REPORTING QUALITY OF SUBSIDIARIES: AN EMPIRICAL
APPROACH
Master’s thesis, MSc Accountancy
University of Groningen, Faculty of Economics and Business
June 24, 2019
FRISO VAN DE AAST Studentnumber: 2382725
Heppenweg 7 7679 TG Langeveen Tel.: +31(6)20758005 email: frisovandeaast@gmail.com
email University: f.w.d.van.de.aast@student.rug.nl
Supervisor/University S. Rusanescu, PhD
ABSTRACT
This study investigates the relation between U.S multinational risk-taking and its effect on subsidiary financial reporting quality. As the relationship between U.S. multinationals and their overseas subsidiaries is increasingly important in global business, it is important to know what factors drive the successes of these subsidiaries. FRQ is an important measure for these successes as they reflect the firm performance to investors, analysts and other users. Thus multinationals have an incentive to let FRQ be as high as possible. These multinational parents are possibly able to influence subsidiaries by taking. Therefore the first hypothesis expects that higher risk-taking of multinationals leads to a lower FRQ of its subsidiaries. Furthermore, the jurisdiction in which the subsidiary is positioned could be of influence to its financial reporting quality. Jurisdictions with attractive tax laws are referred to as tax havens and are often used by multinationals to lower taxes. The second hypothesis expects that when the subsidiary is located in a tax haven, the jurisdiction has a moderating negative effect on the relationship between risk-taking and FRQ. The results show that there is not enough evidence for accepting either hypothesis. However it is shown that when a firm is located in a tax haven, it is significantly negatively related to FRQ.
Keywords: financial reporting quality, risk-taking, U.S. multinationals, subsidiaries, tax haven
I thank Simona Rusanescu for helpful discussion and feedback about my thesis. Furthermore I thank my fellow students who were participating in the same thesis group for their support and mu tual data collection. Also I would like to thank KPMG for allowing and enabling me to write my thesis there and my colleagues at KPMG Enschede for the training, learning and support.
INDEX
ABSTRACT ...2
1. INTRODUCTION...4
2. THEORETICAL FRAMEWORK ...8
2.1 Literature review...8
2.2 Financial reporting quality and its link with risk-taking ... 11
3. METHOD... 13
3.1 Sample selection ... 13
3.2 Variable definitions... 16
3.2.1 Subsidiary financial reporting quality... 16
3.2.2 Parent’s risk-taking ... 17 3.2.3 Tax haven ... 17 3.2.4 Control variables ... 18 3.3 Empirical model ... 18 4 RESULTS ... 20 4.1 Descriptive statistics ... 20 4.2 Correlation analysis ... 22 4.3 Regression analysis ... 23 5. DISCUSSION ... 27 6. CONCLUSION... 28 REFERENCES... 29 APPENDIX ... 38
1. INTRODUCTION
The objective of this study is to research what effect U.S. corporate risk-taking has on the financial reporting quality of its subsidiaries and their subsequent financial statements. I will primarily explore further on how this relationship affects subsidiaries, but also the moderating effect of having a subsidiary located in tax haven is taken into account.
The relation of U.S. multinational firms with their respective subsidiaries is more actual than ever. Due to the trade war the U.S. government is currently involved in with China, many multinationals are affected by import tariffs. The end of this conflict is not yet in sight as advancements to come closer to each other are further away as ever, as stated by U.S. vice-president Mike Pence and Chinese leader Xi Jinping (Bonjer, 2018). As U.S. firms are hugely affected by these tariffs, some are already planning ways to bypass these tariffs by importing via subsidiaries in foreign countries like for instance, Canada (Donovan, 2018). This way U.S. multinationals use their subsidiaries as a tool to avoid possible financial damage that would be incurred otherwise. Also developments regarding Brexit are heavily affecting multinational corporations. As Britain’s scheduled exit date of October 31, 2019 comes in sight (at the date of writing), companies across the globe fear its aftermath. A hard Brexit is still the most likely outcome (PwC, 2018), and eventually is expected to have a negative effect on the British economy as foreign investment in the U.K. will decrease when the sterling rate drops (Driffield & Karoglou, 2019). Also, companies that heavily trade with the U.K. have to take financial and economic measures to comply with non-EU regulations. Foreign companies will rather invest in more stable economies instead as its still uncertain what the final effects on global business will be. As a reaction to the upcoming Brexit, many U.S. multinationals have already moved U.K. assets and employees offshore due to the uncertainty and potential losses they could incur. In 2017 the foreign direct investment (FDI) inflows to the UK already dropped by 10%, while investment in EU countries rose by 10% (Department for International Trade, 2018). So subsidiaries within the UK are moved to more stable and economically healthy countries to prevent potential harm due to new legislation and regulations. By moving their subsidiaries, multinationals are reducing their level of risk-taking as Chinese import tariffs and Brexit will likely have a negative effect on U.S. firms and its subsidiaries. When subsidiaries are located in a more stable economy and environment it is
expected that this has a positive influence on their performance. A higher firm performance is related to a high-quality financial reporting (Kothari, 2000).
Multinationals are becoming increasingly important for the world economy. About half of multinationals’ GDP is earned within foreign subsidiaries and as the 100 world’s largest multinationals have approximately 70% of their total assets invested abroad, the economic importance of these multinationals is greater than ever (Beuselinck et al., 2018). Due to the fact that multinational firms increasingly invest overseas, subsidiaries are becoming important aspects of global business. Due to, for instance favourable laws, low wages or high local demand, business is moved towards these offshore countries. These subsidiaries enhance resources and capabilities of multinationals by adding value to the company as a whole, when effectively managed by its parent (Birkinshaw & Hood, 1998).
