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

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 po

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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

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.

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1 Introduction

In emerging markets, foreign investors play an important role inimproving the quality of financial reports of domestic firms(Huang and Shiu, 2009) They can promote the management ofdomestic firms by using the voting right to influence decisions ofmanagers or to announce divestment from domestic firms(Aggarwal et al., 2005; Gillan and Starks, 2003) According to thereport of World Bank in 2016, the foreign investment increased by40%, which was approximately $1.8 trillion in 2015; this was thehighest since the global financial crisis in 2008 Therefore, foreigninvestors and investment greatly affect the financial management

of firms

In Vietnam, for the past 10 years, the Government hasdeveloped and loosened regulations of attracting foreigninvestment Together with the admission of the internationaltrade organisation, this has contributed significantly to theintegration of Vietnam into the world market Vietnam hasremoved barriers for foreign investors and facilitate both indirectand direct capital investment Using 167 firms listed on VietnamStock Exchange as the case study, this paper focuses onanalysing impacts and relationship between the foreign ownershipand earnings quality of these firms The objectives of this studyare to uncover: (1) influences of the foreign investment on theearnings management of firms and (2) impact of high and lowlevels of the foreign ownership on the earnings quality of firms

2 Background theories and empirical studies

The study of impacts of the foreign ownership on the earningsquality was based on the asymmetric information theory and theknowledge spillover theory

The asymmetric information theory was studied by GeorgeAkerlof, Michael Spence and Joseph Stigliz (1970) Regarding tothe earnings management, the asymmetric information occurswhen managers take the advantage of the fact that foreigninvestors have very little information of situation of firms anddomestic market and, therefore, make fraudulent acts, adjustprofit and indicators on financial reports These activities lead tothe fact that investors, particular foreign investors, cannot control

behaviours of firms; they are classified as the moral hazard Inaddition, the standards and regulations

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of accounting in a particular country may cause restrictions on theunderstanding of foreign shareholders Therefore, in a firm with alarge number of foreign shareholders, managers can manage andadjust income for their own purposes This is called theasymmetric information which is less favourable by foreigninvestors than domestic investors As pointed out by Choe et al.(2001) and Dvorak (2005), in the Indonesian market, domesticinvestors 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 theeconomist 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 toCarlino (2001), the spillover facilitates exchange of ideas andpromotion of creativity and innovation which are the importantfactors for sustainable economic development of countries Based

on this theory, the concentration of firms in a similar industryhelps 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 andreport financial status Therefore, the knowledge spillover theorysuggests that firms with high level of the foreign ownership tend

to perform more real earnings adjustment in a comparison withones having low level of the foreign ownership

Xiao et al (2004) argued that foreign investors faced morechallenges due to the asymmetric information than the domesticinvestors did and managers had more information of status offirms and market compared to foreign investors Therefore, realearnings adjustment is still likely in firms having high foreignownership Similarly, Klai and Omri (2001) showed that thepresence of foreign investors reduced the quality of financialreports Adebiyi and Olowookere (2006) argued that firms withhigh level of foreign ownership are associated with high realearning 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 toimprove the quality and

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

US, Hejazi and Safarian (199) pointed out that the foreign ownershiphas positive spillover effects on efficiency and technology Hallward-Driemeiter et al (2002) conducted surveys in Indonesia, SouthKorea, Malaysia, Philippines and Thailand and found that foreign-owned enterprises in East Asia are more productive compared toother firms The study of Ho et al (2010) showed that, in smallenterprises, the more the foreign ownership, the greater therelationship between technology investment and firm productivity;therefore, foreign investors tend to bring IT professionals to helpsmall enterprises Abor and Biekpe (2007) demonstrated that foreignownership has positive impact on the quality and productivity ofsmall and medium enterprises According to Aydin, Sayim andYalama (2007), foreign-owned enterprises contribute more toenhance the financial performance and improve the performancecompared to owned enterprises in the county Gillan and Starks(2003) argued that foreign investors are the key role in promotingchanges in the corporate governance of firms through directmonitoring 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 thecorporate governance system and argued that a firm withinvestment from foreign financial institutions has a strongerfoundation 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 foreignownership the higher the quality of income Alaryan (2015) pointedout that the foreign ownership plays a vital role in ensuring thequality of profit Taking Jordan as an example, he found that theknowledge spillover theory was supported and that the higherforeign ownership leads to more control over the management ofdomestic business income Gue et al (2005) studies foreignshareholders and real earnings adjustment on financial reports andsuggested that foreign shareholders have positive effects on thequality of the real earnings The higher the foreign ownership, thelower the real earnings adjustment; this is the factor to restrict realearnings adjustment

