Do Firms with Captive Financial Subsidiaries Manage Earnings More Successfully?

Transcription

1 Do Firms wih Capive Financial Subsidiaries Manage Earnings More Successfully? Nikolay Halov Rady School of Managemen Universiy of California, San Diego Lubomir P. Liov Universiy of Arizona Preliminary and Incomplee This draf Nov 5h, 2010 Absrac We find ha conglomeraes wih financial subsidiaries end o have worse reporing qualiy han sand alone firms and conglomeraes wih no financial subsidiaries: hey have higher discrepancy beween operaing income and operaing cash flow and higher signed abnormal accruals. We aribue hese differences in reporing qualiy o several facors. Firs, such firms are less likely o access ouside capial markes in response o inernal capial needs; second, financial subsidiaries may help conglomeraes beer shif income o lower ax subsidiaries hrough he srucure of inercompany loans. We also argue ha financial subsidiaries may faciliae earnings managemen hrough he allowance for uncollecible loans. 1

2 I. Inroducion The Generally Acceped Accouning Principles, or GAAP, allow managers o use judgmen in financial reporing of earnings. The pracice of adjusing repored earnings up or down o mislead some sakeholders abou he underlying economic performance of he company or o influence conracual oucomes ha depend on repored accouning numbers is commonly referred o as earnings managemen. A cenral ask for invesors is o undersand how informaive managed earnings are of he rue economic sae of he reporing firm. In he Unied Saes, naional banks are prohibied from owning general commercial enerprises and vice versa. However holding companies are allowed o conrol subsidiaries ha engage in aciviies ha are closely relaed o banking, such as credi card companies, leasing companies insurance companies and ohers. In his paper we find ha conglomeraes wih financial subsidiaries end o have worse accouning reporing qualiy han sand alone firms and conglomeraes wih no financial subsidiaries: hey have higher discrepancy beween operaing income and operaing cash flow and higher abnormal accruals. We aribue hese differences in reporing qualiy o several facors. Firs, less need for exernal marke access: firms wih inernal capial markes are less likely o need o disclose o ouside marke as here does no exis need o access hese markes; second, income smoohing: financial capive segmens help conglomeraes beer shif income o he lower ax subsidiaries hrough he srucure of inercompany loans. In addiion, we argue ha financial subsidiaries faciliae earnings managemen hrough he allowance for uncollecible loans/bad deb expense. This is consisen wih managers ha are overly conservaive wih heir allowance for 2

3 uncollecible loans when he non financial side of he firm has higher han expeced earnings. In urn, when in need, managers could resae ha allowance downward in order o mee or bea analyss' forecass. The accouning lieraure has raised he quesion wheher he mandaory consolidaion of he capive financial subsidiaries, subsequen o FASB Rule 94 of 1987, effecive in 1988, may have lead o less informaive financial saemens of conglomeraes ha have financing capive subsidiaries. We define earnings qualiy as an earnings sream more closely associaed wih fuure cash flows from operaions. Beneish (2001) argues ha accruals he difference beween a firm s repored earnings and is cash flows is he componen of earnings ha is mos sensiive o managerial discreion over accouning sandards. Many models in he accouning lieraure proxy for firm s level of earnings managemen by esimaing he porion of is repored accruals resuling from managerial discreion. We follow he convenion in his lieraure and esimae discreionary accruals using he modified Jones (1991) model (see Table 1 for deails of he calculaion.) These discreionary accruals proxy for he degree o which a firm manages is earnings up or down. II. Lieraure review and hypohesis developmen For reviews of he earnings managemen lieraure, see Healy and Wahlen (1999) and Fields, Lys and Vincen(2001). For discussions of he benefis and drawbacks of focusing on oal accruals raher han individual accrual accouns, see McNichols and Wilson (1998) and McNichols (2000). 3

