Earnings management, cross-listing and the effect of debt financing on a firm’s reporting incentives

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Earnings management, cross-listing and

the effect of debt financing on a firm’s

reporting incentives

Master Thesis

Jacoba Alberdina Sants

28 February, 2013

Msc. International Financial Management Faculty of Economics and Business

University of Groningen

Msc. Business and Economics Faculty of Social Sciences

Uppsala University

Student number: S1612816 / 890819-P383 E-mail address: carolien.sants@gmail.com Supervisor: Dr. H. Gonenc

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Abstract

Lang et al. (2006) found that even though accounting regulation is the same in the basic

principal, it does not lead to comparable accounting data for firms cross-listed in the US and US

based firms. This thesis adds to this line of research by showing the effect of debt financing on

the evidence of earnings management for a sample of 459 firms, cross-listed and US based, over

the time period 2002-2011. More evidence of earnings management is found when companies

increase leverage, where on average the level of leverage is higher for US firms. The effect of an

aspect of the home country institutional environment, the strength of the creditor rights, does not

seem to significantly affect the level of earnings management. However, combining the two

factors provides weak support for a decreasing effect on the use of earnings management.

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1. Introduction

The term earnings management is described by Degeorge et al. (1999) as: “the strategic exercise

of managerial discretion in influencing the earnings figures reported to external audiences”. This

does not sound very disturbing, while in press often the terms manipulation, company fraud and

misleading shareholders is linked to earnings management. Accounting regulations are in place

to protect investors and to provide an incentive for reporting discretion (Payne and Robb, 2000).

Many countries have accounting regulations in place based on the US GAAP (Generally

Accepted Accounting Principles), but in 2002 a number of corporate and accounting scandals

made the Securities and Exchange Committee (SEC) pass the Sarbanes-Oxley Act (SOX) in the

United States. This Act is assigned to improve investors’ protection by imposing more stringent

accounting standards upon US public companies and public accounting firms.

In the past it was assumed that cross-listed firms were held to similar standards as firms

originating from the US. However, this presumption is challenged only recently in 2006 by

Lang, Ready and Wilson. Their study shows that even though regulation is the same in the basic

principal, it does not lead to comparable accounting data due to weak legal enforcement. Leuz

(2006) discusses these findings of Lang et al. (2006) and adds that the difference in earnings

management can also be the result of market forces, firm characteristics and institutional factors.

This thesis will add to the research done by the two main articles in this field by investigating

one overlooked part of external financing. The influence of debt financing on the reporting

incentives through the institutional environment and the managerial incentives will be the focus

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More specifically, the effect of firm level leverage and the strength of the home-country creditor

rights on the level of earnings management will bring about the following research question:

“Can the difference between the level of earnings management of cross-listed and US firms be explained by the debt level and the strength of the home-country creditor rights?”

The effect of leverage on the reporting incentives is addressed by Burgstahler et al. (2004), who

state that the way in which a company raises capital determines the company’s reporting

incentives through capital market forces. Furthermore, Seifert and Gonenc (2012) describe that

the incentive of managers to provide stable cash flows is increased in countries with strong

creditor rights. Besides, management will put more focus on preventing default or financial

distress due to the related costs for managers and shareholders. Risk-reducing activities are taken

when the creditor rights are strong (Seifert and Gonenc, 2012). In this paper a combination of the

two research approaches will be made in examining the gap between the level of earnings

management of cross-listed and US firms. By investigating if the two factors, the strength of

home-country creditor rights together with the level of leverage, influence the firm’s reporting

incentives. In testing this research question the empirical format will be similar to the papers of

Lang et al. (2006) and Leuz (2006), using a sample of firms cross-listed in the US together with

firms originating from the US.

This research can be used by investors as a guideline to assess the comparability and the

informational content of accounting data between firms compelling to regulation of the United

States and firms constrained by the home-country’s regulatory environment. They have to keep

in mind that the nature of external financing plays part in the quality of the accounting figures,

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While it is hard to distinguish the results stemming from managerial incentives and the effect of

regulation due to their linkage, it provides insight into the way in which debt financing can make

accounting data characteristics differ between cross-listed and US firms.

The structure of the thesis is as follows: first the literature surrounding earnings management and

cross-listing will be reviewed. Here the link will be made between the level of earnings

management and the effect of debt financing. Second, the theory is combined in order to

formulate the hypotheses which form the basis in answering the research question. The fourth

chapter describes the empirical model with the corresponding regression analysis and the fifth

chapter the data which is used in testing the hypotheses. After the empirical research the results

will be discussed in the sixth chapter of this paper, all to end with a conclusion providing an

answer to the research question in section seven. Finally, the references and appendix are

provided in the last two chapters.

2. Literature

Earnings management is a management tool which can be applied in different ways. Burgstahler

and Dichev (1997) look into the phenomena of strong management incentives to report a small

increase in the earnings or earnings which are just above zero. Other authors look at different

methods; where Dechow et al. (2000) describe a strategy which they define as beating the

benchmark. In their paper they not only look at firms that report small positive earnings (beating

the zero earnings benchmark), but they add a sample of firms which meet the analysts’ forecasts (having zero forecasting errors). In meeting analysts’ forecasts the company can choose two approaches in earnings management; guiding forecast before they are released or try to meet the

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Last, earnings management can also be used to meet some previous level of earnings, signaling a

sustainable business performance (Degeorge et al., 1999). Since there are many ways in which

earnings management can be performed, finding a measure which captures the evidence for the

level of earnings management is a difficult task.