So the global financial role of multinationals and how they make use of their subsidiaries is becoming increasingly important to international business nowadays as multinationals manage their consolidated earnings through an orchestrated reporting strategy across subsidiaries over which they exert significant influence to gain an advantage over its competitors (Pillania, 2009; Beuselinck et al., 2018). For achieving these advantages, firms have to take substantial risks by making use of these financial opportunities. Risk has already been a central concept in international business for a long time (Figueira-de-Lemos, Johanson, & Vahlne, 2011) and international business risk affects all multinational corporations as they manage activities in foreign countries (Meyer & Peng, 2016). Lu (2012) found that higher earnings quality, which was used as a proxy for FRQ similarly to this research, is accompanied with lower risk-raking and higher firm value. This is because lower earnings quality is positively associated with both proxies of risk-taking (EDP and Stock Return Volatility) and it is negatively associated with firm value proxies, with a more significant effect after the financial crisis of 2008 than before. But when risk-taking is found to be influential to FRQ, will it also affect the FRQ of its subsidiaries?
As more incentives arise for multinationals to apply accruals or earnings management to obtain a financial or competitive advantage due to for instance the Chinese import tariffs, bigger competition and Brexit, they have to take more risks within their business management. Increased risk would make the capital market less attractive to investors, domestic and foreign alike, and also contribute to greater risk in financial markets globally (Kothari, 2000). As an increased risk is
likely to reduce firm value and as Lu (2012) already found firm value to be related to earnings quality, I expect that this higher risk-taking will significantly influence FRQ of subsidiaries. Therefore, I expect that U.S. multinational risk-taking has an negative effect on subsidiary FRQ. Measuring quality is a subjective matter as it depends on multiple variables, which makes it a complex process (Beattie et al., 2004). For this study I use discretionary accruals as a proxy of FRQ. I have collected information of the material subsidiaries of U.S. multinationals from EDGAR. Then I collected the necessary financial information of all variables from the Orbis database and linked it to the subsidiary information from EDGAR. The data from the U.S. parents is extracted from the Compustat database where after it was put together with the data from Orbis and EDGAR to form one dataset. Following Boubakri, Cosset & Saffar (2011), I measure risk-taking as the volatility of the earnings before interest and taxes (EBIT) to total assets ratio over a period of three years. Furthermore I will test whether the jurisdictional location of the subsidiaries has any moderating effect on the relation between risk-taking and FRQ by looking at countries that are regarded as tax haven. I will test this by dividing the locations of the subsidiaries into two categories: tax haven and no tax haven. As all subsidiaries in the dataset are located in Europe, no distinction between domestic and foreign has to be made.
The results show that there is not sufficient evidence to assume that risk-taking is negatively related to subsidiary FRQ. Also there is not sufficient evidence to assume that the moderating effect of having a subsidiary located in a tax haven has an influence on the relation between risk-taking and subsidiary FRQ. However there is some evidence that firms located in a tax haven are significantly negatively related to FRQ. This may indicate that when firms have its jurisdiction in a tax haven, they have lower FRQ.
This study contributes to current research on risk-taking related to FRQ. A few studies have investigated the relation between risk-taking and FRQ in stand-alone companies (Lu, 2012; Nichita, 2018; Ryan, 2012; Meijer, 2011). However, to the best of my knowledge, the relation between risk-taking of a parent level and FRQ on the subsidiary level has not been yet investigated. This could be important for investors, analysts and other users as they rely for a great deal on financial statements and their quality. As the relationship between a multinational and their subsidiaries is not always clear, it may help stakeholders. A high FRQ provides more information about the features of a firm’s financial performance that are relevant to a specific decision made
by a specific decision-maker (Dechow, Ge & Schrand, 2010). This research builds on previous research on earnings management by relating it to prospect theory. Prospect theory suggests that when people make decisions involving risk where the outcomes are uncertain, they weigh the potential value of gains and losses differently. People tend to make decisions based on perceived gains rather than perceived losses (Kahneman & Tversky, 1979; Tversky & Kahneman, 1992). Prospect theory is being used in this study as it can possibly explain the motivation for management to take more risk for achieving financial goals within a firm (Kahneman & Tversky, 1979). Studies like Fiegenbaum (1990) at the firm level and Shen & Chih (2005) at the country level have investigated prospect theory in relation to earnings management, however both studies were limited to certain industries like banking or oil industries. So the studies couldn’t be generalized to all industries as these were industry-specific. This research will look further into how risk-taking is motivating earnings management within U.S. firms. Prospect theory was already found to be a possible motivation for earnings management within Malaysian firms when industries weren’t considered separately (Wasiuzzaman, Sahafzadeh & Nejad, 2015). As different industries can have different motivations, this is a limitation to this research. Also, this study focuses on one country and therefore is not generalizable to global business. This paves the way for this research within U.S. multinational firms where industries are considered separately. The gap that remains in current literature is the discussion how risk-taking of multinationals influences the FRQ of their subsidiaries. Therefore the proposed research is expected to make a valuable contribution to the existing literature.
Having introduced the subject matter of this research, the next section is the theoretical framework, which comprises a review of existing literature on which I build my hypotheses. The third section describes the methodology, while the fourth section presents the results of the empirical tests. The fifth section discusses the findings of this research and provides avenues for future research.
2. THEORETICAL FRAMEWORK
2.1 Literature review
Many studies refer to FRQ as being one of the most important aspects of disclosure of a firm (Mubasshira & Chowdhury, 2018; Ahmed & Hamdan, 2015; Dechow et al., 2010; Biddle, Hilary & Verdi, 2009). FRQ cannot be easily quantified, as it cannot be observed directly, being based on the perception of the users of the financial information being disclosed (Achim & Chis, 2014). Users can have different expectations and perceptions of what information is regarded as useful and of good quality (Dechow et al., 2010). This is also reflected by the fact that several different definitions have been given to FRQ by previous research. Elbannan (2010) defines reporting quality as the extent to which financial statements communicate its underlying economic state and performance to users during the disclosed period. Biddle et al. (2009) define it as the precision with which financial reports convey information about the firm’s operations, in order to inform its investors and Tang et al. (2008) define it as the extent to which financial statements provide true and fair information about the underlying performance and financial position of the firm. The most commonly accepted definition is provided by Jonas & Blanchet (2000), who state that qualitative financial reporting is full and transparent information without errors that is not designed to mislead or obfuscate users. These definitions have in common that they all mention the importance of disclosing true information.