4 We nex seek an explanaion for he differen qualiy of accouning for firms ha have financial subsidiaries. Firs, conglomeraes wih financial subsidiaries arguably have less need o access exernal capial markes and hence are less likely o disclose informaion o he marke analyss and invesors. 1 ). Hence he accouning qualiy of hese firms would be differen (worse). Nex, we consider income smoohing. Financial subsidiaries help conglomeraes beer shif income o he lower ax subsidiaries hrough he srucure of inercompany loans (see Gramlich Limpaphayom, and Ghon Rhee, 2004, for evidence of ha in Korean chaebols.). To es for ha we can check wheher subsequen o he addiion of a financing subsidiary here is smoohing of he overall income. We can also check wheher subsequen o he removal of a financial subsidiary (e.g., carve-ou, divesiure, or spinoff) here is an increase in he cash flow volailiy. In addiion, firms wih financial subsidiaries may be more prone o do earnings managemen o proec he privae benefis of conrol of self-ineresed managers who have chosen o incorporae financial segmens in heir corporae srucure. If hese managers underperform hey can hide underperformance hrough he use of loans from capive financial segmens. To es for ha we can inerac he managerial incenive alignmen proxies (inernal he CEO compensaion, dela, vega, bonus, cash; board size, independence; audi commiee size and independence; exernal acive shareholders ownership; classified board and poison pill adopion) wih he financing subsidiary 1 a esable hypohesis based on his conjecure is ha ha he financing defici of conglomeraes wih financing subsidiaries is less han he one of conglomeraes wihou financing subsidiaries; consequenly he issuance of equiy and deb in overall share of asses would be less han i would be for conglomeraes wihou financing subsidiaries 4

5 dummy and show ha he posiive relaion of financing subsidiary on earnings managemen is increased when he firm has managers ha are more self-ineresed. Finally, prior sudies ha have examined discreionary behavior wih respec o allowance-relaed accrual accouns sugges an addiional reason why conglomeraes wih capive financial subsidiaries may find earnings smoohing easier. McNichols and Wilson (1988) model bad deb expense as a funcion of hree economic deerminans, which explain a subsanial fracion of he variaion in bad deb expense. Their resuls sugges ha firms manage earnings by recording income-decreasing discreionary bad deb expense when earnings are exreme. Teoh, Wong and Rao. (1998) find ha he scaled allowance for uncollecible accouns is smaller for IPO firms han for mached public firms. Marquard and Wiedman (2004) find ha firms manage receivables and revenues in response o equiy offerings and managemen buyous. Caylor (2009) finds ha firms manage deferred revenue and receivables o avoid missing analyss earnings forecass. Jackson and Liu (2010) furher examine wheher firms record lower bad deb expense (including income-increasing bad deb expense) o avoid negaive earnings surprises. Capive financial subsidiaries have larger deb porfolios han manufacuring firms and hence can record relaively higher (smaller) bad deb expenses wih which o counerbalance lower (higher) han expeced earnings in he remaining segmens of he conglomerae. Overall we expec o find worse accouning performance of firms wih financing subsidiaries ha is due o eiher heir lower need for exernal capial marke access, o heir relaive ease in abiliy o smooh income, or o heir managers being self-ineresed. 5

6 III. Daa In his secion, we provide a brief descripion of he variables used in our models. The sample is from 1984 o 2007 and he daa is from Compusa Indusrial Annual and Compusa Segmens daabases. Furher deails on he compuaion of each variable can be found in Table 1. We seek o measure wo underlying characerisics when building proxies for accouning qualiy in conracing. The firs one relaes o measures of overall qualiy of accouning repors. Second one relaes o he discreionary accruals Oher measures of accouning reporing qualiy We employ he following oher proxies for he qualiy of he accouning reporing a he corporae level. Firs, we use he residual of he regression of operaing income on operaing cash flow. We run his regression every year in he cross secion, and hen we predic for each firm he error erm based on ha company s operaing cash flow and operaing income. The higher he error erm, he greaer he degree of income smoohing is. (1a) EBITDA/A = α + β * OCF/A + ε (1b) ˆ ε = EBITDA/A - αˆ - βˆ * OCF/A 6

