The moderating effect of subsidiary
integration on the association between
parent board independence and
subsidiary financial reporting quality
Name: Dennis van der Veen
Student number: S3169979
Address: Nyckle Haismawei 26, Leeuwarden
Phone number: 0645649020
Email: d.k.van.der.veen@student.rug.nl
Supervisor: S. Rusanescu
Word Count: 11,214
Contents
Abstract ... 3
1. Introduction ... 4
2. Theory and Hypotheses Development ... 9
2.1 Parent board independence and subsidiary financial reporting quality ... 9
2.2 Subsidiary integration ... 10 3. Methodology ... 11 3.1 Sample selection... 11 3.2 Variables ... 12 Dependent variable ... 12 Independent variables ... 13 3.3 Empirical model ... 13 Control variables ... 14 4. Results ... 15 4.1 Descriptive statistics ... 15 4.2 Correlations ... 16 4.3 Regressions analysis ... 17
5. Conclusions and discussion ... 19
5.1 Findings ... 19 5.2 Theoretical implications ... 21 5.3 Practical implications ... 22 5.4 Limitations ... 23 References ... 25
Abstract
The effect of board independence on financial reporting quality of standalone firms is well examined in prior research. However, despite the economic importance of MNC’s subsidiaries, prior research ignores the effect of parent boards within MNCs and specifically that of parent board independence on subsidiary financial reporting quality. Agency theory argues and prior research shows that independent board members are more effective monitors, constraining management engaging in earnings management better, leading to a higher financial reporting quality. As parent’s management exerts influence on subsidiary reporting choices incentivized by maximizing MNC’s value as a whole and engages in earnings management through subsidiaries due to many incentives, the board of the parent is concerned about the financial reporting quality of the subsidiaries as those individual statements contribute to the consolidated statements of the MNC as a whole. Therefore the parent’s board needs to monitor and constrain the parent’s management from earnings management through subsidiaries to ensure high financial reporting quality within MNCs. Therefore, I expected a positive relationship between parent board independence and subsidiary financial reporting quality. This study obtains evidence that does not support this expectation in a sample of 5,392 European subsidiaries of US MNCs. Using the modified Jones model to estimate discretionary accruals, this study finds a negative relationship between parent board independence and subsidiary financial reporting quality. Furthermore, I expected that subsidiary integration has a positive or negative effect on the aforementioned relationship, because prior research provides no clear direction of the sign of the relationship and arguments can be made for both directions. The study finds a positive moderating effect of subsidiary integration weakening the negative relationship between parent board independence and subsidiary financial reporting quality. Taken together, my findings provide evidence that the positive effect of parent board independence might be limited to only the parent. Furthermore, as a result of lower information asymmetry, independent board members seem to do a better job at constraining the parent’s management to engage in earnings management through high integrated subsidiaries.
Keywords: multinational corporation, subsidiary, financial reporting quality, subsidiary integration
1. Introduction
A multinational corporation is an ‘economic entity operating in more than one country or a cluster of economic entities operating in two or more countries’ (Weissbrodt & Kruger, 2003, p. 909). Multinational corporations commonly perform their international activities through foreign subsidiaries which are operating in different economic, political and legal environments (Robinson & Stocken, 2013). An entity is called a subsidiary if the parent directly or indirectly holds more than 50 per cent of the control rights of the affiliate company (Beuselinck et al., 2019).
According to a report by the United Nations Conference on Trade and Development the top one hundred multinational corporations, for short MNCs, have invested 70 per cent of their total assets abroad (UNCTAD, 2014). The report also shows that approximately 50 per cent of the world gross domestic product arises from MNCs’ foreign subsidiaries (UNCTAD, 2014). Therefore it is alarming that the Public Company Accounting Oversight Board (PCAOB) raised its concern over the financial reporting quality of multinationals with a substantial amount of foreign subsidiaries (PCAOB, 2011). The chairman of PCAOB stated: ‘I can say the challenges of managing a multi-national audit are great’ (PCAOB, 2011). Primarily inadequate communication between auditors and a lack of reviews led to an insufficient financial reporting quality of the subsidiaries (PCAOB, 2011). In addition, researchers Stewart and Kinney (2013) stated that the audit of the financial statements of subsidiaries by the parent’s auditors is more problematic due to lack of guidelines in determining component materiality. This shows the importance and the challenges of the financial reporting quality of subsidiaries of MNCs.
Following the agency view the board of directors (hereafter board) of a company plays the role of monitors to prevent managers acting in self-interest (Eisenhardt, 1989). Next to their role of monitors, the board has the role to counsel and advise management (Pfeffer & Salancik, 1978). In general, the board consists of executives and non-executives to fulfill both roles (Alves, 2014). Non-executives or outside directors are seen as more independent of the company, due to the fact that they are less likely to collude with management, because they are held accountable for controlling management and they could lose their job and reputation if they do not performed accordingly (Fama & Jensen, 1983; Alves, 2014). In line with these arguments, prior research documents that companies with higher board independence (i.e. more non-executives) have a higher financial reporting quality (Niu, 2006; Dimitropoulos & Asteriou, 2010; Waweru & Riro, 2013; Alves, 2014). Although there is conducted a lot of research regarding the effect of board independence on the financial reporting quality of standalone firms (Dimitropoulos & Asteriou, 2010; Waweru & Riro, 2013), the effect of board independence within MNCs seems to be ignored, likewise the literature on financial reporting quality within MNCs which yet received little attention (Gill-de-Albornoz & Rusanescu, 2018). This is surprisingly given the major impact of subsidiaries on the financial performance of the MNCs, the influence of the subsidiary financial reporting quality on the financial reporting quality of the consolidated statements and the economic significance of MNCs (UNCTAD, 2014). Therefore this paper will examine the relation between board independence of the parent of the MNC and subsidiary financial reporting quality.
Within the MNC-network headquarters play an important role in strategy developing, organizational design decisions and branding issues, etcetera (Foss et al., 2012). Headquarters is the ultimate holder of decision rights and therefore the parent has control over its subsidiaries (Foss et al., 2012). Management of the parent could decide to transfer decision-making rights to the subsidiaries, but even then parent’s management could always choose to
intervene if subsidiaries are not acting the way headquarters want them to act (Foss et al., 2012). So, the management of the parent can exert great influence on its subsidiaries and, among other aspects, the reporting choices of the subsidiary (Foss et al., 2012). According to Beuselinck et al. (2019) parent’s management are more likely to influence their subsidiary reporting choices when more earnings management opportunities are possible at these subsidiaries or when there are incentives to meet reporting goals of the company as a whole. Furthermore, prior research has shown that (foreign) subsidiaries are often used by parent companies to manage earnings (Dyreng et al., 2012; Fan, 2012; Durnev et al., 2017). This is primarily due to the fact that the audit of the subsidiaries is more difficult (Stewart & Kinney, 2013) and misreporting at the subsidiary-level has fewer consequences for the MNCs due to lower reputational costs and legal fines, because it limits the threat of liability (Dearborn, 2009). Moreover, Durnev et al. (2017) shows the parent’s management is more likely to manage earnings in foreign subsidiaries which are located in countries with loose legal regimes, so the probability that earnings management is detected is lower.