Financial statements and the information they provide about the firm’s performance during a specific disclosed period are being used for multiple purposes as they represent the firm’s performance. Whether the firm’s performance represents itself correctly into the cost of debt or the share value is of great value to investors, banks, analysts and other stakeholders, as they use it to improve their decision making process (Dechow et al., 2010). Several studies also showed that higher quality of financial reporting should increase investment efficiency because it mitigates information asymmetries that cause economic frictions such as moral hazard and adverse selection (Leuz and Verrecchia, 2000; Bushman and Smith, 2001; Verrecchia, 2001). Therefore, adequate and high quality financial reporting information is of great importance to potential users who base their decisions on this information (Soyinka, Fagbayimu, Adegoroye & Ogunmola, 2017).
Lacking a well-developed theory about the complex nature of FRQ, most research uses measures that focuses on attributes of financial reporting information like earnings quality and value relevance proxies (Dechow et al., 2010). Healy & Wahlen (1998) defined earnings management as follows: “earnings management occurs when managers use judgment in financial reporting and in structuring transactions to alter financial reports to either mislead stakeholders about the underlying economic performance of the company, or to influence contractual outcomes that depend on reported accounting numbers”. Firms manage earnings to change reported financial performance in a variety of contexts by misrepresenting the real and actual performance using accruals management by for instance different valuation of inventory or depreciation techniques (Bratten, Payne & Thomas, 2015). Many studies have focused on earnings management to gain an understanding of why firms engage in this irrational behaviour and what drives management to perform actions like shifting revenue between periods or deferring recognition of expenditures (Jones, 1991; Sun, & Rath, 2010; Dechow et al., 1995). Also economic consequences of earnings management like for instance stock-price responses to earnings surprises or negative future prospects, and their effect on financial statements have been researched often (Dechow et al., 2010; Stein & Wang, 2016). Prior research by McNichols & Stubben (2008) showed that firms that tend to manipulate earnings also make excess expenditures during this misreporting periods. These are mostly outweighed by the benefits of earnings management as they manage earnings higher than the higher expenditures. Furthermore, Shuli (2011) has found that earnings management by smoothing earnings negatively affects the quality of the financial reporting as there is not enough information among accounting professionals regarding the practices of the earnings management.
Investors must be able to recognize and detect earnings and accruals management within the financial statements in order to adequately base their decisions on this financial information. When investors are not able to see through these reporting techniques, their decisions are based on information that is not reflecting the actual and real firm performance (Dechow et al., 2010). Motivations for managing earnings by firms are often found in industry competitiveness, capital intensity and profitability as these are proven to be influential to the level of earnings quality (Wasiuzzaman, Sahafzadeh & Nejad, 2015). Incentives for managing earnings are that financial statements will be more positively or negatively received by stakeholders and investors, which will ultimately lead to a higher or lower firm value and market position depending on what is
favourable to either the firm or the managers’ remuneration (Lu, 2012; Healy & Wahlen, 1998; Dechow et al., 2010).
Multinationals differ in how they approach risk-taking in corporate business as some may be more aggressive in taking risks than others. Baird & Thomas (1985) identified three different forms of risk: heavy borrowing, committing a relatively large portion of assets to a division with poor odds of contributing significantly to profits, and venturing in the unknown. Hereby risk is commonly conceived as a reflecting variation in the distribution of possible outcomes, their likelihoods, and their corresponding values. The idea of risk is embedded in the idea of choice as affected by the expected return of an alternative (March & Shapira, 1987). The reason why firms choose to take risks can be explained by the risk return trade off. Some industries require more and higher risk-taking of firms than others, due to for instance higher competition and higher levels of technology and innovation. When a firm is taking a risk, it demonstrates a willingness to move from a predictable situation to a position where it can seize opportunities and make commitments, often when the outcome is largely unknown (Covin & Slevin, 1991). As higher risks also reflect into a lower likelihood of a potential positive outcome, firms have to weigh whether to make such risky decisions. The theory that is often used to gain insight into the nature of risk-taking is the prospect theory by Kahneman & Tversky (1979), which outlays the ways people make decisions involving risk. Prospect theory argues that individuals tend to be more risk averse than risk seeking. People rather not lose than that they have the possibility to gain.
Parent-subsidiary relationships within multinational corporations have been studied for many years (Martinez and Jarillo, 1989). But despite being a central topic in international business, risk-taking behaviour by multinationals and its effect on subsidiary FRQ has not received adequate attention. Traditional literature suggests that multinationals handle the risk problem by incremental, cautious and slow-paced foreign expansion (Johanson & Vahlne, 1977). Another interesting research was executed by Singh (1986), who found a positive association between financial resources within a firm and risk-taking. Also it has been found that foreign owners are more likely to take risks under a less predatory government (Knack & Keefer, 1995), and that foreign ownership is positively related to corporate risk-taking (Boubakri, Cosset & Saffar 2011). Furthermore Walls (2005) & Peng (2015) showed that companies that are taking higher risks and have a higher risk appetite, perform financially better and have a higher growing rate compared to
firms that take less risks. However, a gap remains in current research that studies the relationship between risk-taking of multinationals and subsidiary FRQ.