7 For our second measure we use he residual of he regression of ne income on operaing cash flow. This regression is being run every year in he cross secion, and hen we predic for each firm he error erm. The greaer he error erm, he more he income smoohing is. (2a) NI/A = α + β * OCF/A + η (2b) ˆη = NI/A - αˆ - βˆ * OCF/A For our hird measure we calculae he Theil ransformaion of he R-squared saisics from a 10-year rolling window regression, for each firm, of he ne income on operaing cash flow, log (1+R 2 ) log (1-R 2 ). The higher his measure is, he less he degree of earnings smoohing is. For our fourh measure we calculae he Theil ransformaion of he R-squared saisics from a 10-year rolling window regression for each firm of he operaing income on operaing cash flow. The higher his measure is, he less he degree of earnings smoohing is. A deailed descripion of he main variables ha appear in his sudy is shown in Table 1.For brief daa descripion, please refer o Table 2, Panel A. The able shows he averages, medians, and couns for he main variables ha appear in his sudy. In Panel B we furher show he correlaions among he main variables. INSERT TABLE 2 7

8 3.2. Absolue (unsigned) abnormal accruals We use he modified Jones (1991) model o esimae discreionary accruals: ACC TA S PPE γ + γ 2, j, + γ 3, j, + ζ TA TA 1 = 1, j, 1 TA j., (3) where S is he change in annual sales and PPE is propery plan and equipmen. We perform he above regression over he prior en-years. We esimae he regression for each indusry (defined as hree-digi SIC code), indexed by j for fiscal years 1990 hrough We rerieve he coefficien esimaes and hen obain firm-level discreionary accruals (DA) as follows (Dechow, Sloan, and Sweeney, 1995): ACC TA 1 = ˆ γ 0, j, + ˆ γ 1, j, 1 TA 1 + ˆ γ 2, j, S TA 1 RC TA 1 + ˆ γ 3, j, PPE TA 1, where (4) DA ACC ACC =. TAi, 1 TAi, 1 (5) 3.3. Idenifying firms wih capive financial subsidiaries We obain he daa on he companies ha have a financing segmen from he Compusa Segmen apes following Liov (2010). The daa is furher hand checked wih he Dun & Bradsree daabase o assure ha we have he precise dae of he acquisiion, or recogniion of he segmen as a financial one. 8

9 We focus on firms wih book equiy above 10 million dollars (following Baker and Wurgler (2002)), we furher delee all firms ha are financial (i.e., we exclude SIC codes in he 60,61,62,63 and 64 wo-digi headers) and also exclude he regulaed firms. We also exclude any firm ha is no incorporaed and headquarered in he Unied Saes (for example, Siemens, Toyoa, Nissan, and oher foreign firms, among which is common o have a capive financial segmen, are excluded for ha reason). 2 We idenify he firms wih financial subsidiaries by using he Compusa Segmens File ha we also supplemen wih manually colleced daa from he SEC 10-Ks o ascerain he firs and las year when hese segmens appear in he corporae srucure of he non-financial conglomerae. The issue is ha SFAS 131 requires companies o repor heir subsidiaries if hey accoun for a leas en percen of heir sales, or idenifiable asses, or operaing profi or loss. Hence, smaller subsidiaries would be omied from he Segmens ape Firm-Characerisic-Conrol Variables We conrol for several variables ha prior sudies have found o influence he earnings qualiy. Among he conrol variables we include he marke-o-book raio, he raio of fixed- o oal asses (angibiliy), ROA (profiabiliy), naural logarihm of asse size, firm age, he number of segmens and he cash flow volailiy (ROA volailiy). All 2 Our resuls are sronger when we include hese firms in he sample. However, foreign-incorporaed firms may have differen regulaions o abide by, and, hence, be no subjec o he Bank Holding Company Ac, in he Unied Saes. Hence, we exclude hese firms from he sample. 3 Our idenificaion approach is, however, limied in is scope. We underake wo remedies. Firs, we sudy firms ha are wih financial subsidiaries based on an alernaive idenificaion approach. Second, we argue ha smaller subsidiaries would no maerially affec he incenives of he firm o manage is earnings. 9

