Does internal capital market efficiency affect earnings management of diversified firms? Abstract

Transcription

1 Does internal capital market efficiency affect earnings management of diversified firms? Abstract This paper investigates whether internal capital market efficiency affects earnings management of multi-segment firm. We argue that diversified firms have more earnings management due to high information asymmetry. Internal capital market can enhance firm performance, whereas managers will not use accruals to boost earnings. We find that internal capital market efficiency can reduce earnings management of diversified firms. We also consider downward and upward earnings management, other internal capital market efficiency measurements. The results still support our main finding. Keywords: Earnings Management, Internal Capital Market Efficiency, Diversification

2 Does internal capital market efficiency affect earnings management of diversified firms? Introduction This paper investigates whether internal capital market efficiency affects earnings management of multi-segment firm. Previous literatures find that diversified firms do earnings management (Jirapon, Kim and Mathur, 2008; Lim, Thong, and Ding, 2008; and Rodriguez-Perez and Hemmen, 2010). They argue that since the organizational structures are complex, outsiders have to pay more cost and attention on collecting and analyzing financial reports from diversified firms. Therefore, due to complex organization, the information asymmetry between insider and outsider of diversified firm allows managers of diversified firms pursue their self-interests by managing earnings. Theoretically, the benefit of diversification is to finance profitable projects via internal capital market and to avoid underinvestment problems. Within diversified firms, capital demand segments and capital supply segments construct internal capital market. Once internal capital market can reach to efficiency, the equivalent of capital demand side and supply side should increase firms performance. In other words, if internal capital market is efficient, the winner-picking effect (Stein, 1997) will induce top managers to close unprofitable segments and to reallocate resources to profitable segments. Since efficient internal capital market keeps managers allocating resources in profitable segments, the outcome of efficient internal capital market will increase earnings and reduce managers motivation to manipulate earnings. Previous literatures only consider diversification can reduce earnings management due to lower cash flow volatility or induce earnings management due to information asymmetry. However, this paper further improve that internal capital market efficiency can dominate managers behave on earnings management strategy. The research question of this paper is whether internal capital market efficiency affects earnings management of diversified firm? Diversification might induce earnings management. Due to the organization complexity of diversified firms, outsider financial reports users have to pay more resource and costs to collect and analyz financial data from diversified firms. Therefore, an information asymmetry is existing between diversified firms and investors. Rodriguez-Perez and Hemmen (2010) argue that the complex structures of diversified firms cause an information asymmetry between insiders and outsiders of diversified firms. In naturally, diversified firms have complexity structures and product lines. Therefore, outsiders of diversified firms cannot accurately estimate profitability of each division. This information asymmetry, however, gives opportunistic managers a room to pursue their interests. Jiraporn, Kim, and Mathur (2008) argue that managers of diversified firms would like to take their

3 information advantage to manipulate earnings for their self-interests. Recent literatures try to discuss the relationship between diversification and earnings management from several aspects. Lim, Thong, and Ding (2008) state that the managers of diversified firms have an incentive to manage earnings before conducting seasoned equity offering. (SEOs). They argue that the information asymmetry gives managers a room to manipulate earnings when they need to do it (such as SEOs). Rodriguez-Perez and Hemmen (2010) find that debtholders of diversified firms cannot play a monitoring role on alleviating earnings management. They argue that due to complexity structure of diversified firms, there is an information asymmetry between debtholders and diversified firms. Therefore, when the degree of diversification is high, debtholders cannot efficiently monitor the managerial behaviors. These papers posit that information asymmetry is a main driver on triggering earning management. However, these papers overlook the real drivers behind the managerial earnings management. Diversification might reduce earnings management. Barton (2001) argues that earnings volatility can be decomposed into cash volatility and accruals. At a given earnings volatility, once cash volatility is lower, then manager would not use accruals to manipulate earnings. Under this concept, more diversified firms would not manipulate earnings. Since cash flow comes from each uncorrelated segment of diversified firms, the cash flow volatility of diversified firms would not be affected by certain industry characteristics (Berger and Ofek, 1995). Therefore, at a given earnings volatility, less cash flow volatility would reduce managers of diversified firms to use accrual for manipulating earnings. If internal capital market is efficient, it might reduce the managers incentive to manage earnings. Since winner-picking allows managers to reallocate the resources from unprofitable segments to the profitable segments, efficient internal capital market keeps diversified firms profitable. Stein (1997) indicates that under the efficient internal capital market, top managers have power to allocate resource to the segments with valuable projects. Billett and Mauer (2000) document that when firms are with high internal capital market efficiency, they should distribute the resources to the segment with higher return. If so, higher internal capital market efficiency would contribute firm value. High internal capital market efficiency can let managers efficiently allocate capitals from capital supply segments to capital demand segments. At the equivalent point, where the profit reaches to maximization point, firms performance would be enhanced, and managers don t need to use accrual to manage earnings for enhancing earnings. Previous literatures document several factors will affect internal capital market efficiency. Berger and Ofek (1995) indicate that related diversification can improve

