Decision Usefulness of the Equity Method of

Accounting

by

Amanda L. Gonzales

Business Administration Duke University

Date: Approved:

Katherine Schipper, Supervisor

Jennifer Francis

John Graham

William Mayew

Per Olsson

Dissertation submitted in partial fulfillment of the requirements for the degree of Doctor of Philosophy in Business Administration in the Graduate School of Duke University 2013 Abstract Decision Usefulness of the Equity Method of Accounting

by

Amanda L. Gonzales

Business Administration Duke University

Date: Approved:

Katherine Schipper, Supervisor

Jennifer Francis

John Graham

William Mayew

Per Olsson

An abstract of a dissertation submitted in partial fulfillment of the requirements for the degree of Doctor of Philosophy in Business Administration in the Graduate School of Duke University 2013 Copyright c 2013 by Amanda L. Gonzales All rights reserved except the rights granted by the Creative Commons Attribution-Noncommercial Licence Abstract

I examine the decision usefulness of the equity method of accounting from two per- spectives. First, I examine the value relevance of information provided under the equity method relative to the value relevance of information resulting from measur- ing investments in affiliates at fair value. For a sample of 221 U.S. investors with publicly-traded affiliates during 1993-2011, I find that balance sheet measures of in- vestments in publicly-traded affiliates provided under the equity method are associ- ated with investors’ stock prices, but income from these affiliates recognized under the equity method is not associated with investors’ stock prices. In addition, fair value balance sheet and income measures of investments in publicly-traded affiliates are incrementally associated with investors’ stock prices after controlling for infor- mation provided under the equity method. The incremental value relevance of fair value measures for investments in publicly-traded affiliates exists for both investments identified as held for sale and those identified as strategic, with no evidence that the incremental value relevance is higher (lower) for investments identified as held for sale (strategic). This result suggests that the 2010 and 2013 proposals by the U.S. Financial Accounting Standards Board to distinguish between investments in affili- ates based on management’s intended method of value realization are not supported by differences in the relative value relevance of fair value measures for these types of investments. Second, I evaluate whether equity method investors use their significant influence to manage income reported under the equity method. For a sample of 202

iv U.S. firms from 1993-2011, I find that signed discretionary accruals of affiliates are higher when income from affiliates allows investors to meet earnings targets. This result is consistent with equity method investors influencing the financial reporting of affiliates to achieve earnings targets.

v To my husband, Kevin, whose unending support, encouragement, and sacrificial love made it possible for me to complete this dissertation.

vi Contents

Abstract iv

List of Tables ix

Acknowledgements xi

1 Introduction1

2 The Equity Method of Accounting8

3 Sample and Data 10

4 Descriptive Statistics 14

4.1 Variables Specific to the Equity Method...... 14

4.2 Comparison of Equity Method Investors and Affiliates with the Full Compustat Population...... 20

4.3 Analysis of Changes in Firms When Held As Affiliates...... 21

5 Value Relevance of Information Provided by the Equity Method 23

5.1 Related Literature and Hypotheses Development...... 23

5.2 Research Design...... 32

5.3 Empirical Results...... 35

5.4 Supplementary Analyses...... 42

5.4.1 Correlation between Investor and Affiliate Returns...... 42

5.4.2 Theoretical Values in a Residual Income Model...... 43

vii 6 Earnings Management by Investors with Significant Influence 46

6.1 Related Literature and Hypotheses Development...... 46

6.2 Research Design...... 50

6.3 Empirical Results...... 55

6.4 Supplementary Analyses...... 60

6.4.1 Effect of “True” Significant Influence...... 60

6.4.2 Differences in Earnings Management of Public Affiliates and Private Affiliates...... 63

6.4.3 Potential for Mechanical Relation Between Investor Incentive and Outcome Variables...... 66

6.4.4 Additional Investigation into Effects of Accruals Reversal... 67

6.4.5 Other Potential Methods of Managing Earnings from Invest- ments in Affiliates...... 68

6.4.6 Reverse Causality/Endogeneity...... 72

6.4.7 Effect of Equity Method Ownership on Accounting Conser- vatism of Affiliates...... 72

7 Link between Value Relevance and Earnings Management 78

8 Conclusion 82

A Description of the Cost Method 84

Bibliography 87

Biography 94

viii List of Tables

3.1 Sample Identification...... 11

4.1 Descriptive Statistics for Full Sample of Equity Method Investors.. 16

4.2 Descriptive Statistics for Full Sample of Affiliates...... 17

4.3 Investors’ Prior and Subsequent Ownership of Affiliates...... 19

4.4 Industry Analysis...... 20

5.1 Descriptive Statistics for the Analysis of the Relation between In- vestors’ Stock Prices and Balance Sheet and Income Measures of In- vestments in Affiliates...... 36