10 included conrol variables are as of he end of he preceding fiscal year. A deailed summary of all conrol variable definiions in provided in Table 1. IV. Empirical Resuls 4.1. Univariae Resuls Table 2 and Table 3 presen univariae resuls. Recall ha our analysis excludes financial companies and regulaed uiliies, as he financing paerns, he execuive compensaion and hence he incenives of hese firms o manage earnings differ subsanially from oher companies. We noe ha he univariae resuls reveal ha only 3.3% of he sample observaions are of non-financial firms ha have a financial subsidiary. Moreover, in unrepored abulaions, we also noe ha his number is acually decreasing in recen years (see Liov, 2010, for furher deails). This rend is in par due o he increasing number of newly lised firms ha do no have financial subsidiaries, raher han exising firms wih financial subsidiaries selling/ liquidaing hose. In Table 3 we review he pairwise correlaions of he measures of earnings managemen and he financial subsidiary dummy variable. The univariae resuls on he relaion beween unsigned discreionary accruals and he financing subsidiary indicaor sugges hese measures are generally supporing our main hypohesis. The correlaion of measures I and II wih he financial subsidiary dummy are 0.04 and 0.06, respecively, boh saisically significan. Tha is, firms wih financial subsidiaries have a higher degree of earnings smoohing. Similar supporive evidence is recorded for measures III and IV. There he correlaions are and -0.05, 10

11 respecively, boh saisically significan. The inerpreaion is ha he presence of financial subsidiary is associaed wih higher degree of earnings smoohing. We also find ha he financial subsidiary dummy variable is posiively associaed wih signed discreionary accruals. We are unable hough o explain he negaive, significan correlaion of he unsigned discreionary accruals and he financial subsidiary dummy - i could be ha non-financial conglomeraes wih financial subsidiaries migh achieve earnings smoohing hrough means oher han working capial adjusmens Mulivariae Resuls We now urn o he mulivariae resuls. In Table 3 we sudy he associaion beween he financial subsidiary dummy variable and he four measures of earnings smoohing, defined above. We find, consisen wih our null hypohesis, ha earnings smoohing is more pronounced for firms ha have financial subsidiaries. The resuls wih he hree ou of he four proxies ha we sudy suppor our hypoheses in mulivariae ess. The resuls are insignifican for measure III. We also examine he robusness of our findings wih respec o an alernaive measure of he imporance of he financial subsidiary in he overall srucure, namely we use he logarihm of he size of he financial subsidiary (we code i as zero for he cases where we do no a financial subsidiary). Our resuls are similar. As o conrol variables, we find ha firms wih higher profiabiliy and higher cash flow variabiliy are more likely o smooh earnings. This could be explained wih he need of shareholders for smooher earnings (see, for example, Goel and Thakor, 2006). We also find ha firms wih less angible asses are more likely o smooh earnings. Lasly, somewha unexpecedly, we find ha firms wih 11

12 higher marke-o-book raio have higher measures of earnings smoohing I and II, bu also higher measures III and IV (recall ha hese wo measures are inversely relaed o measures I and II). INSERT TABLE 3 We nex urn o our resuls on he signed discreionary accruals (SDA). In Table 4, we find ha firms wih financial subsidiaries have higher signed discreionary accruals, in accord wih our findings in Table 3 for alernaive measures of earnings smoohing. We also find ha firms wih more angible asses, wih higher profiabiliy or wih smaller asse size are also more likely o higher signed discreionary accruals. Older firms are also more likely o have higher signed discreionary accruals. On he oher hand, hough, we find ha firms wih financial subsidiaries have smaller unsigned discreionary accruals (UDA). Perhaps non-financial conglomeraes wih financial subsidiaries use alernaive means of managing earnings, raher han working capial adjusmens. INSERT TABLE 4 We also find ha firms wih higher marke-o-book raio, lower angibiliy, lower profiabiliy, and lower asse size have higher UDA. V. Robusness Checks We also recompue accruals using he balance shee definiion in Sloan (1996) and in Ball and Shivakumar (2005), 12