4 internal capital market efficiency. They argue that diversified firms can allocate resource and skills among related segments, whereby, they can reduce their production cost and extend their economic scope. Stein (1997) and Khanna and Tice (2001) indicate that diversified in core business can make winner picking more efficiently. They argue that headquarters familiar with core business and can correctly judge the potential profitability of each related segment. Shin and Park (1999) and Xuan (2009) argue that comparing efficient internal capital market, socialism effect will allow diversified firms allocate their resource to the segments with poor performance for reducing the perk-seeking of segment managers. Whereby, socialism effect will reduce internal capital market efficiency. Financial constraint restricts internal capital market efficiency. Shin and Park (1999), Billet and Mauer (2003) argue that diversified firms with less finance constraint can invest profitable projects by using either internal capital or external financing. In contrast, financial constraint might limit investment of diversified firms. Billet and Mauer (2003) further indicate that efficient internal capital market allow diversified firms transit resources to the segments with financial constraint but profitable. Shin and Park (1999) also argue that efficient internal capital market makes firms to invest high growth potential segments. Biddle, Hilary, and Verdi (2009) argue that firms have different operation decisions at different stages of business cycle. They find that higher frequencies of loss negatively affect firms capital expenditures. They also posit that bankruptcy cost and firm size might affect capital investment. Internal capital market efficiency posits that headquarters winner-picking effect allows headquarters to allocate the resources from the segments with poor performance to the segments with profitable performance. Since efficient internal capital market can allocate resources well, it will positively affect earnings. Therefore, managers would not have to manipulate earnings to a certain level. We hypothesize that internal capital market efficiency is negatively associate with earnings management. To examine our hypotheses, we obtain segment data from COMPUSTAT Industrial Segment Files (CIS) and Geographical Segment Files (CGS) over the period Further, we subtract financial data from COMPUSTAT. By following our sample selection rule, we get 11,046 firm-year observations. For examine our hypothesis, first we examine the relation between earnings management and diversification. Second, we further examine whether internal capital market efficiency would affect earnings management of diversified firms when we control the characteristics of diversified firms. Next, we concern that internal capital market efficiency might be affected by earnings quality (Biddle, Hilary, and Verdi, 2009). We use simultaneous equation to control following endogenous effects. These

5 endogenous variables are firm size, bankruptcy cost, financing constraint, growth potential, refocus effect, related industry diversification, socialism, frequency losses, geographically diversification, year and industries effects. For our earnings management equation, we control leverage, refocus effect, profitability, outstanding shares, growth potential, firm size, geographically diversification, financial constraint, year and industries effects. Our earnings management measurements are absolute value of discretionary accruals and estimated by cross-sectional Jones model (Jones, 1991), cross-sectional Modified Jones model (Jones, 1991), and performance-matched Jones model (Kothari, Leone, and Wasley, 2005) and performance-matched modified Jones model (Kothari, Leone, and Wasley, 2005). By following Billet and Mauer (2003), we define internal capital market efficient is the sum across a firm s business segments of the product of each segment s subsidy or transfer and relative efficiency, scaled by the sum of segment assets. After we control these variables, we examine whether internal capital market efficiency is negatively associated with management earnings. The main findings support our hypothesis. First, we find that diversified firms have less earnings management, comparing to focus firms. Second, before we control endogenous effect, our findings weakly support our hypothesis, which diversified firms with efficient internal capital market have less earnings management. Third, after we control endogenous effect, our findings strongly support our hypothesis. These findings support Barton s (2001), Jirapon, Kim and Mathur s (2008) argument that diversified firms have less earnings management. These findings also support Berger and Ofek s (1995) argument that efficient internal capital market might enhance firm performance. Therefore, profitable investment via internal capital market makes earnings reach a certain level where managers don t have to manage it. Our robustness test also supports our hypothesis. By following Billet and Mauer (2000), we use alternative internal capital market efficiency measurements which are considering internal capital market is efficiency if the sum across segments of the product of each segment s excess capital expenditures and its industry-adjusted return on investment. Segment capital expenditures are in excess of segment of before-tax cash flow and after-tax cash flow. We also use simultaneous equations to consider endogenous effects. We find that diversified firms with efficient internal capital market have less earnings management. Furthermore, we consider the direction of earnings management. We classify earnings managements into upward earnings management and downward earnings management. After we control these two types of earnings management, the results still support our hypothesis. This paper contributes literatures in two dimensions. First, previous literatures document that diversified firms have lower earnings management (Barton, 2001;

6 Jiraporn, Kim, and Mathur, 2008). They argue that unrelated cash flow of each segments help diversified firms have constant cash flow, therefore, they don t have to keep certain level of earnings volatility by using accruals. However, this paper document that whether diversified firms will do earnings managers is depending on how internal capital market efficiency is. If earnings reach a certain level due to efficient internal capital market, managers don t have to manipulate higher earnings. Second, previous literature indicates that high quality financial reporting improve investment efficiency (Biddle, Hilary, and Verdi, 2009). Our paper finds that efficient investment via internal capital market also improves earnings quality. The remainder of the paper process as follows. Section 2 develops the hypotheses. Section 3 describes the research design. Section 4 presents the main results. Section 5 presents robustness test. Section 6 concludes. Literature Review This paper investigates how internal capital market efficiency affects earnings management of diversified firms. In this section, we will discuss the following parts and try to develop our hypothesis: (1) how the characteristics of diversified firms affect earnings management? (2) how internal capital market efficiency affect the drivers of earnings management of diversified firms? How do the Characteristics of Diversified Firms Affect Earnings Management? Due to complex structure of diversified firms, outsiders will have to pay more resources on collecting and analyzing data from diversified firms. Basically, diversified firms are served more information asymmetry than focused firms. Based on information asymmetry between insiders and outsider of diversified firms, most previous papers argue that diversified firms have more earnings management than it in focus firms. However, this paper tries to argue that diversified firms might not manage earnings. Healy (1985), Defond and Jiambalvo (1991), Burgstahler and Dichev (1997) argue that manager could influence the accounting process and adjust earnings in response to the performance requirement. Thus, due to the interest conflict between managers and shareholders, the higher level of information asymmetry gives managers more room to engage in earnings management once the complex organizational structure hides what managers do from shareholders. Watt and Zimmerman (1986) argue that manager bonus plan and debt covenant violation are the main drivers of earnings management. Healy (1985) and Scott (2006) argue that managers will manage earnings to maximum their bonus under their bonus plan. Scott (2006) also argues that managers would manage earnings to avoid debt covenant