A number of motivations are mentioned in literature for managers to engage in earnings

management. First, the transaction cost theory states that reporting increasing/positive earnings

will decrease the firm’s costs in the transactions with stakeholders due to better future prospects

(Burgstahler and Dichev, 1997). Second, the cost of obtaining company information makes that

investors use heuristics cutoffs at zero earnings or zero earnings growth, making companies with

negative/decreasing earnings an unattractive investment. Third, managers might prefer to report

short run profits due to the short time horizon in which they are assigned, managers often have

stock based compensations, and the performance of the stock price can be a determinant for the

probability to keep the job (Degeorge et al., 1999). Fourth, firms can try to signal future

performance if they expect the earnings to growth in the nearby future. Fifth, avoiding a so called ‘torpedo effect’ as described by Skinner and Sloan (2002). When growth or value stock performs below the analysts’ forecast, the stock price experiences a large decline even if the

forecasting error is rather small. Finally, earnings management can be used to avoid violating

debt covenants when there are restrictions based on earnings to prevent renegotiations with the

debt holders of the firm (Dichev et al., 2002).

In the press earnings management is often linked to manipulation, misleading stakeholders,

company fraud and making short term profits. Managing the earnings comes with a cost in the

form of the agency problem. An agency problem arises due to the fact that there is an

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Investors base their decisions on information about economic performance gathered through analysts’ forecasts and earnings announcements prepared by the corporate insiders (Degeorge et al., 1999). The perception of outsiders can therefore be influenced by the executives of a

company, which can have misaligning objectives, resulting in agency costs. In order to protect

the investors, an accountant needs to check the firm’s financial reports and the application of the

generally accepted accounting principles which put restrictions on the construction of the

financial statements. After a number of accounting scandals in 2001 and 2002 the Congress of

the United States passed the SOX of 2002 to further improve the reliability and accuracy of a

corporation’s financial reports (Li et al., 2008). The accounting standards provide an incentive

for firms to use more discretion in the preparation of the financial statements. Besides a strong

regulatory and legal environment, the level of external financing also has an influence on the

level of reporting discretion through the increased default risk and the existence of debt

covenants (DeFond and Jiambalvo, 1994).

2.1 Leverage

Debt financing is an important source of external financing for corporations. Bharath et al.

(2008) state that in 2005 US corporations issued around $700 billion in corporate bonds and

raised $1,500 billion of new capital on the loan market. Management bonds itself to act in the

interest of the shareholders when issuing debt, which decrease the agency costs. Grossman and Hart (1982) explain that by taking on debt, managers’ incentives will be in line with the profit maximization objective of the shareholders since debt will increases the firm’s market value

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The relationship between managerial incentives and the corporation’s market value is

three-folded; often the salaries of managers are linked to the firm value, higher market values decrease

the probability of a takeover, and the threat of going bankrupt is higher when firms do not pursue

the objective of profit maximization (Grossman and Hart, 1982). Hence, the capital structure of a

firm is driven by managerial incentives.

One determinant of the level of credit which is available to a firm can be based on the

information theory (Djankov et al., 2005). Being able to assess the risk of a financing project is

highly related to the level of information a lender is provided with. The main idea behind the

information theory on credit is that there is a positive relationship between the information that is

available to the investor and their willingness to extend credit (Djankov et al., 2005). The

importance of high quality financial statements holds for both shareholders and bondholders and

it influences the reporting incentives of management.

Bondholders demand high quality financial statements of a company, especially of the earnings,

since they continuously want to assess the creditworthiness of the borrower and determine the

default risk. Where, for a shareholder of a diffusely held public company the cost of monitoring

are higher than the benefits, private debt holders are only willing to risk capital when they have

high quality information with which they can assess the risk of their loan (Ghosh and Moon,

2010). The larger the risk faced by the bondholder, the higher the risk premium he will charge

the firm (Sengupta, 1998). Shareholders also have a big influence on the precision of the

accounting quality due to their role at the time of debt maturity, Feltham et al. (2007) explain.

The choice between retaining the company and repaying the debt holders, or giving the firm to

the debt holders at the time of debt maturity, is done by the shareholders based on the accounting

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A high level of accounting quality can prevent the shareholders from retaining a bad firm or

abandoning a good firm.

The second effect of debt on the managerial reporting incentives can be explained by the debt

covenant hypothesis. With the issuance of debt comes a debt agreement which consists of debt

covenants. Debt covenants are often written in accounting numbers terms and are in place to

reduce incentive problems between creditors and managers. They protect the debt holders from

financing and investment decisions by management which reduces the debt holder’s claims

(DeFond and Jiambalyo, 1994). Creditors can withhold from supplying further credit, increase

the interest rate, and demand immediate repayment when debt covenants are violated (Roberts

and Sufi, 2009). The accounting choices which are made by managers are determined by the

likelihood of a violation of the debt covenants when covenants are based on accounting measures

(Dichev et al., 2002).

The acceleration rights of creditors when a financial covenant is violated could result in the firm

going bankrupt, providing creditors with the power to renegotiate the debt agreement and put

additional restrictions on the firm (Nini et al., 2009). Under the debt covenant hypothesis it is

assumed that in order to prevent the violation of accounting based debt covenants, managers

choose to increase the accounting income (DeFond and Jiambalyo, 1994). The incentive of

earnings management can still be present even when default cannot be prevented, since

increasing income can improve the managers’ bargaining position in times of renegotiation as

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Then, if one investigates the result of the two influences stemming from the debt level on the

managerial reporting incentive, a contrast is found as Ghosh and Moon (2010) explain. First the

level of debt can have a positive influence on the quality of the earnings. When the reported

earnings are more informative about the future economic performance of the firm, the creditor

risk effect will be decreased and therefore will lower the cost of future borrowing (Ghosh and

Moon, 2010). However, on the other hand there is also a negative influence on the quality of the

earnings which comes with high levels of debt. When a company has high levels of debt

financing, the costs stemming from a violation of debt covenants become larger and default risk

is increased (DeFond and Jiambalyo, 1994).

The increased risk of lender intervention and loss of control benefits can create an incentive for

using earnings management, even though this means borrowing costs will rise (Seifert and

Gonenc, 2012). The higher the costs and risk of debt covenant violation, the greater the

management incentive to manipulate accounting information (Dichev and Skinner, 2002). Gosh

and Moon (2010) found that the relationship between private debt and earnings management is

dependent on the level of debt a company has taken on. When the level of private debt (long +

short term debt to total assets) is higher than 41%, firms are willing to lower earnings quality

since the benefit of avoiding a violation of the debt covenants is higher than the increase in the

borrowing costs. With private debt levels which are lower than 41% Gosh and Moon (2010)

found that there is a positive effect between debt level and earnings quality, while a negative

effect is apparent when the debt level is above 41%.