According to the agency theory, the board is appointed by the shareholders to ensure that management is not acting in their own interest (Eisenhardt, 1989). Therefore the board needs to monitor management and prevent management from manipulating earnings (Eisenhardt, 1989), because this will negatively influence the financial reporting quality. Shareholders benefit from a higher financial reporting, because this enable them to make more precise estimations of the expected cash flows which is one of the main goals of financial reporting according to the Financial Accounting Standards Board (FASB, 1978). Evidence from standalone firms has shown that independent board members are more effective monitors and therefore do a better job in constraining management to engage in earnings management, because they have no ties to the company which enable them to observe the company with more scrutiny (Alves, 2014). Dimitropoulos and Asteriou (2010) support this evidence by finding that a higher proportion of outside directors report more informative earnings and they report earnings of higher quality in comparison to firms with a low proportion of outside directors in a Greek context. Furthermore, Waweru and Riro (2013) show that even in development countries the results are consistent with the aforementioned findings. Many studies are conducted in different contexts, but the extant literature does not show how board independence can influence financial reporting quality within MNCs.
As discussed previously, management of the parent of MNCs has its reasons to manipulate earnings through (foreign) subsidiaries (Dyreng et al., 2012; Fan, 2012; Durnev et al., 2017). Furthermore, parent’s management has the power to influence subsidiaries and their reporting choices (Beuselinck et al., 2019). This makes it more difficult for the parent’s board as it has to ensure that management is not managing earnings through headquarters, but also has to make sure that management of the parent is not managing earnings via (foreign) subsidiaries. Besides, parent’s board wants to ensure good subsidiary financial reporting quality, because the individual statements of the subsidiaries are used in the consolidated statements of the MNC (Glover & Wood, 2014; Beuselinck et al., 2019). So, the parent’s board can influence the subsidiary financial reporting quality indirectly by constraining parent’s management to engage in earnings management through subsidiaries. As in standalone firms, I expect that independent board members can monitor the parent’s management more effectively and therefore I predict that independent board members of the parent can influence the subsidiary financial reporting quality positively.
It is interesting to examine whether the effect of the board independence of the parent of the multinational reached so far, or that the parent’s board might have difficulties monitoring the subsidiaries due to geographic, cultural, administrative and/or economic distance and therefore the board might not influence the financial reporting quality of the subsidiary (Zaheer et al., 2012). MNCs are known for having to deal with distance problems, because they have many subsidiaries operating in different environments (UNCTAD, 2014), so the idea that board independence has not a positive effect on the subsidiary financial reporting quality cannot be ruled out completely.
This paper also examines the impact of subsidiary integration on the relationship between board independence of the parent of the MNC and the subsidiary financial reporting quality. Subsidiary integration is a difficult concept to define, but in this paper subsidiary integration is defined as ‘the process of combining the parent and the subsidiary legally, structurally, and culturally, and it is critical to acquisition success and value creation’ (Colman & Grøgaard, 2013, p. 407). Integration for MNCs is important as it helps gaining economies of scope and shifting competitive advantages between countries where the MNC is located (Porter, 1986). Furthermore, integrating subsidiaries enhances the transfers of knowledge across the MNC-network (Porter, 1986). In this study, subsidiary integration increases as the percentage of ownership of the parent company in the subsidiary grows. The extant research does not provide a clear direction of the sign of the influence of subsidiary integration as arguments can be made for both a positive and negative direction.
On the one hand, I predict that the board of the parent can monitor the influence of the parent’s management on the subsidiary financial reporting quality more effectively. The independent board of the parent can monitor a high integrated subsidiary more effectively, because there is less information asymmetry between headquarters and the subsidiary (O’Donnell, 2000). Therefore, the parent’s board will be able to detect the engagement in earnings management by parent’s management at the subsidiaries more quickly and will be able to constrain parent’s management more effectively. Furthermore, parent’s management is expected to have more knowledge about the earnings management opportunities of high integrated subsidiaries through a closer connection (Beuselinck et al., 2019). The parent’s board will be aware of the fact that management of the parent has more opportunities to engage in earnings management through high integrated subsidiaries. The parent’s board is likely to anticipate on this, because the financial reporting quality of the subsidiary will influence the financial reporting quality of the MNC as a whole via the consolidated statements (Glover & Wood, 2014; Beuselinck et al., 2019). Therefore the parent’s board will observe management of the parent exerting influence on high integrated subsidiaries with more scrutiny.
On the other hand, the results of Beuselinck et al. (2019) show that MNCs manage earnings more through high integrated subsidiaries. These results suggest that boards have more difficulties preventing parent’s management to engage in earnings management for high integrated subsidiaries or the parent’s board may not be (fully) aware of the high earnings management opportunities at high integrated subsidiaries. Furthermore, as stated previously, parent’s management has knowledge about the earnings management opportunities of high integrated subsidiaries through a closer connection and parent’s management is more likely to influence financial reporting choices of subsidiaries if the earnings management opportunities are higher (Beuselinck et al., 2019). In addition, the management of high integrated subsidiaries is more likely to be persuaded to follow orders of the parent company, because high integrated subsidiaries are more dependent on the parent and have less decision-making
rights (Beuselinck et al., 2019). This could lead to more earnings management through high integrated subsidiaries and therefore a lower financial reporting quality of subsidiaries. Based on these arguments it is expected that the relation is moderated by subsidiary integration, but it is the question whether the parent’s board can monitor the influence of the parent’s management on the subsidiary financial reporting quality even more or less effectively.
The empirical analysis of the parent board independence and subsidiary financial reporting quality relationship is conducted on a sample of 1,548 unique European subsidiaries of US MNCs. The data is collected over a 7-year period starting from 2011 to 2017. The US MNCs are identified using the Compustat database. The subsidiaries of the US MNCs are obtained from the exhibit 21 or 21.1 of the 10-K Securities Exchange Commission’s (SEC) Edgar database. This information is used to obtain the financial information from the Orbis database about the (European) subsidiaries. Furthermore, information on parent board independence was obtained from the MSCI database and information of subsidiary integration from the Orbis database. My tests are based on discretionary accruals estimated by the modified Jones model. In addition, regression analysis is used to test the hypotheses.
The results from my tests suggest a negative relationship between parent board independence and subsidiary financial reporting quality. Furthermore, this study shows a positive moderating effect of subsidiary integration weakening the negative relationship between parent board independence and subsidiary financial reporting quality. All in all, my findings suggest that the positive effect of parent board independence might be limited to only the parent. In addition, my findings find evidence that supports O’Donnell (2000) suggesting that independent board members seem to do a better job at constraining the parent’s management to engage in earnings management through high integrated subsidiaries as a result of lower information asymmetry.