5.2 Correlation Coefficients for the Analysis of the Relation between In- vestors’ Stock Prices and Balance Sheet and Income Measures of In- vestments in Affiliates...... 37

5.3 Relation between Investors’ Stock Prices and Balance Sheet and In- come Measures of Investments in Affiliates...... 40

5.4 Effect of the Correlation of Investor and Affiliate Stock Returns on the Relation between Investors’ Stock Prices and Balance Sheet and Income Measures of Investments in Affiliates...... 43

5.5 Evaluation of Theoretical Values of Coefficients Relating Investors’ Stock Prices to Balance Sheet and Income Measures of Investments in Affiliates...... 45

6.1 Descriptive Statistics for the Discretionary Accruals Analysis..... 56

6.2 Correlation Coefficients for the Discretionary Accruals Analysis... 57

6.3 Relation between Equity Method Ownership and Discretionary Accru- als of Affiliates...... 59

ix 6.4 Effect of “True” Significant Influence on the Relation between Equity Method Ownership and Discretionary Accruals of Affiliates...... 64

6.5 Effect of Existence of Private Affiliates on the Relation between Equity Method Ownership and Discretionary Accruals of Affiliates...... 66

6.6 Effect of Defining Investor Incentive Variable as Just Meeting or Beat- ing an Earnings Target on the Relation between Equity Method Own- ership and Discretionary Accruals of Affiliates...... 67

6.7 Relation between Equity Method Ownership and Discretionary Accru- als of Affiliates for Investors with INCENTIVEINV EST ORk,t = 0 in All Periods...... 69

6.8 Relation between Equity Method Ownership and Accounting Conser- vatism of Affiliates...... 77

7.1 Effect of Earnings Management by Investors on the Relation between Investors’ Stock Prices and Balance Sheet and Income Measures of Investments in Affiliates...... 80

7.2 Effect of Separating Publicly-Traded and Private Affiliates on the Re- lation between Investors’ Stock Prices and Balance Sheet and Income Measures of Investments in Affiliates...... 81

x Acknowledgements

I thank my dissertation committee members Jennifer Francis, John Graham, Bill Mayew, Per Olsson, and Katherine Schipper (chair) for valuable comments and di- rection. I also thank Dirk Black, Thomas Steffen, and workshop participants at Duke University, Georgetown University, Indiana University, Pennsylvania State Univer- sity, Texas A&M University, the University of Nebraska—Lincoln, and the University of Washington for helpful suggestions.

xi 1

Introduction

This paper examines two aspects of the decision usefulness of information provided by applying the equity method of accounting. First, I examine the value relevance of balance sheet and income statement information provided under the equity method relative to the value relevance of balance sheet and income statement information resulting from measuring investments in affiliates at fair value.1 Second, I evaluate whether equity method investors use their significant influence to manage income reported under the equity method. The equity method of accounting was promulgated in its current form over forty years ago by APB Opinion No. 18 “The Equity Method of Accounting for Invest- ments in Common Stock” (APB 18). APB 18 preceded the Conceptual Framework of the U.S. Financial Accounting Standards Board (FASB) and does not specify a measurement attribute for investments in affiliates.2 Instead, it describes the me-

1 Throughout this paper, I use the term “affiliate” to refer to a firm that has a corporate investor applying the equity method of accounting to its investment in that firm. 2 The FASB (ASC Glossary) defines a measurement attribute as the “quantifiable characteristic of an item that is measured for accounting purposes.” For example, fair value is the “amount at which an asset (or liability) could be bought (or incurred) or sold (or settled) in a current transaction between willing parties, that is, other than in a forced or liquidation sale.” In contrast, the carrying