2.2 Cross-listing in the US

When firms are located in countries with poor disclosure standards and weak supervision, the

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By cross-listing on a foreign exchange market, firms can overcome financial constraints in the

home country stemming from the weak regulatory environment.

Cross-listing makes foreign funds more easily available or cheaper than in the home country due

to an increased shareholders base and the possible decrease in the barriers of capital flows

reduces the company’s cost of capital (Pagano et al., 2002). Furthermore, by committing to the

disclosure and governance standards of the country in which the company chooses to cross-list,

the reputation with its stakeholders can be enhanced and thereby it can strengthen the company’s

competitive position (Pagano et al., 2002).

There is a difference between cross-listing in the United States or in other regulatory

environments. Foreign companies wanting to cross-list on the US stock exchange need to follow

the US GAAP regulation, making reconciliation of the shareholders’ equity and net income

necessary (Lang et al., 2006). Furthermore, the accounting laws and legal enforcement in the US

are thought to be stronger than in most other countries, making it more difficult for managers and

controlling owners to reap private benefits at the costs of the outside investors. This will have a

reducing effect on the agency costs related to external financing (Leuz, 2006). Moreover,

cross-listed firms are subjected to the SEC oversight with respect to their financial reports. The

oversight board can investigate violations of the security laws and seek for remedies when the

law is not followed (Lang et al., 2003). Where under the US GAAP regulation cross-listed firms

only needed to report reconciliations, the SOX of 2002 requires cross-listed firms to apply to the

auditing firms’ regulation and the management confirmation of the results (Lang et al., 2006).

Furthermore, annual reports on the internal control and the procedures’ effectiveness are required

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The level of which a foreign firm needs to adhere to the SOX, depends on the level on which the

foreign firm is listed on American exchange, unlike public companies based in the US, which

need to be fully compliant.

Litvak (2007) explains that there are four different levels in which foreign firms can be listed in

the United States. In order to select the foreign firms which are subjected to the financial

reporting requirements of the United States, one must select merely the firms which are

cross-listed on the American stock exchanges at level 2 and 3 (level II ADRs1 and level III ADRs) :

 Level II ADRs = foreign securities which are listed on US security exchanges (NYSE, AMEX, and others) or quoted on the NASDAQ. These firms comply with the full

registration and reporting requirements of the 1934 Exchange Act and SEC regulation.

 Level III ADRs = the public offering of foreign securities in the US which allows listing and trading on US exchanges and NASDAQ. Full compliance to various registration

requirements and rules of the 1934 Act is necessary for these firms listed on level III.

The strict regulation in the United States provides an incentive for cross-listing based on the

bonding theory; where cross-listing can be seen as a bonding device which provides a tool for

controlling insiders to reassure the outside investors (Leuz, 2006). By cross-listing the firms ties

itself to the regulatory environment of the US and the additional exposure to the SEC oversight

and litigation. The increased disclosure and the strong enforcement and litigation environment of

the US decrease agency costs as it becomes less costly for investors to monitor the behavior of

the managers in charge (Lang et al., 2006).

1_{American depositary receipt, a negotiable security that represents securities on a non-US company that trade in the}

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Furthermore, the benefits from cross-listing are found to be the greatest for firms from countries

with weak legal institutions, since the legal protection of US investors is similar when investing

in cross-listed or US domestic firms (Lang et al., 2003). By this reassurance of the outside

investors it becomes easier for a foreign firm to raise external financing (Leuz, 2003).

The SEC believes that the SOX regulations enhance comparable accounting data for US and

cross-listed firms of a similar quality. Nevertheless, the compliance to the foreign accounting

standards is found be different due to the legal environment, regulatory enforcement and

managerial incentives even when the regulation is the same in the basic principles, as Lang et al.

(2006) describe. Cross-listed firms often engage in what they call ‘reputational bonding’, where the actual ‘legal bonding’ is rather limited (Lang et al, 2006). Burgstahler et al. (2004) add to this by stating that often reporting incentives are overlooked when an attempt is made to improve the

accounting quality by harmonizing accounting standards. For cross-listed firms the obligation to

comply with the US GAAP regulation does not imply that the accounting quality is similar to

that of US based firms (Luez, 2003). Lang et al. (2006) found that the earnings from cross-listed

firms in accordance to the US GAAP show significantly more earnings management than their

US counterparts for the period 1991 until 2002. They argue that compliance of cross-listed firms

to the regulations of the SEC is unable to completely overcome the effect of the local regulatory

environment.

2.3 Creditor rights

For firms which are cross-listed in a country with a strict regulatory and legal environment, the

paper of Lang et al. (2006) show that there appear to be no full compliance to this strict

regulation. The degree of earnings management of cross-listed firms remains to be influenced by

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For example, the home-country investors’ protection is known to have an effect on several

corporate choices, such as financing and dividend policies and the ownership structure (Leuz et

al., 2003). The outside investors’ protection of a country is measured through the voting rights of

minority shareholders; taking the anti-director rights index from the research of La Porta et al.

(1998). However, in a later paper La Porta et al. (2000) explain that under corporate governance

it is the protection by the legal system which is crucial in protecting the minority shareholders

and creditors from expropriation by the controlling shareholders and managers of the firm. Not

only the strict regulation but also an increase in the effectiveness of enforcement makes

shareholders and creditors feel more protected. Furthermore, there exists a difference between the investors’ protection when looking at the shareholders or when considering the bondholders (La Porta et al., 1998).