13 ( CL STD TP) Depi ACC CAi, Cash, =, (6) where ACC i, is he accruals of firm i in year, liabiliies (Compusa iem #4), CA, is he change of curren Cash i, is he change in cash/ cash equivalens i (Compusa iem #1), CL, is he change in curren liabiliies (Compusa iem 5), i STD i, is he change in deb included in curren liabiliies (Compusa iem #34), TP is he change in income axes payable (Compusa iem #71), and Dep i, is depreciaion and amorizaion expense (Compusa iem #14). Our resuls are qualiaively similar when using he alernaive definiion of accruals. Addiional ess To also esablish he validiy of he main finding of his paper, we may also do he following ess. 1. Examine he analys forecas dispersion, he analys forecas error, and he abiliy o mean analys consensus forecas for firms wih he financing subsidiaries in comparison wih wo groups of oher firms: conglomeraes wihou financial subsidiary and non-financial single segmen firms. We expec ha: a. Conglomeraes wih financial capive subsidiary have greaer analys coverage, lower forecas dispersion and lower forecas error. We also expec ha such firms bea by only a small margin he analys consensus forecass. b. This finding is sronger for comparison o he sand alone firms han o he conglomeraes wih no-financial subsidiaries. 13

14 We also examine he correlaions beween book performance of subsidiaries and correlaions of heir sand alone indusry counerpars: - H1: i should be lower for conglomerae. - H2: i should be even lower for conglomeraes wih a financial/insurance subsidiary VI. Conclusion We find ha conglomeraes wih financial subsidiaries end o have worse accouning reporing qualiy han sand alone firms and conglomeraes wih no financial subsidiaries: hey have higher discrepancy beween operaing income and operaing cash flow and higher abnormal accruals. We aribue hese differences in reporing qualiy o several facors. Firs, less need for exernal marke access: firms wih inernal capial markes are less likely o need o disclose o ouside marke as here does no exis need o access hese markes; second, income smoohing: financial capive segmens help conglomeraes beer shif income o he lower ax subsidiaries hrough he srucure of inercompany loans. In addiion, we argue ha financial subsidiaries faciliae earnings managemen hrough he allowance for uncollecible loans/bad deb expense. This is consisen wih managers ha are overly conservaive wih heir allowance for uncollecible loans when he non financial side of he firm has higher han expeced earnings. In urn, when in need, managers could resae ha allowance downward in order o mee or bea analyss' forecass. 14

15 References Baker, Malcolm P. and Wurgler, Jeffrey A., Marke Timing and Capial Srucure. Journal of Finance, Vol. 57, No. 1, pp. 1-32, February 2002 Ball, R., Shivakumar, L., Earnings qualiy in U.K. privae firms: comparaive loss recogniion imeliness, Journal of Accouning & Economics 39, Barron, J., A. Chong, and M. Saen, 2004, The Emergence of Capive Finance Companies and Risk Segmenaion of he Consumer Loan Marke: Theory and Evidence, Journal of Money, Banking and Cred forhcoming. Beneish, M. D., 2001, Earning Managemen: A Perspecive, Managerial Finance 27, Caylor, M Sraegic revenue recogniion o achieve earnings benchmarks. Journal of Accouning and Public Policy, forhcoming Cormier, D., Andre, P. and E. Charles-Cargnello, 2004, Incenives for consolidaion of finance subsidiaries: evidence from France, Inernaional Journal of Accouning, Audiing and Performance Evaluaion, Vol. 1: Dechow, P.M. and I. Dichev The Qualiy of Accruals and Earnings: The Role of Accrual Esimaion Errors. The Accouning Review, 77 (Supplemen), pp Dechow, P., R. Sloan, and A. Sweeney, 1995, Deecing earnings managemen, Accouning Review, Vol. 70: Denning, L., A Bid o Recapure Capive Finance, WSJ. July 31 s, Dubois-Pelerin, E. and A. James, 2008, Assumpions: Analyical Adjusmens for Capive Finance Operaions, Sandard & Poor s repor. Fields, T., T. Lys, and L. Vincen Empirical research on accouning choice. Journal of Accouning and Economics 31 (1-3):