1 chanics of calculating the carrying value for such investments (a calculated value, not a measurement). Since APB 18 was issued, accounting standard setters have required fair value measurement for certain financial assets (e.g., SFAS No. 12, Accounting for Certain Marketable Securities (1975); SFAS No. 115, Accounting for Certain Investments in Debt and Equity Securities (1993); SFAS No. 133, Accounting for Derivative Instruments and Hedging Activities (1998)). However, the FASB has not changed the accounting requirements for investments in affiliates. The durability of the equity method raises questions about whether some distinctive feature of invest- ments in which investors have the ability to exercise “significant influence” over the operating and financial policies of investees makes the equity method a decision useful accounting treatment for these types of investments. My research aims to shed light on the decision usefulness of the information pro- vided by applying the equity method from two perspectives. First, I examine the value relevance of balance sheet and income statement information provided under the equity method relative to the value relevance of information resulting from mea- suring investments in affiliates at fair value; that is, accounting for them as if they were trading securities. This analysis can be thought of as a joint test of relevance and faithful representation, the two fundamental qualitative characteristics of useful financial information identified in Chapter 3, Qualitative Characteristics of Useful Financial Information, of the FASB’s Conceptual Framework. For a sample of 221 U.S. investors with publicly-traded affiliates during 1993-2011, I find that balance sheet measures of investments in publicly-traded affiliates provided under the equity method are associated with investors’ stock prices, but income from these affiliates recognized under the equity method is not associated with investors’ stock prices. In addition, fair value balance sheet and income measures of investments in publicly- value of an equity method investment can only be described by explaining how it is calculated; it is not a characteristic of the underlying equity securities held.

2 traded affiliates are incrementally associated with investors’ stock prices after con- trolling for information provided under the equity method. This result suggests that fair value measurement provides incremental relevant information, compared to the equity method, for investments in affiliates.3 I refine this analysis to incorporate the FASB’s most recent deliberations on the accounting for investments in affiliates, which reflect the idea that an entity’s plan for realizing value from its investment in an affiliate (i.e., its business model) affects the relevance of various measurement attributes. In particular, the FASB’s 2010 Exposure Draft, Accounting for Financial Instruments and Revisions to the Accounting for Derivative Instruments and Hedging Activities, proposed restricting the application of the equity method to cases where the investor has significant influence over the investee and the operations of the investee are considered related to the investor’s consolidated operations (“strategic” investments in affiliates). If these two criteria are not satisfied, the investment would be measured at fair value with changes in fair value included in net income. The FASB’s 2013 Exposure Draft, Recognition and Measurement of Financial Assets and Financial Liabilities, revised the proposals to require investors with the ability to exercise significant influence over an investee to use the equity method unless the plan is to realize value by selling the investment. In that case, the investment should be measured at fair value with changes in fair value included in net income. I separately analyze the incremental value relevance of fair value measures for investments in affiliates identified as held for sale and strategic. I find that fair value measurement provides incremental relevant information, compared to the equity method, for both categories of investments in affiliates. In addition, I find no evidence that the incremental value relevance of fair value measures is higher

3 I acknowledge that fair value measurements might be less reliable in other samples, including investments in non-publicly traded affiliates (e.g., investments in some joint ventures). However, that is a measurement (reliability) issue, separate from the relevance of the information provided by measuring investments in affiliates at fair value. The issue of reliability is discussed further in Chapter 5.1.

3 (lower) for investments in affiliates identified as held for sale (strategic). This result suggests that the FASB’s 2010 and 2013 proposals to distinguish between investments in affiliates based on management’s intended method of value realization are not supported by differences in the relative value relevance of fair value measures for these types of investments. My second research question views the equity method from an income statement perspective and examines the neutrality of income reported under the equity method. Neutrality is identified as a component of faithful representation in the FASB’s Con- ceptual Framework. Specifically, I investigate whether the equity method achieves its objective of reducing earnings management. In developing APB 18, a reason noted for requiring the equity method when investors can exercise significant influ- ence is that the cost method might invite earnings management through the timing of dividend payments. However, the equity method does not eliminate the potential op- portunity for earnings management; it shifts the opportunity to a different channel. Equity method investors might have the ability to use their “significant influence” to manage the earnings of affiliates and thereby affect their own income, because a proportionate share of the affiliates’ income flows into investors’ net income. I investigate this issue by examining signed discretionary accruals of affiliates, using a sample of 202 publicly-traded U.S. firms that were affiliates for a portion of the period 1993-2011. I find that signed discretionary accruals of publicly-traded affiliates are higher when income from the affiliates allows investors to meet earnings targets. This result indicates that the equity method does not eliminate concerns about earnings management (such as those expressed in relation to the cost method); instead, it changes the mechanism through which earnings are managed. In supple- mentary analyses, I find evidence that the earnings management result is stronger (a) for equity method investors that are more likely to exercise significant influence (e.g., those that held a subsidiary-level interest in the affiliate prior to application of the