7 violation, and so as to skip heavy violation cost, such as to constraint their freedom of investment decisions. Therefore, earnings management could be a mechanism to reduce the probability of debt covenant violation. Dye (1988), Trueman and Titman (1988) document that the presence of information asymmetry is a necessary condition for earnings management. High level of information asymmetry between managers and shareholders is evidence of shareholders lacking sufficient resources, incentives or access to relevant information to monitor manager s actions (Schipper, 1989; Warfield, Wild, and Wild, 1995). When asymmetric information problem is severed, managers could easily hide what they do and engage in earnings management. Richardson (2000) finds that information asymmetry is positively associated with the managerial earnings management. Jensen and Meckling (1976) argue that when firm s management is separated from ownership, it will arouse the interest conflict between managers and shareholders. Thomas (2002), Rodriguez-Perez and Hemmen (2010) argue that the diversification increases organizational complexity, and leads the information asymmetry exists between diversified firms and external capital market. For example, Jiraporn, Kim and Mathur (2008) indicate that once the firms operate cross many industries and countries, the structures of firms will be more complexity. Due to complexity operation structure, outsiders (such as, analysts, investors) have to do more effort on collecting and analyzing on firms earnings report from different industries and countries. Therefore, the information asymmetry would be increasing in diversified firms. The degree of information asymmetry between managers and outsiders may be difference in diversified firms and focused firms. Due to complex organization structures, diversified firms may cause higher level of information asymmetry between inside manager and outside shareholders. Goldberg and Heflin (1995) argue that when a firm is more diversified, its information environment will be more complex. When the outside financial report users of the firms with multi-industry divisions want to collect and judge firms earnings information, they have to pay more attention and resources on it. For instance, managers of diversified firms know the amount of the cash flow of each division separately and, hence, could easily access divisional cash flows. However, outsiders could observe only consolidated amount of divisional cash flows. Thus, the pattern of divisional cash flows may be obscure to outsiders, and reported earnings will convey less value-relevant information. Based on the assumption that accounting numbers for diversified firms are less informative relative to those of focused firms, asymmetric information problems are severe more in diversified firms. Jirapon, Kim and Mathur (2008) document that due to information asymmetry

8 between diversified firms and outsiders, diversification would exacerbate earnings management. Lim, Thong, and Ding (2008) claim that due to information asymmetry between diversified firms and investors, diversified firms would like to manage their earnings before they conduct seasoned equity offerings (SEOs). They argue that comparing to focused firms, diversified firms have more complexity structure than focused firms, therefore, information asymmetry will serves in diversified firms worse compared to focus firms. Since SEO firms have strong incentives to manipulate their earnings before SEOs, diversified firms would have higher degree of earnings management than focused firms do when they conduct SEO. Geographically diversification might increases complexity. Shroff, Verdi, and Yu (2011) argue that once foreign subsidiaries operate in the countries with less transparent information environments, there is an information asymmetry between subsidiaries and headquarters. Therefore, headquarters might inefficiently allocate resource to the subsidiaries with poor growth potential. Watt and Zimmerman (1986) states that given covenant violation can impose heavy costs, firm managers will be expected to avoid them. Manager will even try to avoid being close to violation, because this will constrain their freedom of action in operating the firm. Thus, earnings management can arise as device to reduce the probability of covenant violation in debt contracts. Ahn and Choi (2009) argue that borrowers would manage their earnings, because they consider consequences of debt covenant violation would be costly to firms. The consequences of violating debt covenant are increasing in interest rates or request for early repayment, et al. Rodriguez-Perze and Hemmen (2010) argue that whether debt covenant induces or reduces earnings management depends on the level of diversification. They argue that debt can induce managers to enhance earnings and to avoid costs of debt covenant violation. In contrast, debt can play monitory role in reducing managers to manage earnings. If firms have huge amount of debt, it is worth for banks or debtholders to incur monitoring costs on limiting managerial opportunism behavior. However, the monitoring effectiveness of debtholders is depending on how much information transparency it is. They argue that the complex structure of diversified firms would likely to reduce information transparency. It could let mangers of diversified firms to get benefits from conducting earnings-enhancing earnings management. The number of outstanding shares might induce earnings management. Zang (2006), Cohen and Zarowin (2010) state that higher number of outstanding shares requires more earnings management to hit a certain per share earnings benchmark. Growth opportunities might increase earnings management. Alnajiar and Riahi-Belkaoui (2001) argue that growth opportunities and information asymmetry

