Earnings Management through Affiliated Transactions

Prior research has investigated earnings management primarily through the use of discretionary accruals. We examine whether, in addition to discretionary accruals, firms further engage in earnings management using transactions with affiliated companies. When a parent company has a dominant relation over affiliated companies, the parent company can structure transactions between itself and affiliates in a way that allows it to achieve income-reporting objectives beyond the use of discretionary accruals. We address this research issue in Japan because Japanese firms issue both parent and consolidated financial statements. In addition to earnings management techniques that can be used to manage consolidated earnings, parent earnings can also be managed using transactions with affiliates. We find earnings management behavior for both parent and consolidated earnings around three earnings thresholds: avoiding losses, avoiding earnings declines, and avoiding negative forecast errors. Consistent with additional earnings management through affiliated transactions, parent earnings show stronger evidence of earnings management than consolidated earnings at each of these three earnings thresholds. Further tests indicate that the increased management of parent earnings around these three earnings thresholds is related to the firm's ability to use affiliated transactions, while the management of consolidated earnings is unrelated to the firm's ability to use affiliated transactions.