4 equity method, those with ownership of less than 20%, and those with longer holding periods) and (b) when equity method investors do not have an option to manage income from private affiliates and therefore might be more likely to manage income from publicly-traded affiliates even though it might be more difficult or costly. Two previous studies compare the decision usefulness of the equity method of ac- counting with that of proportional consolidation for Canadian firms during 1995-2001. Graham et al. (2003a) and Kothavala (2003) find that proportionate consolidation better predicts future return on equity and price volatility, respectively. Kothavala also finds that the equity method is more risk relevant than proportionate consoli- dation for explaining bond ratings. In addition, Lee et al. (2013) find that analysts’ annual earnings forecasts are less accurate and more dispersed for firms with affiliates relative to firms without affiliates for a sample of 21,336 U.S firm-year observations from 1985-2010. The authors suggest that this is due to the lack of disclosure of com- ponents of affiliate earnings under the equity method. Related to my study, Graham et al. (2003b) examine a sample of 55 U.S. investors from 1993-1997 and find that both the carrying values reported under the equity method and the fair values of in- vestments in publicly-traded affiliates have a positive association with stock prices of investor firms. The authors also find no association between income from investments in affiliates reported under the equity method and investors’ stock prices. I confirm this result for a larger sample and longer time period and also provide evidence of the incremental value relevance of income from investments in affiliates measured using fair value. I also contribute to the equity method literature by providing ev- idence that equity method investors influence the financial reporting of affiliates to achieve their own earnings objectives; that is, use of the equity method does not elim- inate concerns about earnings management. This identification of ex post earnings management extends previous literature documenting ex ante actions taken by firms to manage earnings in relation to equity method investments (e.g., Comiskey and

5 Mulford (1986, 1988); Morris and Gordon (2006)). I also extend the literature investigating the relation between large shareholder ownership and financial reporting characteristics of investees. The literature finds divergent effects of large shareholders on financial reporting quality and suggests the importance of considering the heterogeneity of large shareholders (e.g., Cronqvist and Fahlenbrach (2009) and Hope (2013)). I contribute to this literature by identifying the financial reporting requirements of the large shareholder as a potential factor that can influence the large shareholder’s effect on the financial reporting of its investee. In particular, I find that the mechanics of the equity method (the flow-through of affiliate income to investor income) create both an incentive and an opportunity for earnings management. Finally, I contribute to the ongoing debate at the FASB and International Ac- counting Standards Board (IASB) about the appropriateness of business-model-based accounting for financial instruments. The IASB has promulgated IFRS 9 Financial Instruments which includes a business-model-based provision for the measurement of financial assets; the FASB is proposing a similar provision for investments in debt securities in its project on financial instruments.4 However, the FASB previously stated an objective to improve and simplify the accounting for financial instruments by requiring “all financial instruments to be measured at fair value with realized and unrealized gains and losses recognized in the period in which they occur.”5 These differences in the standard setters’ decisions illustrate a fundamental difference of views about whether measurement attributes should be based on management’s in- tended method of value realization for the items in question (the IFRS 9 position) or

4 IFRS 9 requires entities to measure financial assets at amortized cost subject to impairment if the assets meet specified criteria, including that they are “held within a business model whose objective is to hold assets in order to collect contractual cash flows” (para 4.2(a)). 5 FASB website, Accounting for Financial Instruments—Joint Project of the FASB and IASB. Available at http://www.fasb.org/cs/ContentServer?c=FASBContent C&pagename=FASB%2F FASBContent C%2F ProjectUpdatePage&cid=1175801889654.