16 Goel, Anand M. and Thakor, Anjan V., Overconfidence, CEO Selecion, and Corporae Governance (Augus 29, 2006). Journal of Finance, Vol. 63, No. 6, pp , December Graham, J. and A. Tucker, 2006, Tax Shelers and Corporae Deb Policy, Journal of Financial Economics, Vol. 81: Gramlich, J., P. Limpaphayom, and S. Ghon Rhee, 2004, Taxes, keiresu affiliaion, and income shifing, Journal of Accouning and Economics, Vol. 37: Healy, P., and J. Wahlen A review of he earnings managemen lieraure and is implicaions for sandard seing. Accouning Horizons 13 (4): Jones, J., 1991, Earnings Managemen During. Impor Relief Invesigaions, Journal of Accouning Research, Vol. 29. Jackson, Sco B. and Liu, Xiaoao Kelvin, The Allowance for Uncollecible Accouns, Conservaism, and Earnings Managemen. Journal of Accouning Research, 2010 Jiang, G., C. Lee, and H. Yue, 2009, Tunneling in China: The Remarkable Case of Iner- Corporae Loans, Journal of Financial Economics, forhcoming. Khorana, I., 1991, Securiy Marke Effecs Associaed wih SFAS No. 94 Concerning Consolidaion Policy, Accouning Review, Vol. 66: Liov, L., 2010, Do firm boundaries affec financing policy? Evidence from non-financial conglomeraes wih financial subsidiaries, working paper, Universiy of Arizona. Marquard, C., and C. Wiedman How are earnings managed? An examinaion of specific accruals. Conemporary Accouning Research 21 (2): McNichols, M Research design issues in earnings managemen sudies. Journal of Accouning and Public Policy 19 (4/5):

17 McNichols, M., and P. Wilson Evidence of earnings managemen from he provision for bad debs. Journal of Accouning Research 26 (Supplemen): Mian, S. and C. Smih, 1990, Incenives for Unconsolidaed Financial Reporing, Journal of Accouning and Economics, Vol. 12: Robers, G. and J. Viscione, 1982, Capive Finance Subsidiaries and he M-Form Hypohesis, Bell Journal of Economics, Vol. 12: Ronen, J. and A. Sondh 1995, Deb Capaciy and Financial Conracing: Finance Subsidiaries, in Off-Balance Shee Aciviies, edied by J. Ronen, A. Saunders, and A. Sondh Quorum Books: New York. Selling, T., A. Sondh and G. Sorer, 1989, Consolidaing Capive Finance Subsidiaries: The Impac of SFAS 94 on Financial Saemens, Financial Analys Journal, Vol. 45: Shin, H. and R. Sulz, 1998, Are Inernal Capial Markes Efficien? Quarerly Journal of Economics, Vol Shull, B., 1999, The Separaion of Banking and Commerce in he Unied Saes: an Examinaion of Principal Issues, Office of he Comproller of he Currency, E&PA Working Paper Sloan, R.G., Do sock prices fully reflec informaion in accruals and cash flows abou fuure earnings? The Accouning Review 71, Slovin, M. and M. Sushka, 1997, The Implicaions of equiy Issuance Decisions Wihin a Paren-Subsidiary Governance Srucure, Journal of Finance, Vol. 52: Sprinzen, S., and R. Pressman, 2007, Capive Finance Operaions, Sandard & Poor s repor. 17

18 Spong, K, and E. Robbins, Indusrial Loan Companies: A Growing Indusry Sparks a Public Policy Debae, working paper, Federal Reserve Kansas Ciy. Teoh, S., T. Wong, and G. Rao Are accruals during iniial public offerings opporunisic? Review of Accouning Sudies 3 (1/2): Teoh, S. H., I. Welch, and T. J. Wong, 1998, Earnings managemen and he underperformance of seasoned equiy offerings, Journal of Financial Economics, Vol. 50:

