The impact of the foreign ownership on the real earnings management of firms in Vietnam

The impact of the foreign ownership on the real earnings management of firms in Vietnam TRAN THI THUY LINH University of Economics HCMC – linhtcdn@ueh.edu.vn NGUYEN THANH NHA nhatdg@yah

The impact of the foreign ownership on the real earnings management of firms in Vietnam

TRAN THI THUY LINH University of Economics HCMC – linhtcdn@ueh.edu.vn

NGUYEN THANH NHA nhatdg@yahoo.com HOANG THI PHUONG ANH anhtcdn@ueh.edu.vn

DANG THI VY NGOC

dangthivyngoc2013@gmail.com

Abstract

The paper analysed the impacts of the foreign ownership on the behaviour of the real earnings management of firms in Vietnam and the difference in the quality of operating income between firms with high and low levels of the foreign ownership Data of 167 firms listed on the Vietnam Stock Exchange for the duration from 2011 to 2015 was taken as the case study and the regression models which are OLS, Robust and 2SLS were applied

Results of this study demonstrated that the foreign ownership contributed to the behaviour of the real earnings adjustment of firms; a high level of the foreign ownership was found to positively affect the real earnings management of firms in Vietnam In addition, this study supported the knowledge spillover theory that highly skilled foreign investors had the tendency to assist their owned firms to improve the earnings quality on financial reports Therefore, it was important for financial managers to develop appropriate strategies to manage and improve the quality of financial reports according to the International Financial Reporting Standards (IFRS) This helped increase competitiveness and transparency of firms to attract more foreign investors on the Vietnam Stock Exchange

Keywords: foreign ownership; real earnings adjustment; real earnings management;

earnings quality; abnormal levels of operating cash flows

1 Introduction

In emerging markets, foreign investors play an important role in improving the quality

of financial reports of domestic firms (Huang and Shiu, 2009) They can promote the management of domestic firms by using the voting right to influence decisions of managers or to announce divestment from domestic firms (Aggarwal et al., 2005; Gillan and Starks, 2003) According to the report of World Bank in 2016, the foreign investment increased by 40%, which was approximately $1.8 trillion in 2015; this was the highest since the global financial crisis in 2008 Therefore, foreign investors and investment

greatly affect the financial management of firms

In Vietnam, for the past 10 years, the Government has developed and loosened regulations of attracting foreign investment Together with the admission of the international trade organisation, this has contributed significantly to the integration of Vietnam into the world market Vietnam has removed barriers for foreign investors and facilitate both indirect and direct capital investment Using 167 firms listed on Vietnam Stock Exchange as the case study, this paper focuses on analysing impacts and relationship between the foreign ownership and earnings quality of these firms The objectives of this study are to uncover: (1) influences of the foreign investment on the earnings management of firms and (2) impact of high and low levels of the foreign

ownership on the earnings quality of firms

2 Background theories and empirical studies

2.1 Background theories

The study of impacts of the foreign ownership on the earnings quality was based on

the asymmetric information theory and the knowledge spillover theory

The asymmetric information theory was studied by George Akerlof, Michael Spence and Joseph Stigliz (1970) Regarding to the earnings management, the asymmetric information occurs when managers take the advantage of the fact that foreign investors have very little information of situation of firms and domestic market and, therefore, make fraudulent acts, adjust profit and indicators on financial reports These activities lead to the fact that investors, particular foreign investors, cannot control behaviours of firms; they are classified as the moral hazard In addition, the standards and regulations

of accounting in a particular country may cause restrictions on the understanding of foreign shareholders Therefore, in a firm with a large number of foreign shareholders, managers can manage and adjust income for their own purposes This is called the asymmetric information which is less favourable by foreign investors than domestic investors As pointed out by Choe et al (2001) and Dvorak (2005), in the Indonesian market, domestic investors have more profit compared to foreign investors Thus, according to the asymmetric theory, the real earnings adjustment is more likely on firms with higher level of the foreign ownership