6 whether the same measurement attribute should be applied to similar items regard- less of management’s intent. The issue is also part of the FASB’s and IASB’s joint work to develop conceptual guidance for selecting measurement attributes that sat- isfy the objectives and qualitative characteristics of financial reporting and contribute to the reporting of decision useful information. My results suggest that significant influence might not be a foundation for requiring or permitting the use of a different measurement method for investments in affiliates than other investments in mar- ketable equity securities (which are required to be measured at fair value under U.S. GAAP). The results might generalize to other investments in securities accounted for under the business-model-based guidance in SFAS No. 115. For example, the results suggest that fair value might be an appropriate measurement attribute for debt se- curities classified as held to maturity. Even though a firm might intend to realize the value of a debt security through the collection of cash flows, fair value measurement might provide a similar level of information about that investment as is provided for investments that the firm intends to sell. This paper proceeds as follows. Chapter 2 provides a description of the equity method of accounting. Chapter 3 summarizes my sample and data. Chapter 4 presents descriptive statistics. Chapters 5 and 6 summarize related literature, for- mulate hypotheses, outline my research design, discuss the results of my empirical tests, and present supplementary analyses for the value relevance and earnings man- agement tests, respectively. Chapter 7 describes the link between the value relevance and earnings management analyses. Chapter 8 summarizes and concludes.

7 2

The Equity Method of Accounting

In March 1971, the Accounting Principles Board issued APB 18, requiring the eq- uity method of accounting to be used by an investor whose investment in voting stock gives it the ability to exercise significant influence over the operating and financial policies of an investee. APB 18 describes significant influence and specifies that an investment of 20% or more indicates significant influence in the absence of evidence to the contrary and an investment of less than 20% indicates that an investor does not have significant influence unless it can be demonstrated to exist. Under the equity method of accounting, the investor initially recognizes its in- vestment at acquisition cost as a single line item in its balance sheet. Subsequent measurement is based on a calculated value, rather than on a measurement attribute. Each period, the investor recognizes its proportionate share of the affiliate’s net in- come (loss) as income (expense) with the offsetting amount increasing (decreasing) the investment asset balance. Dividends received from the affiliate are recognized as a reduction in the carrying value of the investment. In calculating the amount of income from affiliates, the investor eliminates profits and losses arising from transactions between the investor and affiliate and accounts

8 for any difference between the acquisition cost of the investment and the investor’s share of the underlying equity in the net assets of the affiliate as if the affiliate were a consolidated subsidiary. For example, if the fair value of the affiliate’s property, plant and equipment (PPE) at the time of the investor’s purchase exceeds its carrying amount, the investor adjusts the affiliate’s income to reflect the additional deprecia- tion expense associated with the higher value of PPE. If an investor’s share of affiliate losses exceeds the carrying value of its investment, the investor suspends application of the equity method and does not recognize addi- tional losses (unless it has otherwise committed to provide financial support to the affiliate). The investor resumes applying the equity method only after its proportion- ate share of income exceeds any losses that were not recognized during the time the equity method was suspended. The investor evaluates its equity method investment (as a whole) to determine whether an other-than-temporary impairment has occurred. The equity method in- vestor does not separately test the affiliate’s underlying assets for impairment. If the affiliate recognizes an impairment charge, the investor considers the effect of that impairment on the investor’s basis difference in the assets giving rise to the affiliate’s impairment charge.1

1 ASC 323-10-35 (based on APB 18 and EITF Issue No. 08-6, “Equity Method Investment Ac- counting Considerations) clarifies, “A series of operating losses of an investee or other factors may indicate that a decrease in value of the investment has occurred that is other than temporary and that shall be recognized even though the decrease in value is in excess of what would otherwise be recognized by application of the equity method. A loss in value of an investment that is other than a temporary decline shall be recognized. Evidence of a loss in value might include, but would not necessarily be limited to, absence of an ability to recover the carrying amount of the investment or inability of the investee to sustain an earnings capacity that would justify the carrying amount of the investment. A current fair value of an investment that is less than its carrying amount may indicate a loss in value of the investment. However, a decline in the quoted market price below the carrying amount or the existence of operating losses is not necessarily indicative of a loss in value that is other than temporary. All are factors that shall be evaluated.”

