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Earnings management and government restrictions on outward foreign direct investment: evidence from Taiwanese firms

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Abstract

This study examines whether firms engage in earnings management to overcome government policies on limiting outward foreign direct investment (FDI), and whether their earnings-management behavior is aligned with shareholders’ interests. Using the regulatory setting in Taiwan, where the government has placed a cap on FDI in China for listed firms, we find that firms with FDI ratios near the limit (near-limit firms) are more likely to engage in income-increasing earnings management to shore up their shareholders’ equity, thus reducing their propensity to breach government policy. In addition, near-limit Taiwanese firms engaged in income-increasing earnings management show greater increases in FDI in China and better performance in the years following their earnings-management activities. We also find that the positive effects of earnings management on the future performance of these firms are driven by incremental FDI in China. The effects are more pronounced in firms with strong corporate governance. The results suggest that when the government’s restrictions on outward FDI are inconsistent with an individual firm’s objective of maximizing shareholder value, managers are motivated to use earnings-management strategies to circumvent governmental constraints on outward FDI.

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Notes

  1. In this study, FDI refers to the direct or indirect acquisition of long-term interest in a foreign company. Unlike foreign portfolio investments, which does not involve the investor actively in management, FDI entails long-term interest-rate and management control. FDI may take many forms, such as direct acquisition of a foreign firm, construction of a facility, or investment in a joint venture or strategic alliance with a local firm.

  2. For example, Gomes-Casseres (1990) finds that local-ownership restrictions imposed by a host government on foreign firms induce foreign enterprises to choose joint ventures (i.e., shared ownership) over wholly owned subsidiaries as their primary method of FDI, and that such restrictions can reduce firm performance.

  3. We focus on the period after 2001, as earnings management since that time is related only to the value of shareholders’ equity, not to the amount of paid-in capital.

  4. However, caution may be needed when interpreting the results, because the use of earnings management to circumvent regulations may hurt the interests of the government.

  5. The Taiwanese government maintained a “restrain rush and exercise patience” policy from 1996 to 2001, after China’s provocative missile tests in 1996, and warned that greater economic dependence would make Taiwan vulnerable to political pressure from China.

  6. Local firms with shareholders’ equity of less than NT$5 billion are allowed to invest up to 40 % of their shareholders’ equity in China, but firms with shareholders’ equity between NT$5 billion and NT$10 billion can invest no more than 30 %, depending on their size.

  7. The other two sources of motivation are the capital market and contractual obligations.

  8. We also use the raw value of INV_LIMIT it as a measure; the results are the same as those obtained using the quintile rank of INV_LIMIT it .

  9. The results do not change when all of the variables in the top and bottom 1 % are Winsorized.

  10. In Taiwan, companies are required to file their annual financial statements to the Securities and Exchange Commission (SEC) 4 months after the end of the fiscal year. RET at t + 1 is measured over a 12-month period starting from 4 months after the end of the fiscal year. The results are the same. Our untabulated results are also robust to firm performance at t + 2.

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Acknowledgments

We thank the reviewer and the editor for many helpful comments and suggestions. We also appreciate Chih-ying Liao, Yi-hsuen Huang, Kaichuen Chang, Tsai-hsien Deng, Ya-Yi Chao, Yu-Hao Chang, Chun-Yo-Lin, Hsin-Yu Yao, Yi-Zhu Chen, Men-Chuen Chi, Yi-Wen Wang, Shen-Hsiuen Cheng, Si-Yu, Lin, and Chiun-yi Jiang for data and case analyses. We gratefully acknowledge the financial support from the National Science Council in Taiwan, and all the students participating in the advisory gathering in 2011.

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Authors and Affiliations

  1. Department of Accounting, National Taiwan University, No. 1, Sec. 4, Roosevelt Road, Taipei, 106, Taiwan

    Rong-Ruey Duh & Audrey Wen-Hsin Hsu

  2. Department of Accounting, City University of Hong Kong, 83 Tat Chee Avenue, Kowloon Tong, Hong Kong

    Sidney Leung

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  1. Rong-Ruey Duh
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  2. Audrey Wen-Hsin Hsu
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Correspondence to Rong-Ruey Duh.

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Duh, RR., Hsu, A.WH. & Leung, S. Earnings management and government restrictions on outward foreign direct investment: evidence from Taiwanese firms. Rev Quant Finan Acc 44, 41–67 (2015). https://doi.org/10.1007/s11156-013-0398-0

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