2.2 Financial reporting quality and its link with risk-taking
Not much prior research has been conducted that links the subject of FRQ with risk-taking of multinationals. Lu (2012) found that firms with lower earnings quality, which represents lower FRQ, are related to a higher degree of risk-taking. Nichita (2018) found that risk transparency is a key principle of comprehensive risk management, both in terms of internal risk reporting as well as external disclosure for users of information in making decisions. Also, Biddle & Hilary (2006) found that firms with higher FRQ are less likely to be financially constrained and thus have lower investment-cash flow sensitivities, which is a proxy for investment efficiency. Therefore you could argue that higher FRQ leads to better investment efficiency and is related to more efficient risk-taking. Furthermore, Biddle et al. (2009) found that firms with higher FRQ have less overinvestment and less underinvestment. Financial outcome of risk-taking is related to investment efficiency because when more risks have been taken on an efficient manner, this leads to a greater reward for firms (Gorter & Bikker, 2013). So one could argue that FRQ is dependent on the amount of risk that has been efficiently taken. The link between FRQ and risk-taking is critical, because it is imperative that financial reporting adequately depicts the financial status (e.g., valuations, estimates) and associated risks of a company as revealed by risk management. It is found that risk management is strongly linked with the quality of the financial reporting process (Cohen, Krishnamoorthy & Wright, 2017). Based on the previous reasoning above regarding the relationship of FRQ and risk-taking, I expect to find a negative effect of the increase in risk-taking of multinationals on the quality of financial reporting of their subsidiaries. Therefore I formulate the following hypotheses:
H1: Risk-taking of U.S. multinationals is negatively associated with financial reporting quality of their subsidiaries
Multinational corporations manage earnings through a strategy across foreign and domestic subsidiaries over which they have considerable influence (Beuselinck et al., 2018). However this
varies with the amount of jurisdictional space subsidiaries give their parent firms for practising earnings management (Beuselinck et al., 2018). The corporate structures of MNC’s are often very complex (Faccio & Lang, 2002) as multinationals typically own subsidiaries across different countries that differ in law & legislation. When managing earnings abroad, MNC’s tend to choose jurisdictions with less strict laws and regulations, also referred to as “tax havens”. Reporting practices of subsidiaries also have an effect on the consolidated financial statements of the parent as the financial information is added up while subtracting intercompany transactions (EY, 2015). Thus, it is important for multinationals to have adequate reporting at the subsidiary level to disclose a qualitative financial consolidated report at the parent level. Prior research has already found that Spanish subsidiaries that are being controlled by foreign shareholders have poorer accruals quality and thus poorer FRQ than locally-owned subsidiaries (Gill-de-Albornoz & Rusanescu, 2017).
Furthermore, it has been proven that highly capital-intensive U.S. firms are more likely to undertake foreign tax planning when they are capital constrained (Chow et al., 2018). Some of the biggest U.S. corporations, including Microsoft, Apple and Alphabet are minimizing their corporate taxes via this structure. These firms use subsidiaries which are located abroad for participating in tax planning in tax holidays or tax havens. Tax holidays are temporary tax reductions that governments grant to firms, usually with the expectation that firms will also make operational investments in the country. Unlike tax planning using tax havens, which often involves intangible property and/or financial transactions (Dyreng et al., 2018). This way they benefit from attractive regulations as foreign tax authorities in tax havens are less strict on having residency or business presence within the country itself. For this research tax haven jurisdiction will be researched as a moderator between risk-taking and FRQ to gain more insight into the relational effect it has on the research question.
As corporate risk-taking positively influences performance and growth due to higher investments and innovation (Walls, 2005), lawmakers have incentives to try to increase investment and innovation behaviour of companies as this would eventually economically benefit the country as a whole. To promote this kind of behaviour, policymakers can introduce laws and instruments that benefit these firms by for instance creating attractive tax conditions. Countries that levy these low effective tax rates are also referred to as “tax havens” (Menkhoff & Miethe, 2018). When companies intentionally position their subsidiaries in these countries, and aggressively make use
of tax planning, the risk of brand image due to society not agreeing with this behaviour is real as often they find this behaviour unethical (Campbell & Helleloid, 2016). Furthermore, Ljungqvist, Zhang & Zuo (2016) found that risk-taking behaviour of U.S. firms is negatively associated with tax levels. They find evidence that higher taxes reduce expected profits more for risky projects than for safe ones, as the government shares in a firm’s upside but not in its downside. So according to this research the average firm reduces risk in response to a tax increase. Therefore one could say that lower tax rates increase risk-taking. To test whether the relation between risk-taking of U.S. multinationals and FRQ is more significantly moderated by having subsidiaries located in tax havens than having subsidiaries located in non-tax havens, I propose the following hypothesis:
H2: Risk-taking of U.S. multinationals is more negatively associated with financial reporting quality when subsidiaries are positioned in tax havens than when they are not positioned in tax havens.
3. METHOD
3.1 Sample selection
The sample used in this research consists of 2,391 non-financial private company years that are subsidiaries of listed U.S. MNCs. The period analysed is 2015-2017. First, I used Compustat to select non-financial listed MNCs located in the U.S. Then, for each MNC and year, I hand-collected the name and jurisdiction of all material subsidiaries from the EDGAR database via the 10-k filings and the 21.1 exhibits where the subsidiaries that were mentioned in annual reports of the firms were included. Given the coverage of the Orbis database, I selected only subsidiaries located in 30 different European countries, and I obtained the financial information needed for all the variables. Furthermore, I used Compustat for obtaining information for the U.S MNCs parents, after which I linked the data of the subsidiaries with the data of the multinational parents to create one dataset. For the dataset all firm years that weren’t available for all variables that are used in this study, were let out of the sample. The companies were divided by industry according to the NACE Rev. 2 statistical classifications composed by the European Commission (2008). In table 1 and table 2 the sample distribution by year and by country is displayed. For the sample distribution
by industries, see table 4 under the results. As table 1 shows the years 2016 and 2017 have a far bigger share of the total sample. This is due to the availability of the annual reports in Orbis and due to missing variables or financial information in for some firm years. In Table 2 the distribution of countries is shown. The largest share of subsidiaries in the sample is located in Italy, France and Spain. After that Belgium and Germany have the largest share. This is not surprising as these countries are also some of the biggest countries in the sample. For determining which of these countries are regarded as a tax haven, please refer to Appendix A, where all tax havens are displayed.
