The regulation change in consolidation rules and the incentives for earnings management activities via related party transactions

ABSTRACT

Boundaries of consolidated reporting entities vary between International Financial Reporting Standards (IFRS) and U.S. Generally Accepted Accounting Principles (GAAP). Based on the rules-oriented conceptual framework, U.S. GAAP adopts the ownership-based consolidation approach (ARB 51), while IFRS adopts the control-based approach that is more principle-oriented (IAS 27). Exploiting a unique setting which took place in Taiwan that switched from U.S. GAAP to IFRS in consolidation rules in 2005, this study investigates how the regulation change affects the feasibility to manage earnings via related party transactions (RPTs). Our findings support the predominant role of earnings management incentives for RPTs. Further evidence shows that parent firms conducting more RPTs with their subsidiaries are inclined to hide them from consolidation under ownership-based consolidation. This intention to avoid consolidation, however, is substantially restrained when switching to the control-based consolidation approach. In addition, firms employ real earnings management to substitute for earnings management via RPTs after control-based consolidation approach is adopted. In particular, our results weakly support that better corporate governance is able to mitigate the shift to other kinds of earnings management after the regulation change for those firms with a higher tendency to avoid consolidation. In short, our study complements prior studies that find relative costliness drives the earnings management decision.

KEYWORDS:

• Consolidated financial statements
• control-based approach
• ownership-based approach
• earnings management
• related party transactions

Disclosure statement

No potential conflict of interest was reported by the authors.

Notes

1. In addition to the entrenchment nature behind RPTs, such transactions also serve as a response to incomplete markets where legal enforcement and contracting are relatively difficult, i.e. efficient contracting perspective for RPTs (Khanna and Yafeh 2007). Benefiting from less information asymmetry, RPTs result in a reduction in hold-up problems, and thus, lower transaction costs (Fisman and Wang 2010). This advantage is further documented to be positively associated with higher firm performance (Chang and Hong 2000; Wong, Kim, and Lo 2015), lower audit fees (Habib, Jiang, and Zhou 2015). However, we are not intending to discuss the efficient contracting perspective in this study for the following reasons. First, there is little evidence for the relationship between the efficient contracting perspective of RPTs and earnings quality. Among the few, empirical results regarding RPTs and financial misstatements are inconclusive (Kohlbeck and Mayhew 2017). Similarly, it is difficult to draw a meaningful prediction between our variables of interest in this article. Namely, we are likely to postulate an insignificant association between the tendency to avoid consolidation and the frequency of employing RPTs. In addition, documenting an insignificant (significant) result does not seem to validate (invalidate) the efficient contracting hypothesis since agency and efficient contracting perspectives are not mutually exclusive. Further, insignificant results may only reflect statistical questions such as lack-of-power in our tests. To avoid confusion, we focus on agency perspectives.

2. We also conduct Hausman tests to confirm if endogeneity exists in our proxy for incentives to manage earnings, i.e. HAB_BEAT. P-values for our two regressions in Table 8 are 0.603 and 0.416, respectively, indicating failure to reject the null hypothesis of no endogeneity.