Creditor rights are stated as being more complex than shareholders rights due to the different

strategies in case of a firm’s default (like liquidation and reorganization). Each of these strategies

asks for different creditor rights to be present, and often a firm has different types of creditors

making the protection of some creditors harmful to others (La Porta et al., 1998). For

shareholders the voting, reorganization and liquidation rights are an important part of the

investors’ rights, while for creditors the focus is more on legal enforcement by court; on the

regulators protecting them from bankruptcy and reorganization procedures (La Porta et al.,

2000). Under the power theory of Djankov et al. (2005) it is assumed that lenders will be more

willing to provide credit when they have more power; when they can gain control over the

company, force repayment or demand collateral. Besides, in times of financial distress, the risk

of managers losing their job is increased together with a decrease in their decision making power

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The power of the creditors is reflected in the creditor rights index which is constructed by La

Porta et al. (1998), measuring the legal rights of the creditors in the home country.

La Porta et al. (1998) were one of the first to think of a way in which to construct a measure for

the creditor rights within a country. The creditor rights measure is an index which is composed

out of the sum of four provisions which can each take on the value of one when the component is

present in the bankruptcy code of the country, and zero otherwise. The provisions, all concerning

bankruptcy or reorganization, are explained in several articles which use the measure of La Porta

et al. (1998) as a guideline (Acharya et al., 2011; Seifert and Gonenc, 2012; Djankov et al.,

2007). This first provision is called “no automatic stay”, providing a value of one when no law is

present in the country which puts an automatic stay on the firms’ assets in case of a

reorganization. In this way creditors can obtain their collateral when a reorganization petition is

signed. The second provision is called “reorganization”, measuring if the country imposes

restrictions like minimum dividend payments before a debtor can file for reorganization or creditors’ contention laws. “Secured debt first” is the third provision, scoring one when after a bankruptcy the assets will go to the secured creditors first instead of other creditors like

governments or employees. The last provision called “no management stay” provides part of the creditors’ strength as during a reorganization, management does not keep administration of its property since an official is assigned by court or by the creditors (Acharya et al., 2011). All taken

together a country can score between a zero and a four as to the strength of its creditor rights,

zero being weak and four representing strong creditor rights.

Creditors have more control rights in case of a firm’s bankruptcy when situated in a country

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The liquidation of poorly performing firms therefore becomes more apparent under strong

creditor rights as creditors want to liquidate firms which are insolvent (Akbel and Schnitzer,

2011). Furthermore, strong creditor rights can induce risk-reducing behavior of managers since

in times of default it can lead to an inefficient liquidation, or impose private costs to managers

when they are dismissed after bankruptcy (Acharya et al. 2011).

The agency costs of external financing can be reduced for companies from countries with a high

creditor rights value due to the subjection to tighter standards (Pagano et al., 2002; La Porta et

al., 2005). The lower risk stemming from extensive and well enforced creditor rights encourage

lending and increase the possibility for firms to raise external capital because of the lower cost of

capital (Pagano et al., 2002). The strong regulatory and oversight environment of the US has

been found to improve accounting quality for cross-listed firms by committing to an environment

of strong investors’ protection rights (Lang et al., 2006). However, for creditor rights the value

one indicates that the United States has weak creditor protection (Djankov et al., 2005). Hence,

the bonding theorem based on committing to strong creditor rights would not be suitable here,

but as will be argued below, the strength of the home-creditor rights can be influential on the

level of earnings management.

Being able to assess the risk of a financing project is highly related to the level of information a

lender is provided with. The more information that is available to the lender the more credit it

will extend, this is the main idea behind the information theories (Djankov et al., 2005). Roberts

and Sufi (2005) state that in order to obtain high quality accounting information, the loan

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The creditors of a company have power by imposing the firm with additional restrictions when a

violation of the private credit agreements occurs by renegotiating the terms of the loan agreement

(Seifert and Gonenc, 2012). It becomes difficult for companies to find alternative funding at

more favorable terms after a violation, which leaves an opportunity for the same creditors to

increase their power. Firms are then subjected to this power in order to secure the future

financing (Roberts and Sufi, 2005). Creditors are found to increase the interest spread, reduce the

accessibility of credit, or start demanding more collateral at the time of a debt covenants

violation (Roberts and Sufi, 2009). Especially when in the firm’s home country the rights of the

creditor are strongly protected by law, it becomes increasingly important for firms to prevent

debt covenant violations.

2.4 Combination of debt and creditor rights

As is mentioned in the two sections above, a firm’s reporting incentives can be influenced by the amount of debt a company uses, and the strength of the home-country creditor rights. These two

factors used in explaining the effect of debt financing on the level of earnings management both

have two alternative expected outcomes. For leverage there can be a decreasing influence when

following the argument of lower borrowing costs when reporting quality is high. While an

increasing influence is the result of a high risk of debt covenant violation. The same argument of

the risk of debt covenants violation can be made when creditor rights are strong. On the other

hand there is the argument that creditors are not easily fooled, resulting in managers’ incentives

to become in line with the wishes of the creditors to prevent creditors from gaining control over

the company. Especially when the power of the creditors is well enforced in the home-country,

the necessity to keep creditors satisfied is increased. Furthermore, the amount of leverage which

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First of all, the level of debt is influenced by the strength of the home-country creditor rights.

Pagano et al. (2002) finds that stronger investor’s protection reduces the agency costs related to

external financing, which results in a lower cost of capital. Therefore, strong home-country

creditor rights can increase the willingness of the lenders to provide capital and hence the

availability of debt to a company. However, Acharya et al. (2011) found a negative relationship

between the level of corporate leverage and the strength of the home-country creditor rights.

They state that willingness of companies to borrow decreases as strong creditor rights make

firms reduce the risk taking behaviour; cash flow risk as well as the default risk from taking on

debt.

For the combined effect of both explanatory variables on the level of earnings management a

combination of the different theories mentioned in the sections above needs to be made. When a

company, originating from a country with strong creditor rights, cross-lists on the US stock

exchange one can question the extent to which the creditors are concerned with the level of

earnings management. Bondholders demand high quality financial statements when it is

important to determine the creditworthiness and default risk of the borrower (Sengupta, 1998).