TABLE 1
Sample distribution by year
Year Frequency Percentage Cumulative
2015 162 6.78 6.78
2016 1,224 51.19 57.97
2017 1,005 42.03 100.00
TABLE 2
Sample distribution by Country
Country Country ISO code Frequency Percentage Cumulative
Austria AT 11 0.46 0.46 Belgium BE 188 7.86 8.32 Bulgaria BG 16 0.67 8.99 Czech Republic CZ 95 3.97 12.97 Germany DE 222 9.28 22.25 Denmark DK 37 1.55 23.80 Estonia EE 4 0.17 23.96 Spain ES 270 11.29 35.26 Finland FI 61 2.55 37.81 France FR 448 18.74 56.55 Greece GR 7 0.29 56.84 Croatia HR 14 0.59 57.42 Hungary HU 28 1.17 58.59 Italy IT 443 18.53 77.12 Luxembourg LU 2 0.08 77.21 Netherlands NL 30 1.25 78.46 Norway NO 93 3.89 82.35 Poland PL 101 4.22 86.57 Portugal PT 84 3.51 90.09 Romania RO 49 2.05 92.14 Sweden SE 144 6.02 98.16 Slovenia SI 12 0.50 98.66 Slovakia SK 32 1.34 100.00 T otal 2,391 100.00
3.2 Variable definitions
3.2.1 Subsidiary financial reporting quality
The dependent variable in this research is FRQ of subsidiaries of MNCs. Various measures of earnings quality have been used in prior research like persistence, accruals, smoothness, timeliness, loss avoidance, investor responsiveness and external indicators such as restatements and SEC enforcement releases (Dechow et al., 2010). Most studies investigating earnings management use accruals models such as the ones from DeAngelo (1986), Jones (1991) or the modified Jones model from Dechow et al., (1995). For this research the modified Jones model has been used. The variable will be defined as an absolute value. The discretionary accruals are estimated for each industry and year combination. The modified Jones model is displayed below. First the total accruals will be calculated after which the discretionary accruals will be calculated. The different variables that are needed for the modified Jones (1991) model are explained below. After calculating the total modified Jones model, the discretionary accruals can be calculated in Stata.
𝑇𝐴𝐶𝐶𝑡= ∆𝐶𝐴𝑡− ∆𝐶𝑎𝑠ℎ − ∆𝐶𝐿𝑡+ ∆𝐷𝐶𝐿𝑡− 𝐷𝐸𝑃𝑡 𝑇𝐴𝐶𝐶𝑡 = Total accruals in year 𝑡,
∆𝐶𝐴𝑡 = Change in current assets in year 𝑡,
∆𝐶𝑎𝑠ℎ = Change in cash and cash equivalents in year 𝑡,
∆𝐶𝐿𝑡 = Change in current liabilities in year 𝑡,
∆𝐷𝐶𝐿𝑡 = Change in short term debt included in current liabilities in year 𝑡, 𝐷𝐸𝑃𝑡 = Depreciation and amortization expense in year 𝑡.
𝑇𝐴𝐶𝐶𝑡 𝐴𝑡 −1 = 𝛼1 1 𝐴𝑡−1+ 𝛼2 (∆𝑅𝐸𝑉𝑡 − ∆𝑅𝐸𝐶𝑡 ) 𝐴𝑡 −1 + 𝛼3 𝑃𝑃𝐸𝑡 𝐴𝑡−1
𝑇𝐴𝐶𝐶𝑡 = Total accruals in year 𝑡 divided by total assets in year 𝑡 − 1, ∆𝑅𝐸𝑉𝑡 = Revenues in year 𝑡 less revenues in year 𝑡 − 1,
∆𝑅𝐸𝐶𝑡 = Delta revenues in year 𝑡 less delta net receivables in year 𝑡 − 1, 𝑃𝑃𝐸𝑡 = Gross property plant and equipment in year 𝑡,
𝐴𝑡−1 = Total assets in year 𝑡 − 1,
𝛼1, 𝛼2, and 𝛼3 = Parameters to be estimated, namely alphas,
𝜀𝑡 = Residuals in year 𝑡.
3.2.2 Parent’s risk-taking
The independent variable of this research is risk-taking of MNCs. My measurement capturing risk-taking of multinationals is calculated at the parent level only because the parent exerts influence over all its subsidiaries. It doesn’t work the other way around in multinational firms. For measuring risk-taking I will take the volatility of U.S. firms’ EBIT to total assets ratio over a period of three years. As the sample goes from 2015 to 2017, I also collected the data for this variable for 2013 and 2014 to calculate the volatility. The firm’s earnings are given by the earnings before interest and taxes (EBIT) to total assets ratio (Boubakri, Cosset & Saffar, 2011). This ratio will give a proper estimate and indication of how many risk a firm has been taking for this three-year period, as it takes into account the amount that is earned and invested within a firm.
3.2.3 Tax haven
For determining whether a country is regarded as tax haven, I used the list of tax havens put together by Menkhoff & Miethe (2018) which is shown in Appendix A. My variable
TAXHAVENSUB is a dummy variable equal to 1 if the jurisdiction of the firm year is in a tax haven and 0 when the jurisdiction is a non-tax haven. Additional explanation of the composition of the tax haven list is to be found under Appendix A.
