Diversification and earnings management

Abstract

This dissertation focuses on benchmark-driven earnings management by diversified firms. It is comprised of two essays. The first essay draws a comparison between diversified and focused firms of their propensity to meet or beat earnings benchmarks and investors' reaction to such earnings news. The second essay investigates the impact of diversified firms meeting or beating earnings benchmarks on 'diversification discount'. The operations of diversified firms are inherently more complex and financial information produced by such firms is also more difficult to analyze compared to focused firms (Cohen and Lou, 2012). In the first essay, I reason that this lower transparency in information environment and higher operational complexity gives managers of these firms greater flexibility in making decisions which influence reported earnings. This greater flexibility enables managers to use earnings management when presented with an incentive to do so, for example to achieve important earnings targets. Using annual and quarterly data from 1998 to 2012, I find that diversified firms are more likely to meet or just beat analysts' forecasted earnings as compared to focused firms. I also find evidence that firms are more likely to meet or beat earnings benchmarks in the years following an increase in firm diversification. Further support for greater susceptibility of diversified firms to earning management is gained with evidence that when "unmanaged" earnings of firms fall just below important earnings benchmarks, diversified firms are more likely to use accruals to achieve those targets. Prior studies have demonstrated that firms that meet or beat earnings benchmarks are 'rewarded' by markets in the form of positive stock price reactions. If investors recognize that managers of diversified firms have greater flexibility in manipulating reported earnings through accruals or real business decisions, the positive stock price reaction to meeting such targets by these firms is expected to be of smaller magnitude. I examine 5-days stock price reaction around earnings announcements and find that investors reward less(punish more)the diversified firms, as compared to focused firms, when they (fail to) meet or beat earnings targets. Accounting and finance literature has documented that diversified firms are valued at a discount compared to imputed value of pseudo-conglomerates of standalone firms. The source of this discount has been proposed to be agency problems, poor corporate governance and greater information asymmetry associated with diversified firms. In the second essay I investigate whether earnings quality of diversified firms, as a reflection of such problems, is associated with this 'diversification discount'. I find evidence that diversified firms which just meeting or beating earnings forecasts and especially the firms suspected of using accruals to meet or beat these targets suffer larger discount. These results further support the suggestion that markets account for the relatively lower earnings quality of diversified firms in pricing decisions. Taken together, results in these essays indicate that diversified firms enjoy more flexibility in financial reporting and are subject to greater asymmetric information problems than focused firms. I also show that investors recognize this flexibility in their capitalization of earnings and in valuation of the diversified firms' stocks.