more effectively monitor for opportunistic executive behaviour. This in turn constrains earnings management, because the board more effectively monitors executive behaviour, including their financial reporting decisions (Pathak & Sun, 2013). Several studies provide evidence of this negative association between board independence and earnings management in stand-alone companies. They find that more effective board monitoring lowers the opportunities of managers to engage in earnings management (Vafeas, 2005; Firth et al., 2007; Pathak & Sun, 2013; Singh et al., 2017). On the other hand, boards will not always act as an effective monitoring mechanism in the best interests of shareholders (Schneider, 2013), which creates an agency problem between the board and the shareholders of the firm (Essen et al., 2015). According to Essen et al. (2015), there are several factors that decrease the independence of non-executive directors (Bebchuk & Fried, 2004; O’Reilly & Main, 2010; Essen et al., 2015). Firstly, directors want to be reelected and keep their position, because a seat on the board provides a certain status, good compensation and social connections (Bebchuk & Fried, 2004). To be reelected the directors have to be put on the slate of directors of the firm (Schneider, 2013), which requires a nomination from the CEO (Essen et al., 2015). When the director disagrees several times with the CEO, the director might develop a reputation of continually arguing against the CEO, which might decrease the likelihood that the director will be nominated for other boards (Schneider, 2013). Therefore, directors may not always argue against the CEO (Schneider, 2013). Secondly, longer tenure of the outside-directors can lower their independence, because when directors serve for longer periods on the board, they might develop closer relationships with managers of the firm (Vafeas, 2003). Also, the outside-directors can develop friendships with other directors on the board, because they have to collaborate a lot (Essen et al., 2015). These close relationships may make it harder for independent directors to argue against the managers and to argue against the other board members, thereby leading to conflict avoidance (Vafeas, 2003; O’Reilly & Main, 2010; Essen et al., 2015). This conflict avoidance decreases the independence of the outside-directors and lowers their ability to effectively monitor management (O’Reilly & Main, 2010; Essen et al., 2015). Lastly, to be able to make decisions the outside-directors depend on the managers to obtain information about the company (Essen et al., 2015). However, managers may provide manipulated information to the board in order

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16 to conceal their activities for private gain (Bebchuk & Fried, 2004; Essen et al., 2015). This can lower the effectiveness of the decision-making of the independent directors, because their decisions might be based on manipulated information (Essen et al., 2015). These factors tend to decrease the independence of the board members and thereby negatively affect their monitoring effectiveness (Ryan & Wiggins, 2004; Schneider, 2013). This can create opportunities for executives to engage in earnings management (Pathak & Sun, 2013 Bonacchi et al., 2018).

Nonetheless, the largest part of prior research finds a negative relation between board independence and earnings management in stand-alone companies (Vafeas, 2005; Firth et al., 2007; Jaggi et al., 2009; Pathak & Sun, 2013; Singh et al., 2017). In MNCs the parent board members focus on the FRQ of the consolidated financial statements, which is based on the quality of the financial statements of the material subsidiaries (Pathak & Sun, 2013; Bonacchi et al., 2018; Al-Haddad & Whittington, 2019). Therefore, the independent directors of the parent board are concerned with the FRQ of the material subsidiaries (Pathak & Sun, 2013; Bonacchi et al., 2018). The independent parent board members are incentivized to apply mechanisms to monitor the consolidated financial statements and to curb earnings management at the subsidiary-level, because this can improve the subsidiary FRQ and thereby the FRQ of the consolidated financial statements (Pathak & Sun, 2013; Bonacchi et al., 2018). Based on these arguments, I argue in this paper that the effective monitoring of parent executive behaviour by independent parent board members could lower the opportunities of parent executives to make discretionary accounting choices in the consolidated financial statements. This could for example lower the opportunities of parent executives to put pressure on the parent CFO to change the subsidiary reporting guidelines and it could also lower their opportunities to use budgets to engage in earnings management through the subsidiary. Therefore, parent board independence could lower the opportunities of the parent executives to engage in earnings management through their subsidiaries.

Based on the arguments in this section and assuming that MNC-parents primarily engage in earnings management through their foreign subsidiaries (Durnev et al., 2017; Beuselinck et al., 2019), I expect that MNC-parent board independence has a negative effect on the extent of earnings management at the subsidiary-level, because curbing earnings management of foreign subsidiaries is likely to improve subsidiary FRQ and thereby the reporting quality of the consolidated financial statements5. Based on these expectations, I state the following hypothesis:

H2: There is a positive association between independence of the MNC-parent board and FRQ of the subsidiary.