The knowledge spillover theory

Alfred Marshall (1890) was the first researcher studying impacts of the kwowledge spillover theory, which was extended by the economist Kenneth Arrow (1962) and Paul Romer (1986) Later, Edward Glaeser, Hedi Kallal, José Scheinkman and Vàrei Shleifer (1992) developed a theory called MAR spillover Accoring to Carlino (2001), the spillover facilitates exchange of ideas and promotion of creativity and innovation which are the important factors for sustainable economic development of countries Based on this theory, the concentration of firms in a similar industry helps spread knowledge and initiate growth and innovation Regarding to issues of the real earnings management, knowledge of accounting and management is enhanced via foreign investors, which enables firms to effectively monitor business activities and report financial status Therefore, the knowledge spillover theory suggests that firms with high level of the foreign ownership tend to perform more real earnings adjustment in a comparison with

ones having low level of the foreign ownership

2.2 Empirical studies

Xiao et al (2004) argued that foreign investors faced more challenges due to the asymmetric information than the domestic investors did and managers had more information of status of firms and market compared to foreign investors Therefore, real earnings adjustment is still likely in firms having high foreign ownership Similarly, Klai and Omri (2001) showed that the presence of foreign investors reduced the quality of financial reports Adebiyi and Olowookere (2006) argued that firms with high level of foreign ownership are associated with high real earning adjustment On the contrary, other studies showed that, with better knowledge and information, foreign investors are more capable of spreading their expertise to domestic firms to improve the quality and

efficiency of their business productivity According to Seaholes (2000), foreign financial institutions perform better than domestic ones, since the foreign ownerships creates significant economic benefits Based on studies in Canada, Italy, Germany, Japan, UK and

US, Hejazi and Safarian (199) pointed out that the foreign ownership has positive spillover effects on efficiency and technology Hallward-Driemeiter et al (2002) conducted surveys

in Indonesia, South Korea, Malaysia, Philippines and Thailand and found that owned enterprises in East Asia are more productive compared to other firms The study

foreign-of Ho et al (2010) showed that, in small enterprises, the more the foreign ownership, the greater the relationship between technology investment and firm productivity; therefore, foreign investors tend to bring IT professionals to help small enterprises Abor and Biekpe (2007) demonstrated that foreign ownership has positive impact on the quality and productivity of small and medium enterprises According to Aydin, Sayim and Yalama (2007), foreign-owned enterprises contribute more to enhance the financial performance and improve the performance compared to owned enterprises in the county Gillan and Starks (2003) argued that foreign investors are the key role in promoting changes in the corporate governance of firms through direct monitoring by using their voting rights to affect managerial decisions or indirect monitoring by threatening to sell their shares Aggarwal et al (2011) investigated impacts of financial institutions on the corporate governance system and argued that a firm with investment from foreign financial institutions has a stronger foundation to promote the development of management According to Ben-Nasr, using data collected from firms in 45 different countries, Boubakri and Cosset (2015) showed that the higher level the foreign ownership the higher the quality of income Alaryan (2015) pointed out that the foreign ownership plays a vital role

in ensuring the quality of profit Taking Jordan as an example, he found that the knowledge spillover theory was supported and that the higher foreign ownership leads

to more control over the management of domestic business income Gue et al (2005) studies foreign shareholders and real earnings adjustment on financial reports and suggested that foreign shareholders have positive effects on the quality of the real earnings The higher the foreign ownership, the lower the real earnings adjustment; this

is the factor to restrict real earnings adjustment

3 Research methodology

3.1 Research data

Research data was collected from the following websites: http://cafef.vn/, www.hsx.vn, http://www.bvsc.com.vn/ The main sample of data used in this study was

167 firms listed on Ho Chi Minh Stock Exchange (HOSE) in the duration from 2011 to

2015 and contained 835 observations in 5 main major disciplines including Consumer Discretionary, Industrials, Real Eastate, Materials and Consumer Staples Firms were categorised according to the Global Industry Classification Standards (GICS)

Table 1

Foreign ownership of different disciplines

Source: Stata analysis performed by the authors

3.2 Research hypothesis

This study was based on the work of Guo et al (2015) which was focused on the Big Bang Accounting Reform in Japan

Hypothesis 1: Firms with high levels of the foreign ownership involve in the

management of the real earnings more than the ones with low levels of the foreign

ownership, which supports the knowledge spillover theory

Hypothesis 2: Firms with high levels of the foreign ownership involve in the

management of the real earnings less than the ones with high levels of the foreign ownership, which supports the asymmetric information theory