19 Table 1. Variable Definiions of Accouning Qualiy of Reporing We employ he following proxies for he qualiy of he accouning reporing a he corporae level. 1. I. We use he residual of he regression of operaing income on operaing cash flow. This regression is being run every year in he cross secion, and hen we predic for each firm he error erm. The greaer he error erm is, he more he income smoohing is. 2. II. We use he residual of he regression of ne income on operaing cash flow. This regression is being run every year in he cross secion, and hen we predic for each firm he error erm. The greaer he error erm is, he more he income smoohing is. 3. III. We calculae he Theil ransformaion of he R-squared saisics from a 10-year rolling window regression for each firm of he ne income on operaing cash flow. The greaer he R-squared is, he less he income smoohing is. 4. IV. We calculae he Theil ransformaion of he R-squared saisics from a 10-year rolling window regression for each firm of he operaing income on operaing cash flow. The greaer he R-squared is, he less he income smoohing is. Oher Definiions Key Explanaory and oher Conrol Variables: Financial subsidiary dummy equals one if in ha fiscal reporing period he non-financial company has a leas one repored segmen in he financial indusry (SIC 2-digi headers 60-69) Financial subsidiary asses he log of he asses of he financial subsidiary o he oal asses of he firm Accruals = [ Curren Asses (ACT) Cash & Shor-erm invesmens (CHE) Curren Liabiliies (LCT) + Deb in Curren Liabiliies (DLC) + Income Taxes (TXP) Depreciaion (DP)]/AT Operaing Income OIBDP/ AT Operaing Cash Flow = Operaing Income (OIBDP/AT) Accruals e Income Ne Income (NI/AT) M/B (oal asses book equiy + marke equiy)/ oal asses. Book equiy is defined as in Fama-French (2001). If PSTKL is no missing, hen book equiy is AT-LT-PSTKL+TXDITC+DCVT; if PSTKL is missing bu PSTKRV is no hen, book equiy is AT-LT-PSTKRV+TXDITC+DCVT; and finally if boh PSTKL and PSTKRV are missing bu PSTK is no hen book equiy is AT-LT-PSTK+TXDITC+DCVT. Tangibiliy PPENT/ AT Profiabiliy OIBDP / AT umber of segmens he number of segmens recorded in he Compusa Segmens apes. Toal Asses - AT Firm Age Recorded as he number of years since firs appearance in CRSP apes. Unsigned Discreionary Accruals (UDA) We use he Jones (1991) model in order o esimae discreionary accruals. We perform he regression: ACC 1 S PPE = γ 1, j, + γ 2, j, + γ 3, j, + ζ. ( * ) j. TA TA TA TA

20 We define accruals as earnings before exraordinary iems (Compusa iem #123) less cash flow from operaions (Compusa iem #308). TA is lagged oal asses (Compusa iem #12), is change in sales (#12), and PPE, is propery, plan, and 1 equipmen (Compusa iem #7). We Winsorize all regression variables a 1% in each ail of he disribuion. We perform he above regression over a en-year window, e.g. in 1990, we would employ he ime window from 1980 hrough We esimae he regression for each indusry defined as hree-digi SIC code and indexed by j. We perform such regressions for fiscal years 1990 hrough We rerieve he coefficien esimaes and obain he discreionary accruals as ACC 1 S RC PPE, ( ** ) = ˆ γ + ˆ γ + ˆ γ + ˆ γ TA DA 1 0, j, ACC 1, j, ACC TA = TAi, 1 TAi, 1 1 2, j, TA 1 TA 1 3, j, TA 1, ( *** ) where RC i, is he change in receivables (Compusa iem # 151) and DA i, is he unsigned discreionary accruals from he modified Jones model in Dechow, Sloan, and Sweeny (1995). To increase he reliabiliy of he esimaes we require a leas en observaions wihin each 3-digi SIC code indusry for a specific en-year window. If here are no enough observaions for ha paricular 3-digi SIC code, we hen use he similarly-compued discreionary accruals for he 2-digi SIC code, subjec o he en observaions resricion. We assign he measure o all peers in he same indusry. S i, i 20

21 Table 2. Descripive Saisics Panel A: In able 2 we show he descripive saisics for all measures of discreionary managemen of he accouning or of he reporing qualiy. Variables Mean Median S. Dev. N I ,469 II ,593 III ,893 IV ,788 Signed Discreionary Accruals ,915 Unsigned Discreionary Accruals ,915 Financing Subsidiary Dummy ,160 M/B ,160 Tangibiliy ,060 Profiabiliy ,949 Log(Asses) ,160 Firm Age ,122 Number of segmens ,160 Panel B: Correlaions among key firm characerisics I II III IV Signed Discreionary Accruals Unsigned Discreionary Accruals II p-value 0.00 III p-value IV p-value Signed Discreionary Accruals p-value Unsigned Discreionary Accruals p-value Financing Subsidiary Dummy p-value