9 might increases earnings management. Since higher growth opportunities would have higher profitability, managers would try to downward earnings to avoid political cost. Previous literatures have well documented that information asymmetry is a main factors of driving earnings management. Diversified firms have high information asymmetry in nature. Based on previous literatures, we construct our first hypothesis: Hypothesis 1: Diversified firms do more earnings management than focus firms do. How does Internal Capital Market Efficiency Affect the Drivers of Earnings Management of Diversified Firms? In the capital market, someone has capital demand and someone is capital supplier. When the demand side and supply side reach to equivalent quickly and can maximize their utility, this market can be so called efficient market. In diversified firms, there are capital demand segments and capital supply segments, which construct a capital market within diversified firms. Headquarters play a role on keeping this market more efficient. They have power to allocate resource (capital) from segments with poor performance to segments with good performance. Myers and Majluf (1984) indicate that the information asymmetry between firms and markets forces firms to forgo valuable investment projects rather than financing these projects from external capital market. However, diversification can create internal capital market where can finance investment projects without facing external capital market inefficiency. Shin and Park (1999) argue that due to information asymmetry between insiders and outsider of firms, external financing is relatively more expensive than internal financing. Williamson (1975), Stein (1997), Khanna and Tice (2001) indicate that internal market is more efficient than external market since headquarters of diversified firms have more knowledge on their investment opportunities than external market does. Moreover, Matsusaka and Nada (2002) indicate that benefit of internal capital can help firm to avoid external market inefficiency and finance their investment project without incurring the cost of external financing. Winner-picking improves internal capital market efficiency. Stein (1997) states that if firms have higher degree of internal capital market efficiency, they would have control rights to shift their funds from one project to another valuable project, so call winner-picking. Once firms practice winner-picking, firms can create value without outside financing. Billett and Mauer (2000) argue that if the firms with efficient internal capital market would like to allocate their resource on the segments with higher return. If so, higher internal capital market efficiency would contribute firm value. Previous literatures documents that the benefits of diversification including greater operating efficiency, allocating internal capital to fiancé valuable projects,

10 greater debt capacity. Lewellen (1971) indicates that the one of the benefit of diversification is the coinsurance effect which allows diversified firms to enlarge their debt capacity. Brealey and Myers (1999) show that once the higher leverage firms with shortage cash flow, the conflicting between various debtholder and stockholder would increase. In order to skip this conflict, managers might consider diversifying to exploiting coinsurance effect. Comparing to concentrated firms, diversified firms hold more assets. Therefore, it could lower financial distress probability and increase debt capacity. Stein (1997) indicates that the assets of one division of diversified firm can be collateral as firms raise external capital to finance other divisions of diversified firm. Hoshi, Kashyap, and Scharfstein (1991) document that diversified firms have less financial constrain, contrast to concentrated firms, external capital market would likely to finance diversified firms. Nayyar (1993) also document that diversified firms can depend on their good reputation in their industries and large economic scale to get external finance easily. Shin and Park (1999) also argue that diversified firms can lower external financing cost because of their size, diversified cash flows and cross-payment guarantees. According to above literatures, we conclude that diversification can enhance debt capacity because of its coinsurance effect. Actually, the coinsurance effect should depend on how efficiency of internal capital market it is. Amit and Livnat (1988) document that the diversification can stably supply internal cash flows and reducing underinvestment problem. Whereby, once internal capital market is more efficient, managers would not face risk of debt covenant violation, since efficient internal capital market can keep generate stable cash flow and repay debt regularly. Barton (2001) indicates that diversified firms have less earnings management because of their stable cash flow. Earnings volatility includes cash flow volatility and accrual. Base on this concept, he argues that at a given earnings volatility, when cash flow volatility is low, managers would not use accrual to reach a certain level of earnings volatility. Biddle and Hilary (2006) document that there is a positive relationship between accounting quality and investment efficiency. They argue that higher quality accounting can reduce information asymmetry between managers and outsiders of firms. Since information asymmetry between mangers and outsiders of firms could induce adverse selection and moral hazard problems, firms would face underinvestment problem. If managers could disclose their private information and make accounting information more transparency, outsiders of firms might not buy the stock at inflected price. Therefore, higher quality accounting might reduce underinvestment problem by eliminating information asymmetry. Since diversified firms have complexity structure, outsiders of diversified firms

11 have to pay more resource and costs to collect and analysis financial data. Whereby, diversified firms have more information asymmetry than focused firms do. Previous literatures try to examine whether information asymmetry triggers earnings management in diversified firms. Jirapon, Kim and Mathur (2008) argue that due to information asymmetry between diversified firms and outsiders, diversification would exacerbate earnings management. Lim, Thong, and Ding (2008) find that diversified firms would like to manage their earnings before they conduct seasoned equity offerings (SEOs), because diversified firms have higher information asymmetry than focused firms do. Rodriguez-Perez and Hemmen (2010) indicate that debtholders can t play a monitoring role on managerial earnings management of diversified firms. They argue that diversified firms have stronger information asymmetry than focused firms. Therefore, debtholders can t efficiently monitor managers and eliminate earnings management of diversified firms. Previous literatures only focus on the relationship between diversification and earnings management, but override the drivers of earnings management in diversified firms. Watts and Zimmerman (1986) indicates that managers would like to manipulate earnings for their bonus plan and avoiding debt covenant violation. Jirapon, Kim and Mathur (2008) and Rodriguez-Perze and Hemmen (2010) argue that complex structures of diversified firms increases information asymmetry and induces managers to conduct earnings management for pursuing their self-interests. However, these factors could be eliminated if internal capital market is efficient. According to Stein s (1997) winner-picking theory, high efficient of internal capital market would invest valuable project. Billett and Mauer (2000) argue that if the firms with efficient internal capital market would like to allocate their resource on the segments with higher return. If so, high internal capital market efficiency would contribute firm value. If firms with higher internal capital market efficiency should reduce the managers incentive to manage earnings to a certain level for their own interests. Previous literatures indicate that efficient internal capital market can improve firms performance. If that is a case, managers would not manipulate earnings to boost firms performance. Based on the inference, we construct following hypothesis: Hypothesis 2: Diversified firms with efficient internal capital market have less earnings management. Methodology Data Resource, Testing Period We subtract segment data from COMPUSTAT Industrial Segment Files (CIS) and the Geographic Segment file (CGS) over the period Since SFAS No. 131 has a new requirement from 1997, we start to obtain segment data from 1997.