3.3 Description of variables

3.3.1 Independent variables

The foreign ownership (FO) of the firm, which was studies in the studies of Dahlquist

et al (2003) and Leuz et al (2009), is the ratio of the number of shares held by foreign investors (which include private foreign investors, supporting funds and financial institutions) to the total amount shares of a firm For one firm, this variable is the measurement of influences of foreign investors on the domestic market at the end of each

year FO is defined as

!" =

$%&'() +, -ℎ/)(- ℎ+01 '2 ,+)(345 356(-7+)-8+7/0 5%&'() +, -ℎ/)(- +, 7ℎ( ,3)& 9100

In addition, the regression model contains other variables showing the economic

characteristics of the firm, which include:

The size (SIZE) of the firm: The size of the firm has an important effect on the management of the real earnings (Roychowdhury 2006) SIZE is given by:

<=>? = @5(8+7/0 / (7-)

LEVERAGE: Previous studies showed that firms use the leverage to avoid breaking

debt agreement when performing any activities relating the real earning management (Dichev and Skinner, 2002) This action is important since most of firms are supported

by banks and creditors can hold important roles in monitoring business activities of firms LEVERAGE is calculated as

@?C?DEF? =

@+54 7()& 03/'3037(-

8+7/0 / (7-Return on assets (ROA): To control effects of financial performances on the real

earning management, the regression model includes ROA which is a reliable index to justify financial performances of firms and to show efficiency in deploying assets

D"E =

=5G+&( '(,+)( (97)/+)135/)2 37(&-

8+7/0 / (7-Growth of assets (GROWTH): Roychowdhury (2006) showed that potential

sustainable growth of assets can lead to substantial changes in the real earnings management

FD"H8I = 8+7/0 / (7- 35 2(/) 7

8+7/0 / (7- 35 2(/) 7 − 1− 1

Absolute values of discretionary accruals (ABS_DA): Cohen et al (2008) showed

the existence of the trade-off between the real earnings management and the saving

management Therefore, ABS_DA was included in their study DA is estimated based on

Kothari et al (2005) while ABS_DA is the remaining calculated from

E<<?8<KLOP+ MP∆<E@?<KL+ MSTT?KL+ MUD"EKLOP+ VKL

Table 2

Descriptions of variables in the equation of TA

Notation Variables Equations

∆SALES Differenc

e sales

<E@?< L − <E@?< LOP

8+7/0 E (7-LOPPPE

Tangible

fixed

Assets

8+7/0 E (7- LOP

8/543'0( !39(1 E (7-ROA Return on

Assets

=5G+&( '(,+)( (97)/+)135/)2 37()&-8+7/0 E (7s LOP

Source: Authors’ summary

According to Chung et al (2004), the discretionary accruals can help managers adjust the real earnings This variable is, therefore, used to increase the accuracy of the regression model and to emphasise the importance of the income management

Dummy variable SUSPECT: The study of Roychowdhury (2006) pointed out that firms

with 0 < ROA < 0.5% are more likely to adjust the real earnings and are associated to

suspicious cash flow, low discretionary expenses and high production costs Therefore,

<d<T?W8 = 0, 1, 0 < D"E < 0.5%

+7ℎ()-Dummy variable LOSS: This variable was used in the regress model because

Roychowdhury (2006) showed that small loss and slightly negative variation in earnings can motivate firms to adjust their earnings to satisfy their previous profit

@"<< = 0,1, D"E < 0D"E > 0 3.3.2 Dependent variables

In this study, the variable of the real earnings management were defined based on studies of Roychowdhury (2006) and Cohen et al (2008) These studies pointed out that the real earnings management are defined by four indices which are abnormal levels of operating cash flow (ACFO), abnormal discretionary expenses (ADIS), abnormal production costs (APROD) and a combined measure (COM_REM)

Abnormal levels of operating cash flows (ACFO): According to the study of

Roychowdhury (2006) which was based on Dechow et al (1998), managers can use excessive price discounts or credit terms to boost temporary sales, which lead to the current period earnings increase However, current period cash flows may not go up