3.2.4 Control variables
My model controls for different firm characteristics that prior literature has shown to be associated with FRQ. These control variables will be included in this research to control for firm characteristics that may explain differences in discretionary accruals in the empirical model. Previous research used several factors that are likely to be associated with FRQ. I will control for leverage (LEVERAGESUB) since that earnings management is more likely to occur in leveraged firms (Chih, Shen & Kang, 2008; Elayan, Li, & Meyer, 2008). Also I control for firm size (FIRMSIZESUB) by using the natural log of sales, because according to Richardson (2000) and Chih et al. (2008) bigger firms want to manage their earnings upward. Chih et al., (2008) also states that firms with high sales growth tend to be more indulged in earning management practices, so I also control for sales growth (SALESGROWTHSUB). Return on assets (ROASUB) and liquidity ratio (LIQUIDITYRATIOSUB) are used as an indicator for the performance of the organization (Biddle et al., 2009). To also capture the overall growth on country-level I control for the GDP growth (GDPGROWTHSUB). The big accounting firms are also negatively influencing earnings management (Ming, Lapley & Lee, 2007), so lastly the control variable for auditor size is added (AUDITORSIZEMNC). Outliers within the variables will be winsorized to reduce their influence on this studies’ results. Also to control for industry, year and country specific characteristics, dummies are added in the model for each of these factors.
3.3 Empirical model
To test the hypotheses of this research, I estimate the regression models displayed below. In Table 3 the definitions and measuring methods will be displayed once more.
H1: DiscAccSub = 𝛽0 + 𝛽1Risktakingm nc + 𝛽2Leveragesub + 𝛽3ROAsub + 𝛽4Liquidityratiosub + 𝛽5Firmsizesub + 𝛽6GDPGrowthsub + 𝛽7Salesgrowthsub + 𝛽8Auditorsizem nc + 𝜀
H2: DiscAccSub = 𝛽0 + 𝛽1Risktakingm nc + 𝛽2Taxhavensub + 𝛽3Risktakingmnc x 𝛽4Taxhavensub 𝛽5Leveragesub + 𝛽6ROAsub + 𝛽7Liquidityratiosub + 𝛽8Firmsizesub + 𝛽9GDPGrowthsub + 𝛽10Salesgrowthsub + 𝛽11Auditorsizem nc + 𝜀
TABLE 3
Variable Calculation Definition
DISCACCSUB The absolute values are estimated with the 1995 Modified Jones model.
The discretionary accruals are non-obligatory expenses yet to be realized but are already recorded in the account books.
RISKTAKINGMNC Volatility over 3 years of the EBIT to total assets ratio.
The act or fact of doing something that involves danger or risk in order to achieve a goal.
TAXHAVENSUB Located in a tax haven (1) or in a non-tax haven (0).
A jurisdiction where taxes are levied at a low rate.
LEVERAGESUB Total debt divided by total assets.
Ratio to assess whether a firm has the ability to meet its financial obligations.
ROASUB Sales divided by total assets. Indicator of how profitable a firm is relative to its total assets.
LIQUIDITYRATIOSUB Current assets divided by current liabilities.
Ratio to assess whether a firm has the ability to pay off current debt obligations.
FIRMSIZESUB The log of the total sales. Way of measuring how big a firm is.
GDPGROWTHSUB Change in GDP rate between years.
Rate at which a nation Gross Domestic Product is changing in one year.
SALESGROWTHSUB (Sales (t) minus Sales (t-1)) divided by sales (t-1).
Rate at which a firm’s sales are changing in one year.
AUDITORSIZEMNC Auditor is Big 4 (1) or is non-Big 4 (0).
Whether the auditor belongs to the Big 4 audit firms or to a smaller audit firm.
4 RESULTS
4.1 Descriptive statistics
The total sample of firm years distributed by industry is presented in table 4. The industries were divided by the NACE Rev. 2 statistical classification of economic activities in the European Community (European Commission, 2008). The biggest industry groups are “C: Manufacturing” with 30.61% and G: Wholesale, retail trade and repair of motor vehicles and motorcycles” with 43.37%. Thereafter the next biggest industry groups are “J: Information and communication” with 10.92% and “M: Professional, scientific and technical activities” with 5.77%. The remaining industry groups have a percentage below 3%. Also what stands out is the frequency of the financial and insurance activities, which is zero. This is because this study doesn’t consider financial firms as they belong to a very specific and different industry.
TABLE 4
Distribution of firm years among industry groups
Industry classification Freq. Perc. Cum.
A: Agriculture, forestryand fishing 9 0.38% 0.38%
B: Mining and quarrying 7 0.29% 0.67%
C: Manufacturing 732 30.61% 31.28%
D: Electricity, gas, steam and air conditioning supply 6 0.25% 31.53% E: Water supply, sewerage, waste management and remediation activities 16 0.67% 32.20%
F: Construction 10 0.42% 32.62%
G: Wholesale, retail trade and repair of motor vehicles and motorcycles 1,037 43.37% 75.99%
H: Transportation and storage 35 1.46% 77.46%
I: Accommodation and food service activities 32 1.34% 78.80%
J: Information and communication 261 10.92% 89.71%
K: Financial and insurance activities 0 0.00% 98.71%
M: Professional, scientific and technical activities 138 5.77% 95.98%
N: Administrative and support service activities 52 2.17% 98.16%
O: Public administration and defence, compulsory social security 0 0.00% 98.16%
P: Education 16 0.67% 98.83%
Q: Human health and social work activities 2 0.08% 98.91%
R: Arts, entertainment and recreation 9 0.38% 99.29%
S: Other service activities 17 0.71% 100.00%
T: Activities of households as employers and activities for own use 0 0.00% 100.00% U: Activities of extraterritorial organisations and bodies 0 0.00% 100.00%
Total 2,391 100.00%
Table 5 presents the descriptive statistics of the dataset used in this study. The mean, median, standard deviation, minimum, maximum and the 25th and 75th percentiles are displayed
for each variable. All variables except for TAXHAVENSUB and AUDITORSIZEMNC have been winsorized at the 5 percent level. DISCACCSUB has a mean of 0.086 with a standard deviation of
0.056. RISKTAKINGMNC has a mean of 0.020 with a standard deviation of 0.295. Furthermore the table shows that 0.097 percent of the firm years are located in a jurisdiction that can be referred to as a tax haven.