12 Further, because firms in financial industry (SIC codes ) have different regulations and characteristics of their financial information, we exclude these firms for imcomparable to other industries. To control extreme value, we winsorize our variables with upper and lower extreme value 1% of total sample. All the variables for Jones model, modified Jones model, internal capital market efficiency model, and control variables of our regressions are obtained from COMPUSTAT. Measurement of Main Variables Accrual Estimation For measuring earnings management, we estimate accruals with main estimation models: cross-sectional Jones model (Jones, 1991), cross-sectional Modified Jones model (Jones, 1991), and performance-matching Jones model (Kothari, Leone, and Wasley, 2005) and performance-matching modified Jones model (Kothari, Leone, and Wasley, 2005). For the first two measurements, first, we use balance sheet approach to compute total accrual (TA) by using model (1): TA t = Current Assets t Cash t Current Liabilities t + Current Maturities of Long-Term Debt t Depreciation and Amortization Expense t (1) Where Current Assets t is the change in current assets in year t (Compustat data #4); Cash t is the change in cash and cash equivalents in year t (Compustat data #1); Current Liabilities t is the change in current liabilities in year t (Computat data#5); Current Maturities of Long-Term Debt t is the change in debt included in current liabilities in year t (Compustat data #34); and Depreciation and Amortization Expense t is depreciation and amortization expense in year t (Compustat data #14). Second, we estimate α 1, α 2, and α 3 for each industry-year specific by using model (2): TT ii A ii 1 = α 1 A ii 1 + α 2 RRR ii A ii 1 + α 3 PPP ii A ii 1 + ε ii (2) Where TA it = total accruals for firm i in year t A it-1 = net total assets for firm i in year t-1, REV it = change in revenue for firm i from year t-1 to year t, PPE it = gross property plant and equipment for firm i in year t, ε it = error term for firm i in year t. We use two-digit SIC as industry-specific. Then we use α 1, α 2, and α 3 estimated from model (2) to calculate nondiscretionary accruals (NDA) in year t with model (3). NNN ii A ii 1 = α 1 A ii 1 + α 2 RRR ii A ii 1 + α 3 PPP ii A ii 1 + ε ii (3) Third, we also calculate absolute value of nondiscretionary accrual (NDA) estimated by model (3). Fourth, by following Modified Jones (1991) Model, we

13 consider change in net receivables ( REV it ) in year t with model (4). NNN ii A ii 1 = α 1 + α A 2 ( RRR ii AA ii ) + α 3 PPP ii + ε ii 1 A ii (4) ii 1 A ii 1 Where REV it is change in net receivables (Computat data#2) in year t, and the α 1, α 2, and α 3 are estimated by industry-year from equation (2). The other variables are as same as in equation (3). Finally, we calculate absolute value of nondiscretionary accrual (NDA) estimated by model (4). We also follow Kothari, Leone, and Wasley (2005) to measure earnings management by using performance matched accrual. The estimation of discretionary accruals is same as Jones model and Modified Jones model. However, performance matched discretion accrual further to minus the matched firm s discretionary accruals. By following Kothari, Leone, and Wasley (2005), we use ROA of year t to fine a matched firm. This logic of this procedure is to concern that firms with excess performance have high possibility to manipulate earnings (Kothari, Leone, and Wasley, 2005). Therefore, firms are classified as high degree of earnings management when they manage earnings more than their comparison sample. Internal Capital Market Efficiency Billett and Mauer (2003) argue that efficient internal capital market can improve firm value. Internal capital market can enhance firm value when firms allocate their resources from a segment with poor investment opportunities and large financing constraint to a segment with good investment opportunities and small financing constraint. By following Billett and Mauer s methodology, we estimate internal capital market efficiency of diversified firms as following procedures: First, we classify which segment is subsidy or transfer. We classify segment is subsidy when its capital expenditure larger than its after-tax cash flow. SSSSSSS i = mmm(ccccc i AAAA i, 0 ) (5) where CCCCC i is segment i s capital expenditure. AAAA i is segment i s after-tax cash flow. We calculate after tax cash flow as follow: AAAA i = (EEEE i I i )(1 T i ) + D i (6) where EEEE i is segment i s earnings before interest and taxes. I i is segment i s imputed interest expense. We use the median ratio of interest expense to sales of single segment firms in segment i s industry to be segment i s interest rate. Segment i s imputed interest is equal to sales times imputed interest expense rate. T i is segment i s imputed tax rate. We use the median ratio of taxes paid to pretax income of single segment firms in the segment i s industry. We base on four-digit SIC to classify industry groups. The value of SSSSSSS i is larger than 0 when segments capital expenditure larger than their after-tax cash flow.