Abnormal discretionary expenses (ADIS) is a subjective cost that is not necessary for

business operation (Roychodhury 2006) This cost was defined as the summation of advertising expenses, R&D expenses, and selling, general and administrative expenses Although these expenses are not essential to business operation, managers can use them

to increase earnings by reducing current expenditures

Abnormal production costs are the third index used by Roychowdhury (2006) The study of Pan (2009) showed that firms try to increase their profit by reducing discretionary expenses and cost of goods sold Then, managers can increase production more than being required to decrease average cost per unit, which leads to lower the reported cost of goods sold (COGS) and inflate operating profit margins The excessive production also leads to higher production and inventory holding costs For a given level

of sales, this increases annual production costs and lowers current period cash flows The production costs were defined as the summation of COGS and changes in inventory during the year

A combined measure (COM_REM): According to Cohen et al (2008), a combined

measure was defined as aggregating three aforementioned variables: ACFO, ADIS, and APROD In detail, this variable is defined as ACFO + ADIS – APROD

Table 3

Description of four indices relating to the variable of the real earnings management (REM)

ACFO Roychowdhury (2006) Abnormal levels of operating cash flows

ADIS Roychowdhury (2006) Abnormal discretionary expenses)

APROD Roychowdhury (2006) Abnormal production costs

COM_REM Cohen et al (2008) A combined measure of the variable REM:

ACFO + ADIS – APROD Source: Authors’ summary

This table listed original studies of the four indices and estimated results in the following 3 equations by the OLS regression model:

D?y = sN+ sP∗ !" + sS∗ <=>? + sU∗ @?C?DEF? + sw∗ D"E + sz

∗ E{<_YE + s}∗ FD"H8I + s~ ∗ @"<< + s∗ <d<T?W8+ uL (4)

The authors used the panel data, the Ordinary Least Square (OLS) regression model, the descriptive statistics and the correlation between variables to uncover statistically meaningful variables The authors performed Durbin-Watson test, White test and Heteroskedasticity test: Breuch-Pagan-Godfrey to correct the OLS regression In addition, the authors used the robust and the two-stage least squares (2SLS) regression

4 Research results

4.1 Descriptive statistics and correlation analysis

Table 4

Foreign ownership in different years

Source: Authors’s compilation by stata 12.0

Table 4 presents the variation of the foreign ownership in different years There were

167 firms each year in the sample of data The averaged ownership of foreign investors in the duration from 2011 to 2015 was 13.18% The averaged ownership was increasing and reached 14.37& in 2015 In a comparison with Vo (2015), the averaged foreign ownership

of Vietnam increased from 10% measured in 2007 to 51.3% measured in 2015 This result

showed that the foreign investors play a more important role in firms in Vietnam

Table 5 reports results of the statistics of all samples (835 observations) The mean values (MEAN) of ACFO, ADIS, APRO and COM_REM were 0.000 These mean values are positive and much smaller than expected value; in addition, they are very small that was close to 0 Therefore, a good agreement can be concluded When using all samples, the mean and median of the foreign ownership was estimated to be 13.25% and 7.3% respectively, which shows that the distribution of the foreign ownership of firms in Vietnam was unbalanced The averaged value of ABS_DA was 0.121 The mean and median of total assets was 159 billion nad 26 billion VND The averaged long-term liabilities was accounted for 12.2% of the total assets 5.87% of the total firms have negative profit and 9.82% of the total firms were suspicious due to very small positive

profit

Table 5

Descriptive statistics of all samples

Source: Authors’s compilation by stata 12.0

Table 6 describes the correlation matrices of all samples In addition to 4 dependent variables, there was weak correlation between variables in the regression model The variable FO possessed the positive correlation with ACFO, ADIS and COM_REM and negative correlation with APROD, which supported the knowledge spillover theory that the foreign ownership positively affects the real earnings management The variables SIZE and ROA had the strongest correlation with FO, 30.5% and 15.6% respectively In general, there were good correlation between ROA and other REM variables: 0.352 with ACFO, 0.184 with ADIS, -0.415 with APROD and 0.436 with COM_REM

4.2 The correlation matrix of the variables in the model

Table 6

Correlation matrix of variables

Table 6 reports the correlation between variables in the research model In addition to the four dependent variables, the variables in the model are almost not strongly correlated The variable foreign ownership- FO is positively correlated with the variables ACFO, ADIS, COM_REM but which is negatively correlated with the variable APROD It is

a good indicator of the knowledge spillover theory that foreign ownership has a positive impact on income management

Table 7

Determine the sample mean/median difference

ownership group

High foreign ownership group

Mean difference