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Table 1

Foreign ownership of different disciplines

No Disciplines

Number of companies

Source: Stata analysis performed by the authors.

This study was based on the work of Guo et al (2015) whichwas 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 theknowledge spillover theory

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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 theasymmetric information theory

3.3.1 Independent variables

The foreign ownership (FO) of the firm, which was studies in thestudies of Dahlquist et al (2003) and Leuz et al (2009), is theratio of the number of shares held by foreign investors (whichinclude private foreign investors, supporting funds and financialinstitutions) to the total amount shares of a firm For one firm, thisvariable is the measurement of influences of foreign investors onthe domestic market at the end of each year FO is defined as

!" = $%&'() +, -ℎ/)(- ℎ+01 '2 ,+)(345 356(-7+)- 9100

8+7/0 5%&'() +, -ℎ/)(- +, 7ℎ( ,3)&

In addition, the regression model contains other variablesshowing 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 monitoringbusiness 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 financialperformances of firms and to show efficiency in deploying assets

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

/ (7-Tran Thi Thuy Linh et

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Growth of assets (GROWTH): Roychowdhury (2006) showed

that potential sustainable growth of assets can lead to substantial

changes in the real earnings management

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

M N

+ M P ∆<E@?< KL + M S TT? KL + M U D"E KLOP + V KL

8EKL = E<<?8< KLOP

<E@?< L − <E@?< LOP

Source: Authors’ summary.

According to Chung et al (2004), the discretionary accruals canhelp managers adjust the real earnings This variable is,therefore, used to increase the accuracy of the regression modeland 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 earningsand are associated to suspicious cash flow, low discretionary expensesand high production costs Therefore,

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<d<T?W8 =

0, 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 adjusttheir earnings to satisfy their previous profit

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 creditterms to boost temporary sales, which lead to the current periodearnings increase However, current period cash flows may not goup

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&Dexpenses, and selling, general and administrative expenses.Although these expenses are not essential to business operation,managers can use them to increase earnings by reducing currentexpenditures

Abnormal production costs are the third index used byRoychowdhury (2006) The study of Pan (2009) showed that firmstry to increase their profit by reducing discretionary expenses andcost of goods sold Then, managers can increase production morethan being required to decrease average cost per unit, whichleads to lower the reported cost of goods sold (COGS) and inflateoperating profit margins The excessive production also leads tohigher production and inventory holding costs For a given level ofsales, this increases annual production costs and lowers current

period cash flows The production costs were defined as thesummation of COGS and changes in inventory during the year.

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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, thisvariable is defined as ACFO + ADIS – APROD

COM_REM Cohen et al (2008)

A combined measure of the variable REM:

This table listed original studies of the four indices andestimated results in the following 3 equations by the OLSregression model:

LOP = s N + s P ∗ ELOP + s S ∗ ELOP + s U ∗ ELOP + s w ∗ ELOP + u L (3)

The impact of foreign ownership regression for the four criteria for the expression of real earnings management By equation:D?y = s N + s P ∗ !" + s S ∗ <=>? + s U ∗ @?C?DEF? + s w ∗ D"E + s z

∗ 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 thecorrelation between variables to uncover statistically meaningfulvariables The authors performed Durbin-Watson test, White testand Heteroskedasticity test: Breuch-Pagan-Godfrey to correct the

OLS regression In addition, the authors used the robust and thetwo-stage least squares (2SLS) regression.