This research makes several contributions. Firstly, this research contributes to the literature on the consequences of board independence. Prior research has shown that board independence influences the financial reporting quality of the company positively (Dimitropoulos & Asteriou, 2010; Waweru & Riro, 2013; Alves, 2014). In standalone firms, Dimitropoulos & Asteriou (2010) and Waweru & Riro (2013) show that a higher proportion of outside directors lead to higher quality earnings and more informative earnings. In addition, Alves (2014) shows, for Portuguese listed firms, that independent board members are more effective monitors and therefore improve earnings quality by reducing earnings management. I expand the current literature by examining the effect of board independence within MNCs and particularly focusing on the financial reporting quality of the subsidiaries. This study contradicts my expectation based on the aforementioned literature by providing evidence that parent board independence is negatively related to subsidiary financial reporting quality. The impact of board independence within MNCs and in particular on the financial reporting quality of the subsidiaries is important, because the financial reporting quality of the individual statements of the subsidiaries are influencing the financial reporting quality of the MNC as a whole via the consolidated statements of the MNC (Glover & Wood, 2014; Beuselinck et al., 2019). Furthermore, UNCTAD (2014) has shown that MNCs in the world are economically important and therefore the financial reporting quality of the MNC as a whole matters.
Secondly, this research contributes to the literature on the determinants of financial reporting quality within MNCs and in particular the financial reporting quality of the subsidiary. Prior literature has shown that parents control their subsidiaries and exert influence on their
decision making and their reporting choices (Foss et al., 2012; Beuselinck et al., 2019). Furthermore, parent’s management is using subsidiaries to manage earnings (Dyreng et al., 2012; Fan, 2012; Durnev et al., 2017). Thus, parent companies are influencing their subsidiaries’ financial reporting quality. This research will extend the determinants of subsidiary financial reporting quality by studying the impact of a board characteristic of the parent on this aspect, namely board independence. The findings of my study suggest that parent board independence is negatively influencing the subsidiary financial reporting quality. It is important to extend the literature on the determinants of subsidiary financial reporting quality, because the extant literature ignores the financial reporting quality of subsidiaries while already 50 per cent of the world gross domestic product arises from MNCs’ foreign subsidiaries (UNCTAD, 2014). So, the individual statements of these subsidiaries, which are aggregated to form the consolidated statements, have a massive impact of the financial reporting quality of the MNC as a whole (Beuselinck et al., 2019). For the MNCs’ shareholders a high financial reporting quality of the MNC is important, because it reduces information asymmetry between management and the shareholders (Biddle et al., 2009). This will enable shareholders to make more reliable estimations of the expected cash flows of the company and therefore the value of the company (FASB, 1978). In addition, a high financial reporting quality helps shareholders to monitor the performance of the management (Biddle et al., 2009). As the financial reporting quality of the MNC as a whole is heavily influenced by the financial reporting quality of its subsidiaries, shareholders will be interested in how the financial reporting quality of the subsidiaries is determined. Furthermore, Dyreng et al (2012) suggested future research about the determinants of earnings management within MNCs as they only investigated earnings management across firms. My study extends their research by studying the determinants of financial reporting quality within MNCs using earnings management as a proxy.
Thirdly, my study adds to the literature concerned with the effects of subsidiary integration. Prior research shows that high integrated subsidiaries are more likely to be used by MNCs to manage earnings, suggesting that the higher the level of integration between the parent and the subsidiary, the more likely the parent’s management is to engage in earnings management through the subsidiary (Beuselinck et al., 2019). Furthermore, O’Donnell (2000) states that the information asymmetry decreases when the integration between the parent and the subsidiary increases, suggesting that the board could constrain earnings management through high integrated subsidiaries better. I extend the current literature by testing the effects of subsidiary integration on a new relationship. I examine the impact of subsidiary integration on the relationship between parent board independence and subsidiary financial reporting quality. My study finds a positive moderating effect of subsidiary integration on the main relationship. This indicates that the negative relationship between parent board independence and subsidiary financial reporting quality is weakened by subsidiary integration. As the extant literature could not help to provide evidence for a clear direction of the effect of subsidiary integration on the main relationship, my results seems to support the reasoning of O’Donnell (2000). The independent board members cannot (fully) constrain earnings management through subsidiaries, but high integrated subsidiaries, as a result of lower information asymmetry, seem to help independent board members to better constrain earnings management through subsidiaries in contrast to the findings of Beuselinck et al. (2019). In section 2, the theory is reviewed and the hypotheses are developed. The methodology is described in section 3. Subsequently, section 4 reports the results. Finally, section 5 presents the discussion and the conclusions of this research.
2. Theory and Hypotheses Development
2.1 Parent board independence and subsidiary financial reporting quality
Financial reporting quality can be defined as ‘the precision with which financial reporting conveys information about the firm’s operations, in particular its expected cash flows, that inform equity investors’ (Biddle et al., 2009, p. 114). A high financial reporting quality is important, because it reduces information asymmetry between companies and external capital providers that cause economic frictions and therefore increases investment efficiency (Biddle et al., 2009). So, this is beneficial to the company and its owners, the shareholders. Furthermore, it is a way for shareholders to monitor the performance of managers (Biddle et al., 2009). According to the Financial Accounting Standards Board, one of the goals of financial reporting is ‘to inform present and potential investors in making rational investment decisions and in assessing the expected firm cash flows’ (FASB, 1978).
Within MNCs both the financial reporting quality of headquarters and the subsidiaries are important. Headquarters is responsible for preparing the consolidated financial statements (Beuselinck et al., 2019). Through the consolidation process the financial position and results of the operations of the parent company and its subsidiaries are combined as if the group was a single company (Beuselinck et al., 2019). So, the financial statements of the subsidiaries matter as they contribute to the consolidated statements reported by the MNC (Beuselinck et al., 2019). Therefore, the parent’s board will care about both the financial reporting quality of headquarters and the subsidiaries. Furthermore, prior literature has shown that parent’s management may have more incentives to manage earnings at the subsidiary level than at the headquarters level. The risk that earnings management is detected is lower at the subsidiary level, because audits of subsidiaries by parent’s auditors are more difficult (Stewart & Kinney, 2013) and (foreign) subsidiaries have often more loose legal regimes (Durnev et al., 2017). Furthermore, there are fewer consequences in the form of reputational costs and legal fines for the MNCs when misreporting occurs at the subsidiary level, because the threat of liability is limited (Dearborn, 2009).