22 Table 3. Mulivariae Resuls In his able we model he four main proxies for he qualiy of he accouning informaion, described above. All conrol variables winsorized a 1% in each ail. Models (1) and (2) use measure one, models (3) and (4) use he measure wo, models (5) and (6) use measure hree, and models (7) and (8) use measure four. Included bu no repored are hisoric SIC four-digi SIC code fixed effec and year dummies. We repor -saisics based on robus sandard errors clusered a he firm level. ***, **, and * indicae significance a he 1%, 5%, and 10% levels, correspondingly. The able furher repors he number of observaions and R-squared. Dependen Variable I I II II III III IV IV Explanaory Variables (1) (2) (3) (4) (5) (6) (7) (8) Financial Subsidiary Dummy, *** *** ** -sa (4.3) (5.25) (1.21) (2.55) Log(Financial Subsidiary Asses in US$ M), *** *** ** -sa (3.26) (4.26) (1.12) (2.03) M/B, *** *** ** ** *** *** *** *** -sa (10.19) (10.18) (2.12) (2.12) (6.23) (6.23) (5.21) (5.22) Tangibiliy, *** *** *** *** *** *** -sa (0.98) (1.08) (19.12) (19.16) (4.62) (4.61) (4.16) (4.16) Profiabiliy, *** *** *** *** ** ** ** ** -sa (38.21) (38.19) (14.88) (14.88) (2.11) (2.11) (2.26) (2.26) Log(Asses), *** *** *** *** -sa (0.43) (0.41) (8.17) (8.13) (1.49) (1.49) (4) (3.97) Firm Age, *** *** *** *** *** *** sa (6.02) (6.06) (4.12) (4.05) (3.05) (3.04) (1.53) (1.51) Number of segmens, ** * ** ** * -sa (2.32) (1.94) (0.63) (1.04) (2.08) (2.12) (1.55) (1.66) S. Dev. of ROA, ** ** *** *** *** *** *** *** -sa (2.61) (2.57) (4.78) (4.8) (7.17) (7.17) (7.18) (7.19) N 39,913 39,913 39,988 39,988 9,910 9,910 9,835 9,835 R-squared 21.2% 21.2% 12.8% 12.8% 27.7% 27.7% 34.5% 34.4% 22

23 Table 4. Mulivariae Resuls Signed and Unsigned Discreionary Accruals In his able we model he signed (SDA) and unsigned discreionary accruals (UDA). All conrol variables winsorized a 1% in each ail. The dependen variable is signed discreionary accruals as in he Jones (1991) model in models (1) and (2). I is he unsigned discreionary accruals in models (3) and (4). Included bu no repored are hisoric SIC four-digi SIC code fixed effec and year dummies. We repor -saisics based on robus sandard errors clusered a he firm level. ***, **, and * indicae significance a he 1%, 5%, and 10% levels, correspondingly. The able furher repors he number of observaions and R-squared. Dependen Variable SDA SDA UDA UDA Explanaory Variables (1) (2) (3) (4) Financial Subsidiary Dummy, *** *** -sa (3.51) (4.14) Log(Financial Subsidiary Asses in US$ M), ** *** -sa (2.25) (2.81) M/B, *** *** -sa (0.31) (0.32) (7.06) (7.07) Tangibiliy, *** *** ** * -sa (7.39) (7.32) (2.03) (1.94) Profiabiliy, *** *** *** *** -sa (7.51) (7.49) (5.42) (5.41) Log(Asses), *** *** *** *** -sa (11.28) (11.18) (9.22) (9.19) Firm Age, *** *** sa (9.51) (9.54) (0.24) (0.26) Number of segmens, * ** sa (1.77) (2.02) (0.84) (0.53) N 18,363 18,363 18,363 18,363 R-squared 6.3% 6.3% 12.3% 12.2% 23