The resulting lower borrowing costs under this high reporting quality is the main argument of the

information theories, explaining the incentive of management to use reporting discretion

(Sengupta, 1998). However, in a country with a high level of creditor protection in times of

bankruptcy or reorganization and under strong legal rights, assessing the default risk is less

important according to the power theories. Creditors have strong control rights when

home-country creditor rights are strong; implying that creditors can gain control over the company,

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Furthermore, the need for strict debt covenants is less important when home-country creditor

rights are strong, which decreases the support for the argument of the debt covenant hypothesis

related to the level of leverage.

On the other hand when the company that cross-list in the US originates from a country with

weak creditor rights, another line of reasoning can be used. Now the bonding theory can have an

effect on the level of earnings management. The strong regulatory and oversight environment of

the US has been found to improve the accounting quality for cross-listed firms by committing to

an environment of strong investors’ protection rights (Lang et al., 2006). Under strong creditor

rights the likelihood of the liquidation of insolvent firms is increased as creditors have more

control rights. However, this effect is less likely when the creditor rights are weak. Then the

threat of liquidation is lower and hence the disciplining effect which debt can have is less

existent for companies (Akbel and Schnitzer, 2011). Creditors may feel the need to impose strict

debt covenants in order to protect themselves when home-country creditor rights are weak. Debt

covenants can also deliver power to the creditors by imposing acceleration rights, the option to

demand collateral in response to covenant violations, and creditors can put on capital expenditure

restrictions (Nini et al., 2009). Under the debt covenant hypothesis, managers want to prevent the

violation of debt covenantssince after a violation the terms of (additional and existing) financing

are worsened (Roberts and Sufi, 2009). As was explained, high levels of debt increase the costs

of a covenant violation and increase the default risk. Under weak creditor rights, the incentive of

using earnings management might be increased by the increased risk of lender intervention and

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2.5 Other explanatory factors for differences in earnings management

Several other factors, besides the ones described above, can explain for the difference in the level

of earnings management between cross-listed and US firms. One factor discussed in the literature

is the institutional environment of the home country. Lang et al. (2006) argue that the

compliance of cross-listed firms to the regulations of the SEC is unable to completely overcome

the effect of the local regulatory environment. Differences in the level of investors’ protection or

disclosure regulations may create different incentives for reporting discretion. The degree of

earnings management is thought to be increasing with the ability of insiders to reap private

benefits, while decreasing with the strength of the outside investors’ protection (Leuz et al.,

2003). There is a possibility for insiders to enjoy some value when not shared with outsiders.

However, if this is detected the outsiders will take disciplinary actions depending on the strength

of their rights. Leuz et al. (2003) found that in countries with strong investors’ protection there is

a lower managerial incentive to use earnings management over firms originating from countries

with weak investors’ protection as the ability of insiders to reap private benefits is reduced.

Second of all, the ownership structure can explain for the difference between cross-listed and

non-cross-listed firms in the reporting incentive. The level of ownership concentration can vary

from public to private and it determines the way in which the information is communicated; for

instance information about performance. Leuz (2006) shows that non-cross-listed firms have a

higher degree of ownership concentration when compared to cross-listed firms, and the

difference is even bigger when compared to US firms. When a firm only has a few large owners,

the communication of firm performance through public disclosures and financial statements

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Furthermore, when these owners can reap private benefits the incentive to hide firm performance

can be increased. This indicates a positive relationship between ownership concentration and

earnings management (Leuz, 2006). La Porta et al. (2000) link the two variables, ownership

concentration and investors’ protection by showing that countries with weak investors’

protection often have a higher ownership concentration than countries with strong investors’

protection.

3. Theory and Hypotheses

Many studies (Lang et al., 2006; Leuz et al., 2003; Burgstahler et al., 2004) address the fact that

the institutional environment has an important influence on the reporting incentives of firms,

like the strength of the home-country investor rights is found to be negatively related to the level

of earnings management (Leuz et al., 2003). In the paper from Lang et al. (2006) they show that

the cross-listed firms reconciling to the US GAAP have higher levels of earnings management

over firms from the United States, over a period from 1991 till 2002. It is argued that the

regulatory environment of the US was unable to overrule the local regulatory and legal

environment, which still has an influence on the reconciled financial reporting. The papers of

Leuz (2006) and Lang et al. (2006) both found that even though the reporting quality of the

cross-listed firms appear to improve, it is still not comparable to the reporting quality of US

firms. The incentive of cross-listed firms to reflect economic performance in their reported

earnings is weaker when compared to the US firms (Leuz, 2006). In order to prevent the results

on earnings management to be caused by changes in accounting regulation, the used timeframe is

that of when SOX came into effect. It will be checked if, for the sample used, it holds that:

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As is explained in the Literature section, the level of debt influences the incentive of managers to

use earnings management. However, the two main arguments used in explaining the effect of

leverage are contradictory. On one hand, the quality of financial information is highly important

for investors and financial institutions in order to be able to assess the risk of the investment

(Sengupta, 1995). Based on the information theory, the level of debt has a positive influence on

the quality of the earnings since future borrowing costs are lowered due to more informative

reported earnings. The higher quality of the financial statements decreases the creditor risk and

hence the risk premium which creditors will ask (Ghosh and Moon, 2010).

On the other hand there are papers which investigate the debt covenant hypothesis, where the

likelihood of violating accounting based debt covenants and the resulting default risk, influence

the accounting choices of management (Dichev et al., 2002). Feltham et al. (2007) found that the

accounting precision is decreased when a firm is performing poorly, in order to reduce the

probability of a violation of the debt covenant and the subsequent lender intervention.