Agency theory helps to get insights in the role of boards. This theory argues and helps to resolve a situation in which the interest of the principals and the agents may be in conflict (Eisenhardt, 1989). In such a situation an agent may take actions that are not in the best interest of the principals (Eisenhardt, 1989). In this paper the principals are the shareholders and the agents are the managers of a company. In order to ensure that the managers do not have too much power and can easily act into their own interest, the board of directors is appointed by the shareholders to decrease information asymmetry and to monitor the behavior of the management (Eisenhardt, 1989). So the board’s function is to mitigate agency problems (Eisenhardt, 1989).
Following agency theory the board is required to prevent that management are acting in their own interest (Eisenhardt, 1989). Therefore, the board has to prevent that management is able to manage earnings, because this decreases the financial reporting quality which is unfavorable for the shareholders. As stated previously, a high financial reporting quality is important for the shareholders, because it helps shareholders to monitor management and make rational investment decisions (FASB, 1978; Biddle et al., 2009). The board can prevent managers to act self-interested by effective monitoring (Alves, 2014). According to Alves (2014) independent outside directors are more effective monitors. Directors of the board of a company are considered independent as the person has no family or business ties to the company he or she works for which makes independent non-executive directors better able to
monitor management effectively (Alves, 2014). In this research paper this implies that boards with a higher percentage of non-executive directors are seen as board with a higher level of board independence as regulations in the U.S. often prohibit appointments of non-executive directors with such ties (Aggarwal et al., 2019). A drawback of this independent characteristic is that independent outside directors are less informed than the executives of the company and that the executives are often not willing to share all firm-specific information with independent outside directors, because they are perceived as ‘watchdogs’ (Raheja, 2005; Adams & Ferreira, 2007). This makes it more difficult for the board to assess and evaluate performance and monitor effectively (Duchin et al., 2010; Faleye et al., 2011). Furthermore, the effective monitoring ability determines the human capital value of the non-executive directors which makes them want to avoid colluding with management and motivate them to effectively perform their job (Fama & Jensen, 1983). Independent directors will also be more likely to stimulate managers to engage in activities that maximize long-term performance rather than letting them engage in activities that only lead to short-term profits (Patton & Baker, 1987). By preventing management to manipulate earnings, the financial reporting quality will be higher (Alves, 2014). This is in favor of the principals who want to be informed with reliable financial information about the performance of the company. Therefore prior research has shown that in standalone firms higher board independence has a positive effect on the financial reporting quality which can be explained using the agency view (Niu, 2006; Dimitropoulos & Asteriou, 2010; Waweru & Riro, 2013).
As mentioned earlier, in the MNC context, parent’s management has incentives to manage earnings through (foreign) subsidiaries (Dyreng et al., 2012; Fan, 2012; Durnev et al., 2017). Furthermore, parent’s management is the ultimate holder of authority and therefore can exert their influence on its subsidiaries (Foss et al., 2012). According to Beuselinck et al. (2019) parent’s management is more likely to influence the reporting choices of the subsidiaries when this helps to meet MNC-level reporting objectives or to avoid covenants violation. For parent’s boards this implies that they have to monitor and constrain management from managing earnings at headquarter level, as well as, at the subsidiary level. The parent’s board is motivated to monitor and constrain management from negatively influencing the subsidiary financial reporting quality, because the subsidiaries’ statements are influencing the consolidated statements of the MNC as a whole (Glover & Wood, 2014; Beuselinck et al., 2019). The parent’s board can monitor through the personal supervision of parent’s management and bureaucratic monitoring mechanisms (O’Donnell, 2000). Bureaucratic monitoring mechanisms consist of rules, programs and procedures to collect information regarding the actions and decisions of the management of the parent (O’Donnell, 2000). These mechanisms could help the parent’s board to prevent parent’s management to engage in earnings management at the subsidiary level, and therefore help the parent’s board to indirectly influence the subsidiary financial reporting quality positively. Therefore my main hypothesis is:
H1: Parent board independence has a positive effect on the subsidiary financial reporting quality
2.2 Subsidiary integration
As stated earlier, subsidiary integration is about the combination between parent companies and subsidiaries legally, structurally and culturally (Colman & Grøgaard, 2013). The degree of subsidiary integration rises as the percentage of ownership of the parent company in the subsidiary increases. Subsidiary integration plays an important part in sharing knowledge across the MNC-network (Porter, 1986). In addition, subsidiary integration assists in
achieving international economies of scope (Porter, 1986). Based on the current literature about the effects of subsidiary integration, the extant literature does not provide a clear direction for my expectation about the effect of subsidiary integration on the relationship between parent board independence and subsidiary financial reporting quality.
On the basis of O’Donnell (2000) I expect that an independent board of the parent can monitor a high integrated subsidiary more effectively. Her results show that there is less information asymmetry between parent companies and high integrated subsidiaries, which can enable the parent’s board to monitor more easily (O’Donnell, 2000). Consequently, the parent’s board will be able to detect earnings management at the subsidiary level by parent’s management more timely. So, the parent’s board can constrain the parent’s management engaging in earnings management at subsidiaries more effectively. In addition, the management of the parent has knowledge about high integrated subsidiaries’ earnings management opportunities through a closer connection (Beuselinck et al., 2019). The board will be conscious of this fact and is likely to take action due to the fact that the financial reporting quality of the subsidiaries is influencing the financial reporting quality of the MNC as a whole through the consolidation process (Glover & Wood, 2014; Beuselinck et al., 2019). Therefore the board will be more cautiously observing parent’s management exerting influence on high integrated subsidiaries.
In contrast, on the evidence provided by Beuselinck et al. (2019) I expect that an independent board of the parent can monitor a high integrated subsidiary less effectively. Beuselinck et al. (2019) found that MNCs manage earnings more through high integrated subsidiaries, where the parent company is particularly prominent. The findings of Beuselinck et al. (2019) indicate that parent’s board has difficulties monitoring the parent’s management to not engage in earnings management through high integrated subsidiaries. Apart from that management of the parent is aware about the earnings management opportunities of high integrated subsidiaries through a closer connection and management of the parent is more likely to exert influence on the financial reporting choices of subsidiaries if the earnings management opportunities are higher (Beuselinck et al., 2019). Besides, as high integrated subsidiaries are more dependent on the parent company and often have fewer decision-making rights, high integrated subsidiaries are easier to be persuaded to follow the orders of the parent company (Beuselinck et al., 2019). As a consequence, the probability that earnings management will occur through high integrated subsidiaries is higher which will negatively affect the financial reporting quality of the subsidiary.