14 Second, we calculate how many resources are potentially transferred from contributors to subsidies. If the value of SSSSSSS i is equal to 0, segment i will classified as transfer. We compute segment i s potential transfer of resources as follow: PPPPPPPPP i = mmm AAAA i wddd j CCCCC i, 0 (7) where w is the ratio of segment i s assets to the sum of the assets of the transfer segments. DDD j is the cash dividend paid by the firm j. PPPPPPPPP i indicates how many resources can contribute into internal capital market from contributors (PPPPPPPPP i >0). Third, we calculate how many resources are exactly transferred from contributors to subsidies. TTTTTTTT i = mmm PPPPPPPPP i, PPPPPPPPP i n i=1 PPPPPPPPP i n ( i=1 SSSSSSS i ) (8) where the TTTTTTTT i is minimum of its potential transfer and its weighted share of total internal capital market subsidies. Forth, we classify our transfers or subsidies as efficient or inefficient by using segment s excess return on assets (ROA). Subsidy is classified as efficient if return on assets of segment i (ROA i ) larger than average return on assets (RRR ) of the firms remaining segments. In contrast, Transfer is classified as efficient if return on assets of segment i (ROA i ) less than average return on assets (RRR ) of the firms remaining segments. Fifth, Billett and Mauer (2003) argue that financing constraint is the driver of internal capital market efficiency. By following their method, we estimate a logit model of the possibility of not paying cash dividend of all single segment firms. We include investment opportunity (market-to-book ratio), size (log of total assets), return on assets, assets turnover rate, year effect and industry effect (two-digit SIC codes). We assume that each segment of diversified firms would has its dividend policy if it were single firm. For each year, we estimate the possibility of not paying dividend of each segment by inputting into segment fitted Q, size (log of total assets), return on assets, assets turnover rate. Fitted Q is estimated by taking all single firms within the same two-digit SIC code into the following regression: Q jj = β 0 + β 1 SSSS jj + β 1 CCC jj +β 1 TT jj + ε jj (9) where Q jj is the Tobin s Q of single segment firm j in a same two-digit SIC industry in year t; SSSS jj is the log of total asset of single segment firm j in year t; CCC jj is the ratio of earnings before interest, taxes, and depreciation to total assets of single segment firm j in year t; TT jj is the assets turnover rate of firm j in year t. Sixth, we use two dummy variables to classify segments of each diversified firm into two groups. If ROA i >RRR then Positive i is equal to 1, else it is equal to 0. If

15 probability of not paying cash dividend is larger than 0.5 then Constrained i is equal to 1, else it is equal to 0. Seventh, we calculate internal capital market components for each diversified firms. n (RRR i RRR )(SSSSSSS i )(CCCCCCCCCCC i )(PPPPPPPP i ) EEEE = i=1 (10) n TT (RRR i RRR )(SSSSSSS i )(1 CCCCCCCCCCC i )(PPPPPPPP i ) EEEE = i=1 (11) n TT (RRR i RRR )(SSSSSSS i )(CCCCCCCCCCC i )(PPPPPPPP i 1) IIII = i=1 (12) n TT (RRR i RRR )(SSSSSSS i )(1 CCCCCCCCCCC i )(PPPPPPPP i 1) IIII = i=1 (13) n TT (RRR RRR i )(TTTTTTTT i )(1 PPPPPPPP i ) EEE = i=1 (14) n TT (RRR RRR i )(TTTTTTTT i )(PPPPPPPP i )( 1) III = i=1 (15) TT where TA is the sum of segment assets. Subsidy Segment Efficient Subsidy (ROA i >ROA ) Inefficient Subsidy (ROA i <ROA ) Financing Constrained ESCS ISCS Not Financing Constrained ESNS ISNS Transfer Segment Efficient Subsidy (ROA i <ROA ) Inefficient Subsidy (ROA i >ROA ) ETS ITS Finally, we sum up all the components of internal capital market efficiency to internal capital market efficiency (ICM). If internal capital market is more efficient, then the value of ICM is larger. ICM=ESCS+ESNS-ISCS-ISNS+ETS-ITS (16) We use dummy variable to proxy internal capital market efficiency. If diversified firms with high internal capital market efficiency (ICM>0) then Efficiency is equal to 1, else Efficiency is equal to 0. Product Diversification We also use dummy variable (DIVERSIFICATION) to proxy diversification. If firms with more than 1 segment, we would classify these as diversified firm. Thus, DIVERSIFICATION is equal to 1, otherwise, it is equal to 0.