Furthermore, the closer a firms comes to violating a debt covenants the more likely managers

choose accounting methods that increase income (Begley, 1990). The higher the level of debt

financing, the larger becomes the default risk and the higher the costs stemming from debt

covenants violations (DeFond and Jiambalyo, 1994). Research by Watts and Zimmerman in

1986 found that the probability of managers choosing accounting procedures which shift future

reported earnings to the current period, is increased when debt-equity ratios are high (DeFond

and Jiambalvo, 1994). Based on the two lines of reasoning, firms need to consider both

conflicting effects of earnings management. Assuming that one of the two will be present, the

exact influence is not clear. Therefore, hypothesis one is stated as followed:

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The requirement of highly informative and extensive accounting information is one of the

reasons why Roberts and Sufi (2009) question the idea that creditors can be fooled by the use of

earnings management. They state that on average creditors are well aware of accounting

manipulation due to their monitoring and originating loans experience. When a violation of the

debt covenants occurs, it becomes impossible for firms to obtain credit from new lenders at more

favorable terms. As a result the firm often stays with the same lenders. Due to this repeated

lending process between the same players, the incentive of companies to mislead its lender is

decreased. The security of future financing is too important for companies to take the risk of

creditor intervention (Roberts and Sufi, 2005). Especially, under strong creditor rights where

creditors are protected by regulators in case of bankruptcy or reorganization and enforcement is

effective, the risk of creditors taking control can provide incentive for reporting discretion.

Under this line of reasoning one would expect to see a negative relationship between the strength

of the creditor rights and the level of earnings management.

However, when firms are close to violating a debt covenant based on accounting numbers, one

could also argue that strong creditor rights will positively influence the level of earnings

management. In an attempt to prevent becoming subjected to the disciplinary actions of their

creditors, the incentive of managers to use earnings management could increase. When creditor

rights are strong, creditors are well protected by law and they can force more restrictions on a

company, replace management or liquidate the firm (Acharya et al., 2011; Akbel and Schnitzer,

2011). Furthermore, Seifert and Gonenc (2012) state that in countries with strong creditor rights

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Increasing accruals to cover up for poor cash flow results, or trying to signal sustainable

company performance, are known methods used by managers which reflect evidence of earnings

management (Lang et al., 2006; Degeorge et al., 1999). The two alternative effects of creditor

rights found in literature lead to the second hypothesis, implying that creditor rights have an

effect but which effect is strongest is not clear from literature:

H2: The strength of the home-country creditor rights has an effect on the level of earnings management

When combining the effect of the firm specific level of leverage with the creditor rights as

present in the country of origin, all effects described above can influence the level of earnings

management. Leverage can decrease the incentive to use earnings management based on the

information theory (Djankov et al., 2005), while increasing the incentive when following the

debt covenant hypothesis line of reasoning (Dichev and Skinner, 2002). Then, for home-country

creditor rights, there is the power of the creditors which makes managers act in line with

providing high quality earnings reports as a result of the liquidation rights (Acharya et al., 2011).

While on the other hand managers might not want to risk covenant violations when the legal

protection of the creditors is high in the home-country (Robert and Sufi, 2009). Last, two

opposing effect are also mentioned in literature when describing the relationship between the

home-country creditor rights and leverage. Strong creditor rights will increase the willingness to

supply credit, but it may also lead to a decrease in the level of debt due a decrease in the risk

taking behavior on the side of the firm (Acharya et al., 2011). Therefore, it is assumed that when

taken the effect of leverage and home-country creditor rights together, it will have an impact on

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This results in hypothesis three:

H3: The level of debt financing in combination with the home-country creditor rights will have an effect on the level of earnings management

In answering these hypotheses, several additional variables have to be added to control for the

effect they have on the level of earnings management, or to explain partly for differences

between cross-listed and US firms that do not stem from earnings management. First of all, Lang

et al. (2006) include size since cross-listed firms are found to have a larger market value of their

equity over US firms. Second the level of sales growth will be included as growth is known to

systematically affect the level of accruals and working capital (Burgstahler et al., 2004); high

levels of discretionary accruals and working capital are predominantly present at high growth

firms since these suffer most from earnings surprises (Dechow et al. (2000)). Furthermore,

cross-listed firms have a higher growth level as the availability of funds to finance growth is one of the

driving forces to cross-list in the US (Pagano et al., 2002). Third, cross-listing can be used as a

tool for companies that have run out of their debt capacity but when they require funding

(Pagano et al., 2002). Cross-listing in the US by European companies was found to be done by

companies with a strategy to expand their equity, where after cross-listing the equity issuance

was found to be increased for firms from weak-investors’ protection countries (Pagano et al.,

2002). Therefore, the increasing ability of firms to raise (cheaper) external capital results in the

need to control for equity and debt issuance (Lang et al., 2006). Last, the variable asset turnover

is included since it influences the level of accruals due to the capital intensity, which is also

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4. Methodology

The JP Morgan’s ADR database of cross-listed firms provides companies that are cross-listed in the United States from the years 1969 until 2012. However a large part of the sample did this

after 2001 (253 out of 450), hence the timeframe of the analysis needs to be carefully selected in

order to be left with a reasonable amount of observations. Furthermore, in 2002 the Congress of

the United States passed the SOX Act of 2002 which is designed to improve corporate

governance and restore investors’ confidence (Li et al., 2008). If through this regulation there has

been a replacement of the local regulatory and legal environment by the SEC regulation,

restricting the level of earnings management for in the US cross-listed European firms, is a

question which is not yet answered. In order to prevent the regression results to be altered by an

effect that results from the change in reporting regulation, the time period of the analysis will not

include the period before the SOX; it is set for 2002-20112. A short description of all

abbreviations used in this section is provided in appendix Table A.

Lang et al. (2006) use two different proxies which capture the incentive of managers to smooth

the earnings. First they state that the variability of earnings is expected to be lower when firms

are applying earnings smoothing, and this can be measured indirectly by the volatility of

earnings deflated by total assets. Since there is a strong connection between the volatility of the firms’ cash flows and the volatility of net income, a first proxy is constructed by adjusting for the variability of the cash flows. In this way the outcome is driven by the effect of the accruals and

not the result of smoother cash flows streams (Lang et al., 2006).

2_{Data for 2012 is not yet available, and the data on 2001 will be lost when taking the differences or percentage}

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Besides the incentive of managers to report sustainable company performance, managing the

level of accruals is a strategy that is used by corporations in meeting a certain earnings

benchmark or meeting analysts’ forecasts. High levels of abnormal accruals indicate less

managerial discretion in the reporting of the earnings (Dechow et al., 2000; Payne and Robb,

2000; Li et al., 2008). The second proxy is found by applying a more direct approach by

considering the correlation between the accruals and the cash flows. According to Lang et al.