5_{A decrease in the extent of subsidiary earnings management, can increase the information usefulness of the subsidiary}

financial statements and can therefore enhance the FRQ of the subsidiary and ultimately the reporting quality of consolidated reports (Al-Haddad & Whittington, 2019).

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3. Methodology

3.1 Sample selection

I first identify all listed firms from the U.S. using Compustat. Next, following prior research, I exclude firms from the financial sector (SIC 6000–6999), because of its particular regulatory environment (Almadi & Lazic, 2016; Harris et al., 2019). I also exclude firms with missing board and CEO related information. Information about the parent’s board is gathered from MSCI and that of CEO compensation is gathered from ExecuComp.

Then, for these listed non-financial firms I hand-collect the names and jurisdiction of all material subsidiaries included in exhibit 21.1 or 21 of 10-k filings from Edgar. I focus on the material subsidiaries, because these subsidiaries make up a significant part of the MNC’s consolidated revenues and assets (Thomson Reuters, 2019). Thereafter, I match the names and countries of the material subsidiaries with those of the firms covered by the Orbis database. Given the coverage of Orbis, I select only subsidiaries from 30 European countries. Next, I delete subsidiaries operating in the financial sector (NACE 64–66), because of its particular regulatory environment (Dyreng et al., 2012; Harris et al., 2019). In addition, when there are industry-years with less than 10 observations, I eliminate the corresponding firm-years, because according to Kothari et al. (2005) the estimates of the regression model of discretionary accruals will likely be imprecise for industry-years with less than 10 observations (Dyreng et al., 2012). Following Beuselinck et al. (2019), I also delete subsidiaries with total assets below $10.000, to eliminate outliers. Finally, after discarding firms with unavailable financial information, my final sample consists of 6,263 observations corresponding to 1,608 subsidiaries from 22 countries. The financial information of the subsidiaries is collected from the Orbis database. Furthermore, the subsidiaries operate in 13 different industries, based on the NACE two-digit industry classification. I examine the period 2011-2017, because there was no capacity to hand-collect more information from the Edgar database.

3.2 Variables

Independent variables

Following Harris et al. (2019), equity-based compensation (EqCompParent) is measuredas the

sum of the value of restricted stocks and the value of stock options granted during the fiscal year divided by total MNC-parent CEO compensation. So, EqCompParent is composed of the

following variables out of ExecuComp: ‘OPTION_AWARD_FV’ + ‘STOCK_AWARD_FV’ and total compensation is based on the variable ‘TDC1’, which consists of bonuses, the total value of restricted stock, the value of stock options granted during the fiscal year, salary, long-term incentive pay-outs and all other compensation (Harris et al., 2019).

Furthermore, following previous studies, I measure board independence (BOARDIndParent) with

the proportion of outside directors on the MNC-parent board, which is calculated as the number of outside directors divided by the total number of board members (Pathak & Sun, 2013; Benkraiem et al., 2017).

Dependent variable

To measure subsidiary FRQ I focus on the manipulation of accruals, which is the part of earnings that is not paid or received in cash (Healy & Wahlen, 1999). In particular, I examine the discretionary accruals, as these are primarily used for the purpose of earnings management

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18 (Healy & Wahlen, 1999; Al-Haddad & Whittington, 2019). I follow prior research and use the absolute value of discretionary accruals reported by the subsidiary as a proxy for subsidiary FRQ (Beuselinck et al., 2019). Following Al-Haddad & Whittington (2019), I use the performance-adjusted modified Jones model proposed by Kothari et al. (2005), to measure earnings management. So, following Kothari et al. (2005), I include ROA to the equations (1) and (2). Thereby controlling for exceptional firm performance, because this can distort the estimation of discretionary accruals (Cohen et al., 2008). All variables in these equations are divided by lagged total assets, to take into account the effect of subsidiary size on the variables in these equations (Bergstresser & Philippon, 2006; Chen et al., 2015).