16 Control Variables For controlling firms specific characteristics affect earning management, we consider debt violation risk (Leverage), refocus (HINDEX), profitability (ROA), the natural logarithm of the number of share outstanding (Log(SHARE)), size (Log(AT)), growth potential (CAPXR), information asymmetry (GEO), and financing constraint (Constraint). Ahn and Choi(2009) argue that managers would manipulate earnings to avoid debt covenant violation. Jiraphorn, Kim and Mathur (2008) argue diversified firms might manipulate earnings due to information asymmetry. Once diversified firms reduce their degree of diversification (Refocus), they might reduce information asymmetry. Therefore, we use Herfindahl index to proxy refocus effect. Higher HINDEX, lower refocus effect it is. Herfindahl index, which is suggested by Jacquenmin and Berry (1979), is calculated across n business segments as the sum of the squares of each segment i s sales, S i, as a proportion of total sales: n i=1 ) 2 HHHHHH = 1 { n i=1 S 2 i /( S i } (17) Where HINDEX = Herfindahl index S i n = Sales of 4-digit SIC code i = Total number of different 2-digit SIC codes. All the analyses in the paper are based on the number of 4-digit SIC codes. In order to compare to the results under Herfindahl index, we use 1 minus original Herfindahl index which intuitionally understand that the larger the Herfindahl index, the higher degree of the diversification. Zang (2006), Cohen and Zarowin (2010) state that higher number of outstanding shares require more earnings management to hit a certain per share earnings benchmark. Therefore, we control the number of share outstanding (Log(SHARE)). We also consider profitability (ROA), size (Log(AT)), and growth (CAPXR) in our regression. Bens and Jiraporn, Kim and Mathur (2008) argue that growth opportunities and information asymmetry might increases earnings management. By following Jiraporn, Kim and Mathur s argument, we use capital expenditures (CAPXR) to proxy growth opportunities. Geographically diversification might increases complexity. Shroff, Verdi, and Yu (2011) argue that multination segments companies have more information asymmetry, because foreign subsidiaries might operate in the countries with less transparent information environments. Therefore, we consider geographically diversification (GEO) into our regressions. To measure the complex structures of diversified firms, we follow Jiraphorn, Kim and Mathur (2008) and use

17 geographic segment file. If firms repot foreign sales in the CGS file, then we classify these firms as geographically diversified firms (GEO). Dechow, Ge, Larson, and Sloan (2011) indicate that firms will misstatement when they need external financing. In other words, if firms have financing constraint, earnings quality would be high. Therefore, we consider financing constraint (Constraint) to proxy motivation of managing earnings. For controlling the firms specific characteristics affect internal capital market efficiency, we use earnings quality (Accruals), size (Log(AT)), bankruptcy cost (Tangibility), financing constraint (Constraint), growth potential (Sales growth), refocus effect (HINDEX), information asymmetry between headquarter and segment managers (Core business), socialism (Social), frequent losses (Loss), and complexity of operating structure (GEO). Biddle, Hilary, and Verdi (2009) argue that high earnings quality can reduce the information asymmetry between firms and investors, therefore. They find that earnings quality is positively associated with investment efficiency. Biddle, Hilarty, and Verdi (2009) also indicate that firm size, bankruptcy, sales growth, and frequency of losses might affect investment efficiency. Billet and Mauer (2003) indicate that financing constraint is the driver to affect internal capital market efficiency. They argue that efficient internal capital market can allocate resources to a segment with a growth potential but has financing constraint. Therefore, we consider financing constraint into our internal capital market efficiency regression. Khanna and Tice (2001) indicate that top managers have more knowledge about related businesses. Therefore, they can distinguish which investment project is profitable. We use Herfindahl index to proxy refocus effect. Berger and Ofek (1995) indicate that diversified firms invest in core business can enhance firm value because of less information asymmetry between headquarter and segment managers. Shin and Park (1999) argue that headquarter will allocate more resource to the segments with poor performance to prevent perk-seeking of the managers of these segments, so call Socialism. Therefore, if firms have higher capital expenditure but low Tobin s Q, they might have Socialism. We use dummy variable (Social) to proxy socialism effect. If firms are classified as high capital expenditure and low Tobin s Q, Social is equal to one, else it is equal to zero. Shroff, Verdi, and Yu (2011) argue that geographical diversified firms will have information asymmetry between headquarter and the segments located in less transparency countries. If that is the case, these firms will have inefficient investment. Appendix A presents the variables definition. Research Design We test our hypotheses in four ways. First, we use univariate tests to examine whether diversified firms have more earnings management than focused firms do. Then we test whether earnings management in diversified firms with efficient internal

18 capital market has significantly different from it in diversified firms with inefficient internal capital market. Second, we examine the generous relation between earnings management and diversification strategy. We want to look at how diversification strategy affects managers behavior on managing earnings. Third, we directly look at diversified firms and examine whether internal capital market efficiency could affect earnings management of diversified firms. Forth, we consider endogenous effect of internal capital market efficiency. We use simultaneous equations to examine whether internal capital market efficiency can reduce earnings management of diversified firms after we consider endogenous effect. For examine our first hypothesis, we use three ways to test it. First, we use t-test to examine whether earnings management in diversified firms is significantly different from it in focused firms. Second, we use person correlation matrix to examine this relationship. Third, we examine the generous relation between earnings management and diversification strategy. We argue that diversified firms have more earnings management, because of more information asymmetry in diversified firms. Therefore, we construct following model: EE = β 0 + β 1 DDDDDDDDDDDDDDD t + β 2 LLLLLLLL t + β 3 RRR t + β 4 LOG_SHROUT t + β 5 LLL_AT t + β 6 CCCCC t + β 7 GGG t + β 8 CCCCCCCCCC t + β 9 YYYY + β 9 IIIIIIII + ε t (18) We predict that higher degree diversification is positively associated with earnings management, since more information asymmetry existing between insiders and outsiders of diversified firms. For examine our second hypothesis, we use three ways to test it. First, we use t-test to examine whether earnings management in diversified firms with efficient internal capital market is significantly different from it in diversified firms with inefficient internal capital market. Second, we consider internal capital market efficiency into our regression and test whether internal capital market efficiency of diversified firms negatively affects earnings management. For testing our hypothesis 2, we directly examine how internal capital market efficiency affects earnings management of diversified firms. We construct the model as follow: EE = β 0 + β 1 EEEEEEEEEE t + β 2 LEEEEEEE t + β 3 HHHHHH t + β 4 RRR t + β 5 LOG_SHROUT t + β 6 LLG AA t + β 7CCCCC t + β 8 GGG t + β 9 CCCCCCCCCC t + β 9 IIIIIIII + β 10 YYYY + ε t (19) EFFICIENCY is the dummy variable for internal capital market efficiency. It is equal to one, if diversified firms have efficient internal capital market (ICE1_SALE>0). Other variable are same as model (7). We predict that diversified firms with high internal capital market efficiency are negatively associated with earnings management. We test it by looking at coefficient