(2006), managers are increasing accruals in a response to poor cash flow results. Between

accruals and cash flows there is generally a negative correlation, but the degree of this negative

relation suggests the level of earnings smoothing (Leuz, 2006; Lang et al., 2006).

In order to compute the first proxy of earnings management one needs to compute the earnings

variability. In the paper of Lang et al. (2006) this proxy can be found by performing a regression

analysis on the changes of annual net income (scaled by total assets), pooling the US firms and

cross-listed firms on the control variables, and then taking the residuals. In this manner Lang et

al. (2006) take into account the different firm and country characteristics before the computation

of the proxy for earnings management; the residuals of the regression analysis. Nevertheless,

Leuz (2006) found empirical evidence that it does not matter if first the control variables are

added, or if the proxies are calculated and then a regression analysis is run of the proxies on the

cross-listed indicator while adding the control variables. Since the same results are found in the

application of the two different methods, the method of Leuz (2006) will be followed in this

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The proxy which captures the level of earnings smoothing is therefore calculated by taking the

ratio of the standard deviation of net income to the standard deviation of net cash flows:

(1)

Where, is the standard deviation of the annual net income for company i, and denotes

the standard deviation of net cash flow from operating activities. The net cash flow from

operating activities can be calculated by taking the operating income minus the value of the

accruals (Leuz, 2006). In determining the value of the total accruals the following formula is

used provided by Leuz (2006); ACC = [(∆ total current assets - ∆ cash and equivalents) – (∆total

current liabilities - ∆ short term debt - ∆ income taxes payable) – depreciation expenses)]. I

define as the level of total accruals of the firm. In line with Leuz et al. (2003), when a company does not provide data on the short term debt and/or taxes payable, the change in the

variable is assumed to be zero. Increased evidence of earnings management is reflected by the first proxy by means of a lower value of , indicating less volatile earnings.

The second proxy of earnings smoothing is calculated by taking an approach which is more

direct; the correlation between the net cash flow from operations and the accruals. There

naturally exists a negative correlation between cash flow and accruals (Lang et al., 2006), but the

degree of this negative correlation provides a measure for the degree of earnings management.

Increasing the accruals when cash flows are weak is known to be a method of applying earnings

management. The second proxy is then found by:

(2)

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reflects the operating cash flow which is also scaled by the total assets at the end of year t.

Increased evidence of earnings management in this case means a stronger negative correlation ( ); poor cash flow outcomes are smoothed by an increase in the accruals. The two proxies of earnings management are computed when there are 3 or more3 observations per firm for the

variables used in the calculations (Leuz, 2006) and all input variables are winsorized at the 1st

and 99th percentile.

In order to answer the research question, one needs to work with several companies looking at

the degree of earnings management. This implies that in order to test the hypotheses, one need to

perform a regression analysis on cross-sectional data. In order to test the two hypotheses the

statistical program EViews 7 is used in to perform ordinary least squares regressions (OLS) on

the equations which are developed in this section. Since two different proxies are used for the degree of earnings management, checking if cross-listed firms engage more in earnings

management than US firms will be done by two regression analyses where the dependent variable will take on the value of the different proxies ( - ).

(3)

Where, reflects a dummy variable indicating if the ith firm is cross-listed or a US based firm; giving a value of one when cross-listed and a zero otherwise. The control variables , and reflect the log of the market value of the equity at the end of the year, and the annual percentage change in sales respectively. For each company i the average of the period 2001-2011

is then calculated.

3_{The sample that is used provided at least four observations per firm for each variables used in the computation of}

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The values for and are found by taking the percentage change in the liabilities and common stock during year t and then taking the firm’s average. is the ratio of total sales over total assets at the end of year t, taking the average for each firm to compute the ith firm’s asset turnover. As is explained above, lower values of and reflect more evidence of earnings management. Therefore a negative sign of in equation 3, which is significantly

different from zero, provides evidence for cross-listed firms to exhibit a greater tendency to

smooth the reported earnings. It is expected that the incentive of cross-listed firms to reflect

economic performance in the reported earnings is weaker than for US firms. In order to correct

for a possible intra-industry effect on earnings management, industry dummies will be added to

all regression analysis. These industry dummies are composed based on the one-digit SIC

(standard industrial classification) codes, where code zero is used as the base industry.

In checking the hypotheses which are stated in the Theory and Hypothesis section equation 3

will be slightly altered. The level of leverage is added as an independent variable in the

regression equation. As is explained in the Literature section 2.4, the strength of the creditor

rights and the level of leverage are related to each other. Therefore, in order to solely capture the

effect of the level of leverage, a two stage regression will be used to lose the influence of the

creditor rights on the leverage variable. First leverage is regressed on the home-country creditor

rights:

(4)

The dependent variable denoted by , reflects the ratio of total liabilities to total assets for firm i at the end of time t and then taken the average for the period 2001-2011. provides the strength of creditor protection for the country of origin of company i, measured by the index

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The strength of home-country creditor protection can take on a value between 0 - 4, where zero

indicates weak protection and four represents strong protection. The variation in the level of

leverage, which is not reflected by the variation in the strength of the creditor rights, is reflected in the error term of the regression equation 4 ( ). The residuals will serve as the independent variable in the regression analysis testing hypothesis one:

(5)

Here the independent variable reflects the value of the residuals from equation 4. The sign of will provide the effect of debt financing on the different proxies of earnings management,

answering the first hypothesis:

H1: The level of debt financing has an effect on the level of earnings management

Fromequation 5 it becomes apparent that, in order for leverage to have an effect on the level of earnings management, the regression coefficient needs to be significantly different from zero. Furthermore, higher levels of earnings management mean a lower variability of earnings, and a

more negative correlation between accruals and cash flows. Hence, a negative sign of the

regression coefficient when using one of the two proxies would indicate a higher level of

earnings management. The first hypothesis can be tested by a two-sided t-test based on the

following hypothesis testing:

and

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In testing hypothesis two, one needs to remove the independent variable which represent the

level of debt financing from equation 5 and add the independent variable which accounts for the

strength of the creditor rights. In regression equation 6, reflects the strength of creditor protection for the country of origin of company i, measured by the index as is computed by

Djankov et al. (2007). The value of the index is stated to be highly stable over time, therefore it

is assumed that the values from the paper of Djankov et al (2007) will hold over the time period

investigated (2002-2011).