To calculate the value of discretionary accruals, I first estimate the coefficients of equation (1) (Kothari et al., 2005). 𝑇𝐴𝑖𝑡 𝐴𝑠𝑠𝑒𝑡𝑖𝑡−1= 𝑎1 1 𝐴𝑠𝑠𝑒𝑡𝑖𝑡−1+ 𝑎2 ∆𝑅𝐸𝑉𝑖𝑡 𝐴𝑠𝑠𝑒𝑡𝑖𝑡−1+ 𝑎3 𝑃𝑃𝐸𝑖𝑡 𝐴𝑠𝑠𝑒𝑡𝑖𝑡−1+ 𝑎4𝑅𝑂𝐴𝑖𝑡+ 𝜀𝑖𝑡 (1) Where:

for subsidiary i and year t: 𝑻𝑨_𝒊𝒕 (Total Accruals) is computed by (the change in current

assets – the change in current liabilities – the change in cash – the depreciation expense); 𝑨𝒔𝒔𝒆𝒕_{𝒊𝒕−𝟏} is total assets in year t-1 for subsidiary i; ∆REVit is the change in revenues; PPEit is the gross value of property, plant and equipment; ROAit is return on assets, calculated as net income scaled by lagged total assets (Dechow et al., 1995; Bergstresser & Philippon, 2006; Chen et al., 2015; Al-Haddad & Whittington, 2019). Then I use the estimated coefficients from model (1) to estimate the normal accruals (NAit) in

model (2), which is theperformance-adjusted modified Jones model (Dechow et al., 1995; Kothari et al., 2005). In this second equation, following Dechow et al. (1995), I adjust the change in subsidiary revenue (∆𝑅𝐸𝑉𝑖𝑡) with the change in subsidiary accounts receivable (∆𝐴𝑅_𝑖𝑡), because the revenue can be managed by manipulating the accounts receivable and therefore accounts receivable is not non-discretionary and has to be eliminated from the change in revenue (Lee & Vetter, 2015).

𝑁𝐴𝑖𝑡 𝐴𝑠𝑠𝑒𝑡𝑖𝑡−1= 𝑎̂5 1 𝐴𝑠𝑠𝑒𝑡𝑖𝑡−1+ 𝑎̂6 (∆𝑅𝐸𝑉𝑖𝑡−∆𝐴𝑅𝑖𝑡) 𝐴𝑠𝑠𝑒𝑡𝑖𝑡−1 + 𝑎̂7 𝑃𝑃𝐸𝑖𝑡 𝐴𝑠𝑠𝑒𝑡𝑖𝑡−1+ 𝑎8𝑅𝑂𝐴𝑖𝑡 (2) Where:

NAit is normal accruals; ∆ARit is the change in subsidiary accounts receivable (Chen et al., 2015; Al-Haddad & Whittington, 2019).The other variables are defined as in equation (1).

Lastly, in equation (3) I deduct the NAit from the TAit to calculate the level of subsidiary

discretionary accruals (DASubsidiary,it) (Dechow et al., 1995; Bergstresser & Philippon, 2006;

Chen et al., 2015). 𝐷𝐴𝑆𝑢𝑏𝑠𝑖𝑑𝑖𝑎𝑟𝑦,𝑖𝑡 = ( 𝑇𝐴𝑖𝑡 𝐴𝑠𝑠𝑒𝑡𝑖𝑡−1) − ( 𝑁𝐴𝑖𝑡 𝐴𝑠𝑠𝑒𝑡𝑖𝑡−1) (3)

Following Dyreng et al. (2012), I use the absolute value of subsidiary discretionary accruals (|DASubsidiary,it|) to measure the extent of income-increasing as well as income-decreasing

earnings management. So, a large amount of positive and negative discretionary accruals shows that there is a high level of earnings management at the subsidiary-level (Dyreng et al., 2012;

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19 Chen et al., 2015). I estimate the three equations cross-sectionally for each year and industry combination with a minimum of 10 observations, to control for fixed effects of year and industry (Dyreng et al., 2012; Harris et al., 2019).

3.3 Empirical model

To test my predictions, I estimate model (4). In this model the subscripts i and t represent subsidiary and year respectively and |DASubsidiary,it| is the absolute value of subsidiary

discretionary accruals. Definitions of all the variables can be found in Appendix A. In addition, the control variables are further discussed below.

|DASubsidiary,it| = β0 + β1 EqCompParent,it + β2 BOARDIndParent,it + β3 FSIZESubsidiary,it +

β4 SALESGSubsidiary,it + β5 ROACSubsidiary,it + β6 LEVSubsidiary,it +

β7 LOSSSubsidiary,it + β8 YEARit + β9 INDit + β10 COUNTRYit + εit. (4)

In H1, I predict that there is a negative association between CEO equity-based compensation of the MNC-parent and FRQ of the subsidiary. Therefore, I expect a positive sign for the coefficient of EqCompParent. In addition, I predict in H2 that there is a positive association

between independence of the MNC-parent board and FRQ of the subsidiary. So, I expect a negative sign for the coefficient of BOARDIndParent. All continuous variables are winsorized at

the top and bottom 1% level, to eliminate the effect of extreme observations (Al-Haddad & Whittington, 2019; Harris et al., 2019). I perform ordinary least squares regression analyses on the final sample.