Table 4 presents the variation of the foreign ownership in differentyears There were 167 firms each year in the sample of data Theaveraged ownership of foreign investors in the duration from 2011 to

2015 was 13.18% The averaged ownership was increasing andreached 14.37& in 2015 In a comparison with Vo (2015), theaveraged foreign ownership of Vietnam increased from 10%measured in 2007 to 51.3% measured in 2015 This result showedthat the foreign investors play a more important role in firms inVietnam

Table 5 reports results of the statistics of all samples (835observations) The mean values (MEAN) of ACFO, ADIS, APRO andCOM_REM were 0.000 These mean values are positive and muchsmaller than expected value; in addition, they are very small thatwas close to 0 Therefore, a good agreement can be concluded.When using all samples, the mean and median of the foreignownership 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 was0.121 The mean and median of total assets was 159 billion nad

26 billion VND The averaged long-term liabilities was accountedfor 12.2% of the total assets 5.87% of the total firms havenegative profit and 9.82% of the total firms were suspicious due

to very small positive profit

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Table 5

Descriptive statistics of all samples

Source: Authors’s compilation by stata 12.0

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

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Table 6

Correlation matrix of variables

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Table 6 reports the correlation between variables in theresearch model In addition to the four dependent variables, thevariables in the model are almost not strongly correlated Thevariable foreign ownership- FO is positively correlated with thevariables ACFO, ADIS, COM_REM but which is negativelycorrelated with the variable APROD It is a good indicator of the

knowledge spillover theory that foreign ownership has a positiveimpact on income management

Table 7

Determine the sample mean/median difference

ownership group

This table examines the mean difference between low and high foreign ownership groups The variables are defined in section 3.3 Enterprises are classified as high foreign ownership, if the foreign ownership is

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greater than and equal to 10%; and the foreign ownership is low if vice versa.

*, **, and *** denote significance level of 10%, 5% and 1% respectively

Source: Authors’s compilation by stata 12.0

Table 7 shows the results of the mean/median differencebetween the two groups of high, low and comparable foreignownership The author finds that the average of abnormal cashflows from operations (ACFO), abnormal discretionary expenses(ADIS), and the comprehensive real earnings managementmeasure (COM_REM) are notably higher for the high foreignownership firms than the for the low foreign ownerships firms,which indicates that high foreign ownership firms less likelyinvolve in real earnings management In contrast, the abnormalproduction cost (APROD) is significantly lower for high foreignownership firms than for low foreign ownership firms, suggestingthat a greater foreign investment base will be less likely impacted

by real earnings management High foreign ownership firmsachieve the everage of SIZE, ROA, and GROWTH higher than lowforeign ownership firms.Therefore, we can conclude that foreigninvestors prefer large firms with a high of return on total assetsalso a high annual asset growth

This study also finds that the average value of the absolutevalue of discretionary accruals (ABS_DA) of the low foreignownership firms are higher than the high foreign ownership firms.Assume that firms with more foreign investors are less likely touse discretionary accurals for earnings management, which issuitable for the findings of Chung et al (2004) In addition, thepaper mentions that foreign investors hold disproportionateshares in firms, they will hold more shares in firms with betteraccounting performances and with low leverage, which isconsistent with the evidence from Kang and Stulz (1997).Furthermore, the results show that high foreign ownership firmshave higher growth opportunities than low foreign ownershipfirms Moreover, high foreign invested enterprises are less likely

to be classified as suspected enterprises with earnings adjustmentactivities

4.3 Results of the OLS regression model

4.3.1 Regression Results for 4 Real Earnings Management (REM)

Table 8 presents the estimated parameters from the realearnings management models by results of the OLS regressions