As stated previously, the current literature does not provide a clear direction for my hypothesis. Therefore, I state my sub hypothesis as non-directional. So, my sub hypothesis is the following:
H2: Subsidiary integration influences the relationship between parent board independence and the subsidiary financial reporting quality
3. Methodology
3.1 Sample selection
In this section will be explained how the sample is obtainedprecisely. Firstly, I identified all listed companies from the US using the Compustat database. In addition, I omitted the banking and financial companies in this sample, because these companies have to deal with
different regulations and capital structure requirements (Aggarwal et al., 2019). Furthermore, I excluded companies with unavailable board related information which is gathered from the MSCI (formely KLD and GMI) database. Furthermore, for the listed non-financial companies, I hand-collected the names and jurisdiction of all material subsidiaries in exhibit 21 or 21.1 of the 10-K Securities Exchange Commission’s (SEC) Edgar database. The hand-collected data was then matched with those of the companies covered by the Orbis database. Given the coverage of the Orbis database, I only selected subsidiaries from 30 European countries. As for the listed companies from the US, I dropped the banking and financial European subsidiaries for the same reasons as discussed previously (Aggarwal et al., 2019). To compute subsidiary financial reporting quality and subsidiary integration, the financial and ownership information of the subsidiaries is collected from the Orbis database. Furthermore, following Beuselinck et al. (2019), subsidiaries with sales and total assets fewer than $10.000 are also removed and the independent and dependent variables, except for the subsidiary integration (dummy variable), are winsorized to control for outliers. Finally, after discarding subsidiaries with unavailable financial and ownership information, my final sample consists of 5,392 subsidiary-years observations and 1,548 unique subsidiaries from 22 European countries. The data is collected over a 7-year period starting from 2011 to 2017.
3.2 Variables
Dependent variable
In my quantitative research the dependent variable is SUB_FRQ which measures the subsidiary financial reporting quality. The subsidiary financial reporting quality is made operational by using earnings management as a proxy. Earnings management can be measured by calculating the discretionary accruals per subsidiary, because prior literature explains that managers could use their discretion over certain accounting choices to manage earnings (Jones, 1991). Discretionary accruals are a very common used way to measure earnings management (Dyreng et al., 2012;Bonacchi et al., 2018; Beuselinck et al., 2019). In this research the modified Jones model is used to measure discretionary accruals which is created by Dechow et al. (1995) based on the model originally developed by Jones (Jones, 1991; Dechow et al., 1995). Dechow et al. (1995) adjusted the original model by adding the subtraction of the change in accounts receivables from the change in revenues, because this takes into account the fact that managers could use their discretion over revenue recognition on credit sales. To compute the discretionary accruals, first the balance sheet approach has to be used to calculate the total accruals (Jones, 1991; Gill-de-Albornoz & Rusanescu, 2018). Following Gill-de-Albornoz and Rusanescu (2018) the total accruals are calculated in the following way:
𝑇𝑜𝑡𝑎𝑙 𝐴𝑐𝑐𝑟𝑢𝑎𝑙𝑠𝑖,𝑡 =
𝛥𝑁𝑜𝑛𝑐𝑎𝑠ℎ 𝑐𝑢𝑟𝑟𝑒𝑛𝑡 𝑎𝑠𝑠𝑒𝑡𝑠𝑖,𝑡 – 𝛥𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝑙𝑖𝑎𝑏𝑖𝑙𝑖𝑡𝑖𝑒𝑠𝑖,𝑡 – 𝐷𝑒𝑝𝑟𝑒𝑐𝑖𝑎𝑡𝑖𝑜𝑛 𝑒𝑥𝑝𝑒𝑛𝑠𝑒𝑖,𝑡 (1)
So, the total accruals are calculated as the annual change in noncash current assets less the annual change in current liabilities and less the annual depreciation expense. The noncash current assets are computed as current assets less cash and cash equivalents.
Further, following Dechow et al. (1995) discretionary accruals of the subsidiaries are estimated using the modified Jones model which is described below:
𝑇𝑜𝑡𝑎𝑙 𝐴𝑐𝑐𝑟𝑢𝑎𝑙𝑠𝑖,𝑗,𝑡 𝐴𝑠𝑠𝑒𝑡𝑠𝑖,𝑗,𝑡−1 = ∝0 + ∝1( 1 𝐴𝑠𝑠𝑒𝑡𝑠𝑖,𝑗,𝑡−1) +∝2( ∆𝑅𝐸𝑉𝑖,𝑗,𝑡−∆𝐴𝑅𝑖,𝑗,𝑡 𝐴𝑠𝑠𝑒𝑡𝑠𝑖,𝑗,𝑡−1 ) +∝3( 𝑃𝑃𝐸𝑖,𝑗,𝑡 𝐴𝑠𝑠𝑒𝑡𝑠𝑖,𝑗,𝑡−1) + 𝜀𝑖,𝑗,𝑡 (2)
𝑇𝑜𝑡𝑎𝑙 𝐴𝑐𝑐𝑟𝑢𝑎𝑙𝑠𝑖,𝑗,𝑡 = total accruals for company i in industry j and year t
𝐴𝑠𝑠𝑒𝑡𝑠𝑖,𝑗,𝑡−1 = total assets for company i in industry j in year t-1
∆𝑅𝐸𝑉𝑖,𝑗,,𝑡 = revenue in year t minus revenue in year t-1 for company i in industry j
∆𝐴𝑅𝑖,𝑗,𝑡 = accounts receivables in year t minus accounts receivables in year t-1 for company i
in industry j
𝑃𝑃𝐸𝑖,𝑗,𝑡 = gross property, plant and equipment for company i in industry j in year t
𝜀𝑖,𝑗,𝑡 = error term for company i in industry j in year t
The model is estimated for each industry and year combination. To avoid potential scale bias and heteroscedasticity problems all variables in equation (2) are divided by lagged total assets (Jones, 1991). In this formula the discretionary accruals can be calculated by subtracting the non-discretionary accruals from the total accruals. The residual of the estimation is the error term which is the abnormal accruals of a subsidiary (Dechow et al., 1995). So, the variable SUB_FRQ can be defined as the absolute value of discretionary accruals estimated with the modified Jones model. The absolute value of discretionary accruals will be used as this increases the comparability of the results of this study with previous literature that mostly chose the absolute value of discretionary accruals (Bergstresser & Philippon, 2006; Dyreng et al., 2012; Beuselinck et al., 2019). Furthermore, the absolute value shows the effect of both income-increasing and income-decreasing earnings management (Dyreng et al., 2012; Beuselinck et al., 2019). In addition, this study is not interested in the direction, but rather the magnitude of the discretionary accruals.
Independent variables
The main independent variable, PAR_BI, is defined as the ratio of the number of non-executives directors to the number of the total directors. PAR_BI is used to measure board independence of the parent. Previous research has shown that non-executive directors are a well-used proxy for board independence (Alves, 2014; Waweru, & Riro, 2013). To make sure the size of the board is irrelevant, I have chosen to use the ratio of the number of non-executives directors to the number of the total directors to account for the differences in board size. Furthermore, the ratio can easily be interpreted as a percentage.