Control variables

Building on previous research, I control for several subsidiary characteristics in model (4). Following Beuselinck et al. (2019), I include subsidiary size (FSIZESubsidiary) as a control

variable, by taking the natural logarithm of subsidiary total assets. It is important to control for subsidiary size, because Beuselinck et al. (2019) provided evidence that larger subsidiaries engage less in earnings management than smaller subsidiaries. An explanation for this relation is that larger firms have greater public exposure and larger political costs than smaller firms (Ball & Foster, 1982; Ianniello, 2015). In addition, following Bonacchi et al. (2018), I include subsidiary sales growth (SALESGSubsidiary), which is computed as the change in subsidiary sales,

to control for growth opportunities of the subsidiary. It is important to control for this, because prior research found that accruals emerge when sales grow (Peek et al., 2013). Hence, subsidiaries that are growing are inclined to report a higher value of discretionary accruals (Peek et al., 2013; Beuselinck et al., 2019). Furthermore, I follow Beuselinck et al. (2019) by using return on assets of the subsidiary (ROACSubsidiary), calculated as subsidiary net income

scaled by subsidiary lagged total assets, as a measure of subsidiary profitability. I control for subsidiary profitability because prior studies show that firms use earnings management to hide low performance (Zang, 2012). Also, following Beuselinck et al. (2019), I use the ratio of total debt to total subsidiary assets as a measure of the subsidiary’s leverage (LEVSubsidiary). It is

important to control for leverage, because companies that are highly leveraged are likely to use earnings management to prevent breaching their debt covenants (DeFond & Jiambalvo, 1994). In addition, following Beuselinck et al. (2019), I use a loss-making dummy (LOSSSubsidiary), that

is ‘1’ for subsidiaries that have a negative net income and ‘0’ otherwise. I include this dummy because according to Francis et al. (2004) there is a positive relation between loss-making and earnings management. This relation exists because loss-making firms have an incentive to manage earnings upwards in order to prove that they are able to overcome the temporary negative performance (Ianniello, 2015). Lastly, I include year dummies (YEARit), industry

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20 dummies (INDit) based on the NACE two-digit industry classification and country dummies

(COUNTRYit) to control for the effect of time and for the effect of industry and country

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4. Results

4.1 Descriptive statistics

The descriptive statistics for the full sample are reported in table 1. Subsidiaries in my sample have, on average, discretionary accruals that represent 13% of their total assets. Furthermore, the mean of equity-based compensation (EqCompParent) is 56%, which means that on average

more than half of the total compensation of the MNC-parent CEO is based on equity. Moreover, as the minimum of equity-based compensation is 0% and the maximum is 99%, this shows that some MNC-parents in the sample do not grant equity-based compensation to the CEO and that some MNC-parents base CEO compensation almost fully on equity. In addition, MNC-parent board independence (BOARDIndParent) has a mean of 79% and a median of 83%. So, on

average, the parent board has about 80% of independent directors. Furthermore, the mean subsidiary size (FSIZESubsidiary), which is the natural logarithm of subsidiary total assets, is

$11.09. Moreover, the average sales growth (SALESGSubsidiary) is 6% and the maximum of

327% shows that there are some subsidiaries in the sample with very high growth. In addition, in terms of profitability (ROACSubsidiary) the subsidiaries have an average return on assets of

5%. Also, on average the subsidiaries are highly leveraged (LEVSubsidiary) with a mean of 45%,

compared to the mean of 5% of the sample of Beuselinck et al. (2019), who examine earnings management at subsidiaries located in 89 different countries6. Furthermore, the mean of the loss-dummy (LOSSSubsidiary) of 0.19 shows that 19% of the observations in my sample have

recorded a loss.

Table 1. Descriptive statistics

Variable N Mean Median Std. Dev. Min Max

|DASubsidiary| 6,263 0.13 0.07 0.17 0.00 1.70 EqCompParent 6,263 0.56 0.62 0.21 0.00 0.99 BOARDIndParent 6,263 0.79 0.83 0.14 0.00 1.00 FSIZESubsidiary 6,263 11.09 10.89 1.32 9.21 16.64 SALESGSubsidiary 6,263 0.06 0.01 0.39 - 0.72 3.27 ROACSubsidiary 6,263 0.05 0.04 0.11 - 0.34 0.47 LEVSubsidiary 6,263 0.45 0.42 0.28 0.01 1.27 LOSSSubsidiary 6,263 0.19 0.00 0.39 0.00 1.00

For variable definitions see Appendix A.