19 β 1. Third, we consider internal capital market might be affected by other factors. Therefore, we will construct simultaneous equations to control endogenous effect. We construct the model as follow: EEEEEEEEEE t = β 0 + β 1 EE t + β 2 LLL_AA t + β 3 TTTTTTTTTTT t + β 4 CCCCCCCCCC t + β 5 SSSSS_GGGGGG t + β 6 HHHHHH t + β 7 CCCC_BBBBBBBB t + β 8 SSSSSS t + β 9 LLLL t + β 9 GGG t + β 10 IIDUUUUU + β 10 YYYY + ε t (20) EE = β 0 + β 1 EEEEEEEEEE t + β 2 LLLLLLLL t + β 3 RRR t + β 4 LLL_SSSSSS t + β 5 LLL_AA t + β 6 CCCCC t + β 7 GGG t + β 8 CCCCCCCCCC t + β 9 HHHHHH t + β 9 IIIIIIII + β 10 YYYY + ε t (21) Empirical Results Descriptive Statistic Table 1 show the descriptive statistic of whole samples (including diversified firms and focus firms). The mean value of absolute value of discretion accruals are 0.25, 0.25, 0.18, and 0.18, estimated by Jones Model ( JONES ), Modified Jones Model ( MODIFIED JONES ), Performance Matched Jones Model( KOTHARI JONES ), Performance Matched Modified Jones Model ( KOTHARI MODIFIED JONES ), respectively. The mean value of diversification (DIVERSIFICATION) is equal to 0.43, which means 43% of our observations are classified diversified firms. We also find that the mean value of geographical diversification (GEO) is 0.44, which means 44% of our observations are classified geographical diversification firms. <Table 1 Inserts Here> Table 2 shows the descriptive statistic of diversified-firm sample. The mean values of absolute value of discretion accruals are 0.22, 0.22, 0.26, and 0.26, estimated by Jones Model ( JONES ), Modified Jones Model ( MODIFIED JONES ), Performance Matched Jones Model( KOTHARI JONES ), Performance Matched Modified Jones Model ( KOTHARI MODIFIED JONES ), respectively. The mean value of financing constraint (Constraint) is 0.59, which over half of our sample firms are having financing constraint. The mean value of refocus (HINDEX) is 0.36, which means diversified firms prefer adopt refocus strategy instead of more product lines. The other evidence also shows the similar results. The mean value of core business (Core Business) is 0.57, which means over half of diversified firms are diversified in core business related industries. The mean value of geographically diversification (GEO) is 0.33, which means 33% of our samples are geographical diversified firms. <Table 2 Inserts Here> Panel A of Table 3 shows our t-test on main variables within the diversified firms and focus firms. We find that diversified firms have less earnings management, less

20 financing constraint, larger size. These findings support Barton s (2001) findings that diversified firms have less earnings management, because diversified firms have less motivation to manipulate earnings. Panel B of Table shows our t-test on main variables within the diversified firms with inefficient internal capital market and diversified firms with efficient internal capital market. We find that diversified firms with efficient internal capital market have less earnings management. This finding supports our hypothesis that internal capital market efficient can reduce earnings management. <Table 3 Inserts Here> Table 4 shows the correlations among our variables. We find that internal capital market efficiency (Efficiency) is negatively associated with our earnings management variables ( JONES, MODIFIED JONES, KOTHARI JONES, KOTHARI MODIFIED JONES ), which support our argument that efficient internal capital market enhances earnings due to allocate resources into segments with good growth potential. Therefore, managers would not to manipulate earnings to boost earnings to required level. We also find that refocus (HINDEX) is negatively associated with our earnings management variables, which support Barton s (2001) document that diversified firms would have less earnings management, because lower cash flow volatility reduces managers to use accruals to reduce earnings volatility. Socialism (Social) is associated with earnings management variables, which means that headquarter allocate resources to the segments with poor performance to prevent the perk-seeking of the managers of these segments (Shin and Park, 1999). <Table 4 Inserts Here> At the beginning of our multivariable test, we examine whether diversification induces earnings management. Lim, Thong, and Ding (2008) argue that diversified firms have more information asymmetry than focused firms do. They document that diversified firms would manipulate earnings before they conduct SEOs. However, Barton (2001) argues that diversification can smooth cash flow volatility, therefore, diversified firms wouldn t use accrual to reduce earnings volatility. Table 5 indicates that diversified firms have less earnings management than focused firms. The coefficient on Diversification is negative. Based on the results of table 5, we further examine whether internal capital market efficiency of diversified firms can play an important role on alleviate earnings management. <Table 5 Inserts Here> Table 6 presents whether internal capital market efficiency can alleviate earnings management of diversified firms. If internal capital market is efficient, earnings should reach to a certain level, where managers would not manipulate earnings to get to. Table 6 presents the results. We only find that internal capital market efficiency