Furthermore, another explanatory variable is SI which will measure the subsidiary integration between the parent and the subsidiary. The moderating effect of subsidiary integration is measured following the research by Beuselinck et al. (2019). Therefore, the variable SI is defined as a dummy variable, equal to 1 if the subsidiary is wholly owned by the parent (100% ownership) and equal to 0 if the subsidiary is not wholly owned (Beuselinck et al., 2019).
3.3 Empirical model
To test my hypothesis, I use Ordinary Least Squares (OLS) to estimate the following two empirical models:
SUB_FRQ = β 0 + β 1 PAR_BIi,t + β 2 SUB_SIZEi,t + β 3 SUB_LEVi,t + β 4
SUB_FIRM_GWTi,t + β 5 SUB_CFOi,t + ε i,t (3)
SUB_FRQ = β 0 + β 1 PAR_BIi,t + β 2 SIi,t + β 3 (PAR_BIi,t * SIi,t) + β 4 SUB_SIZEi,t + β 5 SUB_LEVi,t + β 6 SUB_FIRM_GWTi,t + β 7 SUB_CFOi,t + ε i,t (4)
Model (3) is used to examine the effect of parent board independence on subsidiary financial reporting quality. The expectation is that PAR_BI will have a positive coefficient. Furthermore, I controlled for the effect of several subsidiary characteristics based on previous research. In the model SUB_FRQ represents the financial reporting quality of the subsidiary calculated as the absolute value of discretionary accruals estimated with the modified Jones model. PAR_BI stands for the board independence of the parent calculated as the ratio of the number of non-executives directors to the number of the total directors. SUB_SIZE means the size of the subsidiary. SUB_LEV is the leverage of the subsidiary. SUB_FIRM _GWT stands for firm growth of the subsidiary. SUB_CFO is the cash flow from operations of the subsidiary. The control variables will be described in the next section. ε is the error term. Furthermore, the model includes controls for country, industry and year effects with i, j and t, respectively. The industries are classified using the four digits of the NACE Rev. 2 core code which was available for the subsidiaries using the Orbis database.
Model (4) is used to study the moderating effect of subsidiary integration on the relationship between parent board independence on subsidiary financial reporting quality. The expectation is that subsidiary integration has an effect and therefore a positive or negative coefficient could be expected. In model (4) the variable SI was added and its interaction with PAR_BI. SI is subsidiary integration, equal to 1 if the subsidiary is wholly owned by the parent and 0 otherwise. In model (4) the same control variables are used as in model (3).
Control variables
In this research there will also be a number of control variables. These variables are used, because previous research has shown that these variables have an effect on the financial reporting quality of the subsidiary. This research will use the following subsidiary characteristics as control variables: firm size, leverage, firm growth, cash flow, country, industry and year effects.
Firstly, prior research shows that the firm size has a positive impact on financial reporting quality (Sarkar et al., 2008; Alves, 2014). Managers of larger companies are less likely to use their discretion, because they are observed under more scrutiny of authorities than smaller companies (Watts & Zimmerman, 1990; Gular & Wang, 2011; Alves, 2014). Firm size is calculated by the log of the total assets (Sarkar et al., 2008; Gular & Wang, 2011).
Secondly, leverage influences financial reporting quality negatively (Sarkar et al., 2008; Gular & Wang, 2011; Alves, 2014). Prior research has shown that the threat of debt violation lead high leveraged firms to engage in more (income-increasing) earnings management (Klein, 2002; Jiang et al., 2008). The total liabilities divided by the total assets of a subsidiary will give the leverage of a subsidiary (Alves, 2014).
Thirdly, according to Waweru and Riro (2013) one of the short-comings of the modified Jones is that it does not take into account the effect of firm growth. Firm growth is likely to influence accruals negatively and therefore should be controlled for (Lee et al., 2006). Managers could use discretionary accruals, when growth slows down or the firm even shrinks, to pretend that the firm is growing consistently (Summers & Sweeney, 1998). As a measure of firm growth the change in sales is used (Beuselinck et al., 2019).
Fourthly, prior literature found that cash flow from operations influences financial reporting quality positively (Dechow et al., 1995; Jiang et al., 2008). Dechow et al. (1995) found that a higher value of cash flow from operations is related to lower abnormal accruals, because firms
with a high operating cash flow performance are less likely to increase earnings with discretionary accruals because they are already performing well. Jiang et al. (2008) and Yang et al. (2008) found similar results. Cash flow is measured as the cash flow from operations divided by total assets (Alves, 2014).
Lastly, in this research the models control for country, industry and year effects, because previous studies have shown these variables affect financial reporting quality. Tax rates and regulations of the countries have a major influence on earnings management (Beuselinck et al., 2019). Barton (2001) found that some industries allow managers to have more flexibility in managing earnings than others and he found that managers in industries with generally more earnings management flexibility are more likely to manage earnings. Furthermore this research controls for economic changes over the years (Beuselinck et al., 2019). All these variables are included in the empirical model as dummy variables. Multiple control variables will be used of a variety of relevant papers to make sure as little as possible confounding effects could influence the examined relationship.
4. Results
4.1 Descriptive statistics
The descriptive statistics of the sample of the dependent and independent variables used in the regressions are shown in Table 1.
Table 1: Descriptive statistics
Variable N Mean Std. dev. Min Max
SUB_FRQ 5,392 0.13 0.17 0.00 1.20 PAR_BI 5,392 0.88 0.06 0.33 1 SI 5,392 0.82 0.38 0 1 SUB_SIZE 5,392 4.83 0.56 4.00 7.23 SUB_LEV 5,392 0.56 0.35 0.00 6.62 SUB_FIRM_GWT 5,392 0.08 0.52 -0.90 10.99 SUB_CFO 5,392 0.08 0.11 -1.14 1.33
Notes: This table contains descriptive statistics for variables used in my study. The sample consists of 5,392 observations. SUB_FRQ represents the financial reporting quality of the subsidiary calculated by the absolute value of discretionary accruals estimated with the modified Jones model. PAR_BI stands for the board independence of the parent, calculated as the ratio of the number of non-executives directors to the number of the total directors. SI represents subsidiary integration, equal to 1 if the subsidiary is wholly owned by the parent and 0 otherwise. SUB_SIZE means the size of the firm calculated as the log value of the total assets of the subsidiary. SUB_LEV is the leverage of the subsidiary calculated as the total liabilities divided by total assets. SUB_FIRM_GWT stands for firm growth calculated as the change in sales of the subsidiary. SUB_CFO is the cash flow from operations of the subsidiary divided by total assets.
