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The impact of related party transactions on earnings management: some insights from the Italian context

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Abstract

Related party transactions have become a key issue as a result of recent financial scandals. This study examines whether firms use related party transactions for earnings management, and then, whether they try to minimize detection through the format of related party transactions disclosure. Firstly, we analyze the association between related party transactions structure (types and parties involved) and the probability of reporting small earnings increase. Related party transactions may have significant impact on, and implications for, earnings management. According to the agency theory, related party transactions are used opportunistically, while the efficient transaction hypothesis argues that related party transactions meet the economic needs of the business. We next investigate the association between the probability of reporting small earnings increases through related party transactions and disclosure quality. Disclosure quality should be studied in relation to impression management and investor attention; this approach takes account of the idea that earnings management behavior may influence the quality of disclosure as a possible way of lowering conflict of interest. In line with the agency theory, our findings show that revenue related party transactions are more likely to be used to manage earnings than other types of transaction; related party transactions with ultimate parents are associated with lower probability of reporting small earnings increases compared to operations with other related parties. Lastly, our results confirm that the decision to engage in earnings management is related to lower disclosure quality.

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Notes

  1. The term “ultimate parent” refers to the company that owns the majority of the shares of the “immediate parent” listed company, while joint venture and associated firms are aggregated because information is not provided separately in the financial statement.

  2. See one example of RPT disclosure in the annex in Appendix 1.

  3. There is a specific department of CONSOB that takes care of the sanction procedures, called “Administrative Sanction Office”. The commission first makes a monitoring action through several inspections, which can last several months. Then, if there is a violation of a CONSOB regulation, a letter of notification is sent to the company subject to the monitoring, that it may defend itself. Finally, an administrative (for a maximum of 10% of the revenue or the double of the earnings gained by the violation) or another type of sanction (such as additional inspections) is inflicted and published on the website and the legal journal of CONSOB.

  4. Shareholders and stakeholders can sue the managers for a violation related to the financial statement. This usually leads to an administrative sanction. However, in a more serious case, there is also a penal responsibility for “false disclosure” (Italian Civil Code art. 2622).

  5. We define disproportionate control as when insiders have concentrated ownership stakes and enjoy control rights far in excess of their cash flow rights (Gopalan and Jayaraman 2012).

  6. Impression management has its origins in psychology literature (Schlenker 1980; Reiss 1981). The term “impression management” refers to the process by which individuals attempt to control the impressions of others (Leary and Kowalski 1990, p. 34). In the context of corporate reporting, impression management occurs when management selects information to display and presents that information in a manner that distorts readers’ perceptions of corporate achievements (Neu 1991; Neu et al. 1998).

  7. We checked their correlation and there is no problem of multicollinearity.

  8. We run G-power analysis of sample size using an α = 5%, a power (1 − β) = 90%, an effect size (f2) = 0.20 and a number of predictors = 16 in a t test linear multiple regression with fixed effect, and we find a minimum sample size of 56 firms.

  9. The database Analisi Informatizzata Delle Aziende contains financial data for Italian companies.

  10. T test of mean difference with equal variance and t-test of mean difference with unequal variance, level of significance = 5%.

  11. I.e., Insiders’ significant autonomy with regard to firm decisions.

  12. Results for Eq. (3) show that revenue RPT with unconsolidated subsidiaries and joint ventures or associated companies have higher EM than other types and parties (α1 = 0.220; p value = 0.010) and revenue RPT with ultimate parent have lower EM than other types and parties (α3 = − 0.398; p value = 0.069). We show that one aspect of RPT has an effect on the other and thus, the interaction helps us to better estimate the predicted EM.

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Authors and Affiliations

  1. University of Parma, Via Kennedy, 6, 43125, Parma, Italy

    Pier Luigi Marchini & Alice Medioli

  2. Free University of Bozen-Bolzano, Via Università, 1, 39100, Bolzano, Italy

    Tatiana Mazza

Authors
  1. Pier Luigi Marchini
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  2. Tatiana Mazza
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  3. Alice Medioli
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Corresponding author

Correspondence to Pier Luigi Marchini.

Appendices

Appendix 1: Example of RPT disclosure in the annexes

figure a

Appendix 2: Variable definitions

Dependent variables

 EM

 = 1 if 0 ≤ [(earnings t − earnings t − 1)/total assets t − 1] < 0.01, and zero otherwise

Independent variables

RPT variables

Revenue

= 1 if the type of RPT is a sale or service revenue, zero otherwise

Purchase

= 1 if the type of RPT is a goods or services purchase, zero otherwise

Financial revenue and expense

= 1 if the type of RPT is a financial revenue or a financial expense, zero otherwise

Ultimate parents

= 1 if the RPT is with ultimate parents, zero otherwise

Unconsolidated subsidiaries

= 1 if the RPT is with unconsolidated subsidiaries, zero otherwise

Joint ventures or associated companies

= 1 if the RPT is with joint ventures or associated companies, zero otherwise

Disclosure quality

= 1 if the RPT disclosure is in the MD&A—using narrative disclosure;

= 2 if the RPT disclosure is in the MD&A—using a table;

= 3 if the RPT disclosure is in the annexes—using a table;

= 4 if the RPT disclosure is in the note to the financial statements and in the MD&A—using a table;

= 5 if the RPT disclosure is in the note to the financial statements—using narrative disclosure; and

= 6 if the RPT disclosure is in the note to the financial statements—using a table

MD&A

= 1 if the RPT disclosure is only in the MD&A, zero otherwise

Control variables

Size

= the natural logarithm of total assets at the end of the fiscal year;

SDCFO

= the standard deviation of operating cash flow over three years scaled by total assets at the beginning of the fiscal year;

CFO

= operating cash flow of the current year scaled by total assets at the beginning of the fiscal year;

Absaccrual

= absolute value of total accruals in year t − 1 scaled by total assets at the end of t − 1;

Loss

= 1 if net income < 0, and 0 otherwise;

Leverage

= total assets scaled by total equity at the end of the fiscal year;

Sales growth

= (revenues t − revenues t − 1) scaled by revenues t − 1;

CATA

= ratio of short term assets to total assets

IMR

= the inverse mills ratio from Eq. (5)

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Marchini, P.L., Mazza, T. & Medioli, A. The impact of related party transactions on earnings management: some insights from the Italian context. J Manag Gov 22, 981–1014 (2018). https://doi.org/10.1007/s10997-018-9415-y

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