TABLE 5 Descriptive statistics
Variable N Mean Median Std.
Dev. Min 25% 75% Max DISCACCSUB 2,391 0.086 0.080 0.056 0.007 0.037 0.134 0.185 RISKTAKINGMNC 2,391 0.020 0.012 0.200 0.003 0.007 0.028 0.078 TAXHAVENSUB 2,391 0.097 0.000 0.295 0.000 0.000 0.000 1.000 LEVERAGESUB 2,391 0.539 0.536 0.261 0.108 0.319 0.757 0.970 ROASUB 2,391 7.123 5.787 8.864 -9.880 1.743 11.862 27.151 LIQUIDITYRATIOSUB 2,391 2.244 1.564 1.896 0.463 1.047 2.591 7.770 FIRMSIZESUB 2,391 4.383 4.377 0.705 3.098 3.878 4.905 5.707 GDPGROWTHSUB 2,391 2.229 2.183 0.929 1.112 1.489 2.795 4.543 SALESGROWTHSUB 2,391 0.087 0.048 0.214 -0.280 -0.043 0.197 0.621 AUDITORSIZEMNC 2,391 0.957 1.000 0.203 0.000 1.000 1.000 1.000
4.2 Correlation analysis
In table 6 the correlations between the different variables are shown. On basis of the correlation analysis, it is investigated whether the variables are mutually correlated. It is assumed that with a correlation of 0.7 or higher there is multicollinearity (Tabachnick & Fidell, 2001). When multicollinearity occurs, there is a strong correlation between two explanatory variables. This is not desirable as it can influence the outcomes of the regression analysis. The table shows that there are no highly correlated variables with values above the threshold of 0.7, so there is no multicollinearity in this analysis. When values of correlation are positive it indicates that the variables move in the same direction. On the contrary, negative correlations indicate that variables move in opposite directions. Furthermore the table shows that TAXHAVENSUB,
relationship with the DISCACCSUB variable at respectively the 5, 10 and 1 percent level. Also it shows that LEVERAGESUB (positively), FIRMSIZESUB and GDPGROWTHSUB (both negatively) are significantly related at the 5 percent level with RISKTAKINGMNC, while it is negatively related at the 10 percent level with AUDITORSIZEMNC. In addition the table shows that the controlling variables LEVERAGESUB, ROASUB, GDPGROWTHSUB (all negatively) and FIRMSIZESUB (positively) have significant relationships with the moderating variable TAXHAVENSUB at the various levels of significance. Also several control variables correlate with each other at the various significance levels as is shown in table 6.
4.3 Regression analysis
In table 7 the regression analysis is displayed. The hypotheses have been separately tested on significance on basis of a two-tailed test. In model 1 only the control variables are included. In model 2 RISKTAKINGMNC is included to test the first hypothesis. In model 3 the moderating effect of RISKTAKINGMNC x TAXHAVENSUB is included to test the second hypothesis.
The significance of an entire model can be measured based on the F-value. Because the hypotheses have been given a direction, the corresponding p-values must be halved (Keller, 2012). The table shows that the F-values are respectively 2.050, 2.010 and 1.990 for the different models. The corresponding significance levels are all below 0.01 (even so before halving the p-values), which rejects the null hypothesis with extremely high confidence. This indicates that the models can be used for testing the hypotheses.
The adjusted R-squared indicates to what extent the explanatory variables influence the model. A higher adjusted R-squared indicates that the model fits better with the data and that the influence of the variables on the dependent variable is higher. In table 7 is shown that the adjusted R-squared values are 0.020 for all the models. This indicates that there is no significant effect of the various variables on the discretionary accruals as this means that the variables only influence the variation in discretionary accruals by a percentage of 0.020.
Furthermore the table shows the various significance levels of the relationships between the independent, moderating and controlling variables and the dependent variable. In model 1 only the controlling variables have been tested. As the table shows, LEVERAGESUB has a significant
relation on the 5 percent level with the discretionary accruals. The other control variables show no high significance with the discretionary accruals.
In model 2 the first hypothesis is tested. It is shown that only the control variable
LEVERAGESUB has a significant relation with the discretionary accruals. The independent variable
RISKTAKINGSUB has no significant effect on the level of DISCACCSUB. When we refer back to the correlation table, this analysis also showed no significant relation between the two variables. Therefore there is not sufficient evidence to accept the expectation that risk-taking of U.S. multinationals is negatively associated with FRQ of its subsidiaries, and I have to reject the first hypothesis.
In model 3 the second hypothesis is tested. In this model LEVERAGESUB is significant at the 5 percent level. Also, in this model TAXHAVENSUB has a statistical significant negative relation with the discretionary accruals on a 5 percent level. This indicates that when subsidiary FRQ increases, the probability that a firm year has its jurisdiction in a tax haven tends to decrease. This means that subsidiaries with lower FRQ are more often located in a country referred to as a tax haven. However, the independent variable RISKTAKINGSUB and the combined moderated effect of RISKTAKINGSUB x TAXHAVENSUB have no statistical significant effect on the level of discretionary accruals in the analysis. Therefore there is not sufficient evidence to assume that higher risk-taking of U.S multinationals is negatively associated with FRQ when subsidiaries are positioned in tax havens, and the second hypothesis has to be rejected.