The mean of the absolute value of discretionary accruals of the subsidiaries is 0.13 suggests that subsidiary discretionary accruals represent, on average, about 13 percent of their total assets. Furthermore, the boards of the parents of this sample consist on average of 87.7% independent board members. In addition, the minimum percentage of independent board members indicates that at least one third of the parent’s board consists of independent board members for every company. On average, in about 82.2% of the observations the parents of the MNC holds 100% of the subsidiaries in this sample. The mean of the log value of firm size is 4.83 what is corresponding to a value of $67,300 of total assets. The mean leverage
ratio is 0.56, indicating that the subsidiaries in my sample are highly leveraged. The subsidiary sales have an average annual growth of 8 percent. Furthermore, the cash flow from operations mean is 0.08 which means that subsidiary CFOs represent on average 8 percent of the total assets. In general, the descriptive statistics of my sample are similar to those of Beuselinck et al. (2019) and Alves (2014).
4.2 Correlations
Table 2 presents the Pearson correlations between the variables used in my study. Table 2: Correlation matrix
Variable SUB_FRQ PAR_BI SI SUB_SIZE SUB_LEV SUB_FIRM_GWT SUB_CFO
SUB_FRQ 1 PAR_BI 0.01 1 SI 0.02* -0.02 1 SUB_SIZE -0.04*** 0.12*** -0.02 1 SUB_LEV 0.12*** -0.03** -0.03** -0.07*** 1 SUB_FIRM_GWT -0.01 -0.03** -0.03** 0.01 0.01 1 SUB_CFO 0.02* 0.00 -0.02 0.00 -0.29*** 0.00 1
Notes: This table contains the matrix of Pearson correlation coefficients for variables used in my study. The sample consists of 5,392 observations. SUB_FRQ represents the financial reporting quality of the subsidiary calculated by the absolute value of discretionary accruals estimated with the modified Jones model. PAR_BI stands for the board independence of the parent, calculated as the ratio of the number of non-executives directors to the number of the total directors. SI represents subsidiary integration, equal to 1 if the subsidiary is wholly owned by the parent and 0 otherwise. SUB_SIZE means the size of the firm calculated as the log value of the total assets of the subsidiary. SUB_LEV is the leverage of the subsidiary calculated as the total liabilities divided by total assets. SUB_FIRM_GWT stands for firm growth calculated as the change in sales of the subsidiary. SUB_CFO is the cash flow from operations of the subsidiary divided by total assets. *, **, and *** denote statistical significance at the 10%, 5%, and 1% levels, respectively.
The correlation between PAR_BI and SUB_FRQ is not statistically significant, suggesting that the proportion of independent directors on the parent board is not related to the magnitude of subsidiary discretionary accruals. Furthermore, the correlation matrix indicates a positive and significant relationship between the absolute value of discretionary accruals and subsidiary integration, indicating that the magnitude of discretionary accruals is significantly higher in wholly-owned subsidiaries. This result is consistent with Beuselinck et al (2019). In addition, the correlation matrix indicates that leverage and cash flow from operations of subsidiaries have a positive relationship with their discretionary accruals and firm sizes of subsidiaries have a negative relationship with their discretionary accruals. Further, the correlation matrix shows that there is no relation between firm growth of subsidiaries and their discretionary accruals. The correlations between the examined variables are relatively small. Therefore, it can safely be concluded that this research is unlikely to face any multicollinearity problems in the regression analysis.
4.3 Regressions analysis
Results of the regression analysis from model (3) and (4) are presented in Table 3. For the first hypothesis, model (3) is used to examine the relationship between parent board independence and financial reporting quality of the subsidiary. Results show that the relation between parent board independence and discretionary accruals is positive and significant at the 5% level. The results show a positive coefficient of 0.084 which implies that every 1 percentage point increase in the percentage of independent board members increases the discretionary accruals of a subsidiary by 0.084 percentage points. This result is economically important. In contradiction to the prior literature used to develop my expectations, the findings suggest a negative relationship between parent board independence and subsidiary financial reporting quality. Therefore H1 is not supported.
A possible explanation could be that the subsidiaries are literally too far away from the parent’s board. So, the long geographical distance causes independent board members of the parent to not perform their job well, because it could be difficult to monitor what happens at the subsidiaries, especially in the subsidiaries located abroad (Boeh & Beamish, 2012). Furthermore, the information asymmetry could even be higher due to language barriers and insufficient knowledge of local markets, authorities and regulations (Foss et al., 2012). This seems plausible as the sample of this research consists of US parent and European subsidiaries. As a result the independent board members of the parent cannot monitor effectively and consequently parent’s management can more easily engage in earning management through subsidiaries. Further, the operational complexity could help to explain the results. In general, foreign operations tend to be more complex than domestic operations (Birkinshaw et al., 2001). Due to the greater complexity, greater cognitive efforts are required to obtain an understanding of the foreign business environment and processes, which makes it harder for board members of the parent to monitor effectively (Tihanyi & Thomas, 2005). Therefore parent’s management could engage in earnings management through subsidiaries more and the financial reporting quality of subsidiaries is lower.
Besides, another explanation could be that the monitoring ability of the board members is influenced by other personal characteristics which were not included in this study. Prior research provides evidence that the tenure and the number of directorships of the board members influence their monitoring abilities (Bravo and Reguera-Alvarado, 2018). Bravo and Reguera-Alvarado (2018) in particular show that a longer tenure and a higher number of directorships impair the monitoring ability of board members.
For the control variables the results are mostly consistent with the expectations based on prior research. Firm size of the subsidiaries has a negative and highly significant (p < 0.01) relationship with discretionary accruals in line with Sarkar et al. (2008) and Alves (2014), suggesting that larger subsidiaries engage in less earnings management. In addition, consistent with the extant literature leverage has a positive and highly significant (p < 0.01) relationship with discretionary accruals, indicating that subsidiaries with higher levels of debt manage earnings more to avoid debt covenant violation (Sarkar et al., 2008; Gular & Wang, 2011; Alves, 2014). This research did not find a relationship between firm growth of subsidiaries and discretionary accruals of subsidiaries in contrast to Lee et al. (2006). Furthermore, the results for cash flow from operations of subsidiaries are inconsistent with the expectations (Dechow et al., 1995; Jiang et al., 2008; Yang et al., 2008). The findings show a positive and highly significant (p < 0.01) relationship between cash flow from operations and discretionary accruals, suggesting that subsidiaries with higher levels of cash flow from operations engage in earnings management more.