Table 2 provides the Pearson correlations between the variables used in this study. Remarkable is that the correlations between the main independent variables and the absolute value of discretionary accruals (|DASubsidiary|) are not significant, which may indicate that there is no

relationship between them. In addition, the correlations between the control variables and the absolute value of discretionary accruals are all significant at the 5% level. As expected, the correlation between firm size (FSIZESubsidiary) and the absolute value of discretionary accruals (|DASubsidiary|) is negative, suggesting that larger subsidiaries have lower discretionary accruals.

Furthermore, the correlations between |DASubsidiary| and the other control variables are positive.

Specifically, discretionary accruals are higher in subsidiaries that have higher growth opportunities, are more profitable and more leveraged, and also in subsidiaries that report a

6_{The mean, median and standard deviation of the absolute value of discretionary accruals (|DA}

Subsidiary|), the average size

(FSIZESubsidiary) and the average profitability (ROACSubsidiary) of the subsidiaries, are consistent with the sample of Beuselinck

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22 loss. This is in line with my expectations, except for the positive correlation between subsidiary profitability (ROACSubsidiary) and the absolute value of discretionary accruals (|DASubsidiary|). My

expectation was that these two variables are negatively correlated, because according to Zang (2012) firms use earnings management to hide low performance. An explanation for this opposite sign is discussed in section 4.2. In addition, the highest significant correlation of - 0.59 (p < 0.01) exists between the loss-making dummy (LOSSSubsidiary) and the return on assets

(ROACSubsidiary) of the subsidiary. This is plausible, because return on assets measures the

profitability of the subsidiary and the loss-making dummy is ‘1’ if the subsidiary has a loss. Therefore, when the return on assets of a subsidiary is negative, the loss-making dummy will be ‘1’ and the other way around. As no absolute value of a correlation coefficient lies above the generally accepted level of 0.70, it is unlikely that multicollinearity will be an issue in this study (Almadi & Lazic, 2016).

Table 2. Correlation matrix 1 2 3 4 5 6 7 8 1 |DASubsidiary| 1.00 2 EqCompParent 0.01 1.00 3 BOARDIndParent 0.01 0.14*** 1.00 4 FSIZESubsidiary - 0.05*** 0.05*** 0.10*** 1.00 5 SALESGSubsidiary 0.14*** - 0.00 - 0.02 - 0.05*** 1.00 6 ROACSubsidiary 0.03** 0.02 0.03** 0.01 0.06*** 1.00 7 LEVSubsidiary 0.10*** - 0.01 - 0.03** - 0.12*** 0.09*** - 0.24*** 1.00 8 LOSSSubsidiary 0.07*** - 0.02* - 0.08*** - 0.04*** - 0.02 - 0.59*** 0.19*** 1.00

Statistical significance is indicated by: *** for p < 0.01, ** for p < 0.05 and * for p < 0.1. For variable definitions see Appendix A.

4.2 Regression analysis

Table 3 presents the results of the regression analysis. The prediction for H1 was that there is a negative relation between MNC-parent CEO equity-based compensation and subsidiary FRQ. However, the results show that the coefficient on CEO equity-based compensation (EqCompParent) is not significant (p > 0.1). So, according to the results there is no association

between MNC-parent CEO equity-based compensation and the absolute value of discretionary accruals at the subsidiary-level. In other words, the results suggest that the equity incentives of the parent CEO do not impair subsidiary FRQ. Therefore, these results do not confirm H1. An explanation for this result is that the equity-based compensation aims to align the interests of the MNC-parent CEO with the interests of the shareholders (Mehran, 1995), which would likely imply reporting higher quality accounting numbers in the consolidated financial statements (Mehran, 1995; Xie et al., 2003). This is the initial purpose for which equity-based compensation was introduced in the first place (Schneider, 2013; Almadi & Lazic, 2016). The results complement the findings of Mehran (1995) and Hanlon et al. (2003), by providing evidence that equity-based compensation indeed incentivizes the CEO to work in the best interests of the shareholders, by not engaging in earnings management at the subsidiary-level. A second explanation why there may be no association between equity-based compensation and earnings management could be that, as described in section 2.2, when the proportion of CEO equity-based compensation increases, this also increases the commitment of the board to engage in monitoring, because the board is aware of the CEO’s incentives for engaging in earnings management (Laux & Laux, 2009). This lowers the opportunities of the CEO to engage in earnings management (Laux & Laux, 2009).

Foreign earnings management of U.S. multinational companies –