Correlation analysis 1 2 3 4 5 6 7 8 9 10 (1) DISCACCSUB 1 (2) RISKTAKINGMNC -0.0151 1 (3) TAXHAVENSUB -0.0435** -0.0263 1 (4) LEVERAGESUB 0.0234 0.0410** -0.0514** 1 (5) ROASUB 0.0290 0.0150 -0.0378* -0.2275*** 1 (6) LIQUIDITYRATIOSUB -0.0391* -0.0138 0.0167 -0.6141*** 0.1072*** 1 (7) FIRMSIZESUB -0.0284 -0.1226** 0.0346* 0.1095** 0.0405** -0.2038** 1 (8) GDPGROWTHSUB 0.0836*** -0.0420** -0.1700*** -0.0240 0.0382* 0.0463** -0.0446** 1 (9) SALESGROWTHSUB 0.0239 -0.0209 0.0007 0.1267*** 0.0899*** -0.0967*** -0.0018 0.1518*** 1 (10) AUDITORSIZEMNC 0.0007 -0.0784*** -0.0003 -0.0155 0.0322 0.0303 0.1510*** 0.0443** 0.0025 1
*** Indicates significance at the 1 percent level (two-tailed). ** Indicates significance at the 5 percent level (two-tailed). * Indicates significance at the 10 percent level (two-tailed).
Variables (1) (2) (3) LEVERAGESUB 0.001 [0.006] 0.001 [0.006] 0.001 [0.006] ROASUB 0.000 [0.000] 0.000 [0.000] 0.000 [0.000] LIQUIDITYRATIOSUB -0.001** [0.001] -0.002** [0.001] -0.002** [0.001] FIRMSIZESUB -0.002 [0.002] -0.002 [0.002] -0.002 [0.002] GDPGROWTHSUB -0.003 [0.006] -0.003 [0.003] -0.003 [0.003] SALESGROWTHSUB -0.003 [0.006] -0.004 [0.006] -0.004 [0.006] AUDITORSIZEMNC 0.001 [0.006] 0.000 [0.006] 0.001 [0.006] RISKTAKINGMNC -0.019 [0.062] -0.038 [0.065] TAXHAVENSUB -0.030** [0.015]
RISKTAKINGMNC*TAXHAVENSUB 0.193
[0.205] Constant 0.097* [0.058] 0.098* [0.058] 0.123*** [0.023]
Industry dummies Yes Yes Yes
Year dummies Yes Yes Yes
Country dummies Yes Yes Yes
R² 0.040 0.040 0.040
Adjusted R² 0.020 0.020 0.020
F-value 2.050*** 2.010*** 1.990***
N 2,391 2,391 2,391
5. DISCUSSION
In this study I explored the effect of U.S. MNC risk-taking on the FRQ of its subsidiaries and the moderating effect of having a subsidiary located in a jurisdiction that is referred to as a tax haven. The relation between risk-taking and FRQ is an field that is not investigated often (Cohen et al., 2017). However due to globalization and international tensions between countries, the relation is more actual than ever. Some studies have shown that risk-taking can be related to FRQ (Nichita, 2018; Lu, 2012; Cohen et al., 2017), but literature on the subject is scarce. It is difficult to find literature of adequate quality to benchmark a study regarding the subject with, as is also shown in the literature named above, where the authors find it difficult to conduct an qualitative literature review on this subject.
So why is there so little research on risk-taking and FRQ? There is sufficient research available on earnings management but less on risk-taking. This is probably caused by the fact that risk-taking is a hard to define and hard to measure subjective variable. There is not yet a universal model available comparable to the modified Jones (1991) model that measures risk-taking. For this study the volatility of 3 years of the EBIT to total assets ratio has been used, as has been done before by Boubakri et al. (2013). However, it is a very subjective variable as risk-taking can be independent of sales or total assets. Also many other factors could influence risk-taking like the level of technology or innovation or the competition within a market. Furthermore, a factor like variable manager’s remuneration, which is often dependable on the firm’s performance, can be considered to be a factor that can measure risk-taking, as managers tend to increase risk-taking to meet their benchmarks (Lev & Zarowin, 1999). This can be considered a theoretical implication for this study and a possibility for future studies. A great opportunity lies ahead for future research to jump into this risk-taking gap.
Also literature on tax haven can’t seem to agree what exactly defines a tax haven. Different studies state that different countries are regarded as a tax haven (Menkhoff & Miethe, 2018). There is no single indication to measure a country and to place it in one of the two boxes. However the European Commission is trying to launch a Common Consolidated Corporate Tax Base (CCCTB) in the nearby future. This is a single set of rules to calculate companies’ taxable profits in whole
EU (European Commission, 2016). With the CCCTB no further tax benefits exist within the EU. This is very interesting for future research as multinationals eventually tend to find other ways to manage their earnings. Future studies could investigate whether these mutual tax treaties will eventually benefit EU companies.
In this research the relation between risk-taking and FRQ has been investigated. As both hypotheses couldn’t be accepted, there will need to be a follow-up in future research. Factors like the few years that were included in the sample or the fact that risk-taking is a difficult to measure variable could have been of influence. Also the volatility of the various variables, especially risk-taking should be made across more firm years. To further understand how multinationals tend to behave towards subsidiaries further research is needed. It would be interesting to see whether U.S. multinationals affect subsidiaries more significantly that are located domestically than when they are located abroad. Also future research could measure risk-taking in different ways like I described above to compare the various methods.
6. CONCLUSION
The aim of this study is to investigate on how U.S. Multinational risk-taking influences their subsidiaries’ FRQ. Also the moderating factor of having the subsidiary located in a tax haven is investigated. There is not sufficient evidence found to assume that either factor is influencing FRQ. This could be due to practical implications and limitations such as the way risk-taking is measured or the period that is included in the sample. However, a significant relation between tax havens and FRQ has been found, which could probably indicate that when firms are located in tax havens, their FRQ is lower. This could be valuable information for stakeholders like banks, shareholders and potential investors, as they base their decisions on this information. This study gives new theoretical insights on the subject matter as the relationship between risk-taking and FRQ is scarce in current literature. This study explains the different ways risk-taking can be of influence to a firm and what factors it depends on. Future research is needed to elaborate further on the subject to increase knowledge about how multinationals influence their subsidiaries and how this reflects into the financial statements.
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