(6)

By running an OLS regression on equation 6 above one will obtain an answer to the second hypothesis, looking at the coefficient estimate of the creditor rights variable ( .

H2: The strength of the home-country creditor rights has an effect on the level of earnings management

Finding support for this hypothesis can be found in the same manner as for the first hypothesis. If

the regression coefficient of creditor rights is significantly different from zero then the null

hypothesis below can be rejected. Stronger home-country creditor rights are represented by a

higher value of . Therefore, the sign of can tell if the effect of creditor rights has a positive or a negative influence on the level of earnings management. Higher levels of earnings

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and

When taking the level of debt financing together with the creditor rights in trying to explain for

the level of earnings management, an independent variable is added being the cross term of the

strength of the creditor rights times the debt to equity ratio of company i at time t. The third

hypothesis can therefore by tested by the following equation:

(7)

H3: The level of debt financing in combination with the home-country creditor rights will have an effect on the level of earnings management

For hypothesis three to be true, the regression coefficient of the combined term home-country

creditor rights times leverage will be tested with a two-side t-test on the following hypothesis:

and

Firm level leverage and the home-country creditor rights have an effect on the level of earnings

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5. Data and Descriptive Statistics

In order to answer the research question, choices have to be made when determining the sample

and the data that needs to be collected of a number of dependent and independent variables. The

most important ones will be discussed here as well as the statistics on these variables.

5.1 Cross-listed and US firms

When looking at firms which are cross-listed in the US, Litvak (2007) explains that there are

four different levels in which foreign firms can be listed in the United States. In order to select

the foreign firms that are subjected to the financial reporting requirements of the United States

one must select merely the firms which are cross-listed on level 2 and 3 (level II ADRs4 and

level III ADRs) on the American stock exchanges as explained in the Literature section. In order

to identify these types of firms, the depository receipt directory of JP Morgan is used5. With this

ADR (American depository receipt) database the firms which are cross-listed on the American

stock exchanges NASDAQ, NYSE and NYSE ALTERNEXT (an integration of the AMEX and

Alternext European small-cap exchange) are selected by combining the databases of the Bank of

New York, Citibank, Deutsche Bank and JP Morgan. Furthermore, this database indicates on

which level the cross-listed firms are listed on the American exchange, making it possible to

exclude level I and level IV ADRs6. The NASDAQ, NYSE and the NYSE ALTERNEXT are

chosen since listing on these stock exchanges comes with the requirement to file reconciliations

(Lang et al., 2006).

4

American depositary receipt, a negotiable security that represents securities on a non-US company that trade in the US financial markets (Wikipedia.org)

5_www.adr.com_{accessed on the 13}th_{of January 2013;}

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The SOX regulation makes that firms which are cross-listed on these markets are subjected to the

regulation and oversight of the Security and Exchange Commission (Duarte et al., 2007).

For the firms originally stemming from the US, the S&P 500 is used. Following the study done

by Burgstahler and Dichev (1997), banks, financial institutions and firms in regulated industries

should not be used when trying to explain for the determinants for the level of earnings

management since several alternative objectives can play a role. For firms in regulated industries

there can be an incentive to report lower earnings to the regulators, while for the financial

institutions the incentive to report positive/increasing earnings can be the result of regulatory

oversight. Therefore, firms with SIC codes between 4400-5000 and 6000-6500 are not part of the

sample. Then for the data on the explanatory variables used in the regression analyses the

database provided by DataStream will be examined for the selected sample of firms. Firms for

which DataStream does not provide sufficient information will be excluded. Three firms are

excluded since they do not provide more than 3 observations for the variables necessary to

compute the two proxies of earnings management. This leaves one with a sample size of 459

firms. Where, 121 firms, originating from 25 countries, are cross-listed in the United States

against 338 US firms.

5.2 Degree of earnings management

In order to compute the two proxies of earnings management, which encompass the objective of

earnings smoothing from the paper of Lang et al. (2006), DataStream is used to collect the data

on the variables necessary in computing the net income, cash flows and accruals. This data was

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Since, in the calculation of the accruals one needs to work with differences of the variables

needed in the calculation, the observation for the year 2001 is lost for each of them. Then for all

firms independently the standard deviation is taken from the descriptive statistics which EViews

provides for the variables net income and cash flow, given a firm have more than three

observations. For the second proxy one needs to perform a covariance analysis in EViews,

requesting the correlation between the accruals and the cash flows for each firm i over the time

period. In this way one goes from panel data of 459 firms over the years 2002 – 2011, to

cross-sectional data with 459 firm-level observations. Both dependent variables are then winsorized at

the 1st and 99th percentile.

The descriptive statistics of the two proxies are depicted on the next page in Table 1, for a more

extensive table see appendix Table B. There appears to be no real differences in the level of

earnings management when comparing the cross-listed sample with the sample of US firms. The

biggest difference between the two samples is present for the second proxy of earnings

management (∆mean = -0.047); the correlation between the operating cash flow and the accruals.

When comparing the mean and median of the different proxies of earnings management between

the cross-listed sample and the US sample using an equality test in EViews, the t-value indicates

that there is no significant difference between the mean/median of the two samples. Hence, the

average value of earnings management for cross-listed firms is not significantly different from

the average value of the sample of US firms.Similar to the study of Leuz et al (2006), the sign of

the mean and median value of the first proxy is positive and negative for the second proxy. On

average the firms from the sample have a positive variability of earnings and a negative

Earnings management, cross-listing and the effect of debt financing on a firm’s reporting incentives