Table 3: Regression results with modified Jones model
Model (3) Model (4)
VARIABLES SUB_FRQ SUB_FRQ PAR_BI 0.084** 0.277** (0.040) (0.124) SI 0.231* (0.118) Interaction (PAR_BI*SI) -0.248* (0.135) SUB_SIZE -0.014*** -0.008 (0.004) (0.006) SUB_LEV 0.066*** 0.064*** (0.007) (0.009) SUB_FIRM_GWT -0.000 -0.000 (0.000) (0.000) SUB_CFO 0.093*** 0.093*** (0.022) (0.024) Constant 0.163 -0.006 (0.118) (0.126) Year fixed effects Yes Yes Country fixed effects Yes Yes Industry fixed effects Yes Yes R-squared 0.046 0.045 Adj R-squared 0.037 0.036 Observations 5,392 5,392
Notes: This table contains the regression results using the modified Jones model for variables used in my study. SUB_FRQ represents the financial reporting quality of the subsidiary calculated by the absolute value of discretionary accruals estimated with the modified Jones model. PAR_BI stands for the board independence of the parent, calculated as the ratio of the number of non-executives directors to the number of the total directors. SI represents subsidiary integration, equal to 1 if the subsidiary is wholly owned by the parent and 0 otherwise. SUB_SIZE means the size of the firm calculated as the log value of the total assets of the subsidiary. SUB_LEV is the leverage of the subsidiary calculated as the total liabilities divided by total assets. SUB_FIRM_GWT stands for firm growth calculated as the change in sales of the subsidiary. SUB_CFO is the cash flow from operations of the subsidiary divided by total assets. Standard errors in parentheses and *, **, and *** denote statistical significance at the 10%, 5%, and 1% levels, respectively.
For the second hypothesis, model (4) is used to examine the effect of subsidiary integration on the relationship between parent board independence and financial reporting quality of the subsidiary. The regressions analysis shows that the negative relationship between parent board independence and subsidiary financial reporting quality is weakened by subsidiary integration. The result for subsidiary integration shows an economically significant negative coefficient of 0.248. So, subsidiary integration has a positive moderating effect on the aforementioned relationship which is significant at the 10% level. This result indicates that if the subsidiary is more integrated with the parent the negative relationship between the percentage of independent board members of the parent and the financial reporting quality of the subsidiary is lower. An explanation for subsidiary integration attenuating the negative effect of parent board independence on subsidiary financial reporting quality could be that highly integrated subsidiaries have a lower complexity of operations as those subsidiaries are often less specialized (Foss et al., 2012). The lower complexity of the operations makes it easier for the parent’s board to monitor high integrated subsidiaries more effectively than low integrated subsidiaries (Roth & O'Donnell, 1996). So, the results confirm H2. The controls variables have similar coefficients to those obtained with the main model (3). Nevertheless, under model (4) the firm size of subsidiaries is not significant and the positive coefficient of parent board independence rose to 0.28 under model (4).
5. Conclusions and discussion
5.1 Findings
The main purpose of this research is examining the relationship between parent board independence and subsidiary financial reporting quality. Furthermore, this study investigates how subsidiary integration influences the relationship between parent board independence and subsidiary financial reporting quality.
I expected that parent board independence has a positive effect on subsidiary financial reporting quality. Prior literature in standalone firms has already shown that board independence enhances financial reporting quality (Dimitropoulos & Asteriou, 2010; Waweru & Riro, 2013; Alves, 2014). Independent board members are more effective monitors, due to the fact that they are less likely to collude with management, because they are held accountable for controlling management (Fama & Jensen, 1983; Alves, 2014). Therefore independent outside board members succeed more in constraining management to manage earnings than inside board members which results in a higher financial reporting quality (Alves, 2014). Within MNCs, parent’s management has many incentives to manage earnings through (foreign) subsidiaries (Dyreng et al., 2012; Fan, 2012; Durnev et al., 2017). Furthermore, within MNCs, the parent company is the owner of the subsidiary and can exert influence on its subsidiaries’ accounting choices (Foss et al., 2012). Besides, Beuselinck et al. (2019) shows that management of the parent is more likely to influence the accounting choices of the subsidiaries when this helps meeting MNC-level reporting objectives or helps avoiding covenants violation. In addition, the financial reporting quality of the subsidiary is important for the parent’s board as it will influence the financial reporting quality of the MNC as a whole through consolidation (Beuselinck et al., 2019). Therefore the parent’s board is keen on preventing management to manage earnings at headquarters level and the subsidiary level. By constraining parent’s management to engage in earnings management at the subsidiary level, the parent’s board indirectly positively influences the subsidiary financial reporting quality.
The results of this study contradict this expectation. According to the results parent board independence increases earnings management and therefore decreases the financial reporting quality of the subsidiary. The impact of geographic distance could be an explanation for these results. Greater geographic distance between the parent and the subsidiary makes it harder for parent’s boards to assess what really happens at the subsidiaries. In this research it could be that the boards of US parents have difficulties constraining earnings management through subsidiaries by the parent’s management, because the subsidiaries are located in Europe (Boeh & Beamish, 2012). Furthermore, the information asymmetry could be higher due to superior local knowledge about local markets and regulations that only local subsidiary management has, which makes it more difficult to monitor effectively (Foss et al., 2012). Besides, the complexity of the operations could help explaining the negative relation between parent board independence and subsidiary financial reporting quality. As foreign operations tend to be more complex than domestic operations, it is more difficult for the parent’s board to monitor parent’s management influences effectively (Birkinshaw et al., 2001). This could result into more earnings management through subsidiaries by parent’s management and a lower subsidiary financial reporting quality. So, the results of this study indicate that the positive effect of board independence on financial reporting quality is limited. The positive effect of parent board independence that it has on the financial reporting quality of the MNC is not found at the subsidiary level. Board independence at the top of the MNC is not enough to ensure an effective monitoring within MNCs.
Another reason that the results are not in line with the expectations could be that other personal characteristics of the independent board members, which are not included in this research, could be influencing the ability to monitor. Bravo and Reguera-Alvarado (2018) show that the tenure and number of directorships has its impact on the monitoring ability of board members. Especially a long tenure and a high number of directorships impair the ability to monitor effectively (Bravo & Reguera-Alvarado, 2018).
Furthermore, I expected that subsidiary integration has an effect on the relationship between parent board independence and subsidiary financial reporting quality. Based on the expectation that parent board independence had a positive impact on subsidiary financial reporting quality, I predicted that subsidiary integration could have a positive impact as O’Donnell (2000) shows that there is less information asymmetry between high integrated subsidiaries and the parent company. This would enable independent board members to monitor more easily and detect earnings management through subsidiaries more quickly. Furthermore, parent’s management is aware of the earnings management opportunities of high integrated subsidiaries through a closer connection (Beuselinck et al., 2019). The parent’s board is likely to anticipate on this fact as the individual statements of the subsidiaries will lead to the consolidated statements of the MNC as a whole (Glover & Wood, 2014; Beuselinck et al., 2019). Therefore the board of the parent will more intensively observe parent’s management exerting influence on high integrated subsidiaries.
In contrast, subsidiary integration could have a negative effect as Beuselinck et al. (2019) shows that MNCs use high integrated subsidiaries more to manage earnings, indicating that the parent’s board has more difficulties to monitor when the level of integration increases. Furthermore, management of the parent has knowledge about the earnings management opportunities of high integrated subsidiaries through a closer connection and parent’s management is more inclined to exert influence on the financial reporting choices of subsidiaries if the earnings management opportunities are higher (Beuselinck et al., 2019).