9 3

Sample and Data

I identify 283 U.S. firms (“equity method investors”) with investments in equity securities of 414 publicly-traded firms (“affiliates”) accounted for under the equity method at some point during the period 1993-2011.1 Although the equity method applies to investments in both publicly-traded and private affiliates, I focus on firms with publicly-traded affiliates because of the data required for my analyses.2 Table 3.1 summarizes the sample identification process. I begin by identifying all U.S. firms in the Compustat annual dataset with at least

1 My study is based on U.S. firms. Although similar equity method accounting requirements exist for international firms, I focus on U.S. firms because of the availability of Schedule 13D data to assist me in identifying publicly-traded investees. I am exploring the use of the Amadeus database to expand my sample to European firms. 2 Equity method investors are required (by APB 18) to disclose the fair values of investments in affiliates only when a quoted market price is available. Investments in affiliates are excluded from the scope of SFAS No. 107, Disclosures about Fair Value of Financial Instruments, and therefore no fair value information is required to be disclosed for private affiliates. It is not practicable to construct an “as if” fair value measure of private affiliates in my sample. One possibility would be to use a price-earnings ratio. Equity method investors are required to disclose the name of each affiliate and percentage of ownership of common stock (ASC 323-10-50-3a). However, investors are not required to provide summarized financial information (including net income) about affiliates unless the investments are “material” in relation to the financial position or results of operations of the investor (ASC 323-10-50-3c) and often the summarized financial information presented combines several affiliates.

10 Table 3.1: Sample Identification

Investors Investees U.S. firms with at least one equity method investment in Compustat (non-zero IVAEQ or ESUB) from 1993-2011 5,946 Firms with an available 10-K on the SEC website 4,658 Firms with U.S. publicly-traded investees identified through Schedule 13D filings (includes investments in trading and AFS securities, equity method investees, and subsidiaries) 1,291 2,610 Final sample of U.S. firms with publicly-traded affiliates (i.e., investees accounted for using the equity method) 283 414 one equity method investment (non-zero, non-missing IVAEQ or ESUB) during fiscal years 1993-2011. I restrict my sample to begin in 1993 because I review investors 10-K reports from the SEC’s EDGAR system (“SEC website”) to determine which investments are accounted for under the equity method. Of the 5,946 firms in Com- pustat with an equity method investment, 4,658 also have at least one 10-K available on the SEC website. To identify investors with publicly-traded investees, I write a Perl program that identifies all Schedule 13D filings (original and amendments) on the SEC website made by the 4,658 equity method investors during my sample period.3 The Perl program creates a table with the investor name, investor CIK number, investee name, investee CIK number, and percentage of the equity class owned for each Schedule 13D filing. After excluding investees with no 10-K reports on the SEC website and no data available in Compustat, the sample includes 1,291 investors and 2,610 investees with 3,003 unique investor-investee pairs. Finally, I examine the investors’ 10-K reports to identify publicly-traded invest- ments accounted for under the equity method. For each of the 3,003 unique investor- investee pairs identified above, I identify the filing date of the related Schedule 13D with the highest percentage of ownership of the investee. I then review the investor’s

3 When an investor acquires beneficial ownership of more than five percent of the voting class of a company’s equity securities that are registered with the SEC, the investor must file a Schedule 13D with the SEC. Schedule 13D filings include all publicly-traded investments, including those accounted for as trading securities, available-for-sale securities, equity method securities, and subsidiaries.

11 10-K report for the period including that Schedule 13D filing date. I search for “eq- uity method”, “equity basis”, and “equity in” to identify investments accounted for by the equity method. I determine which of those investments are publicly traded by searching for the investees’ names using the “Company Search” feature on the SEC website. When I identify an investor with a publicly-traded affiliate, I examine all of that investor’s 10-K reports available on the SEC website during my sample period to identify any additional publicly-traded affiliates. For each publicly-traded affiliate identified, I record the dates that the equity method began and ceased to be ap- plied.4 After excluding affiliates with no data available in Compustat, my final sample includes data for 283 investors and 414 affiliates during the period 1993-2011. For each investor 10-K in which a publicly-traded affiliate is identified, I hand- collect the following data (where disclosed) for each publicly-traded affiliate: number of shares held, percentage of ownership, carrying value of investment in affiliate, and income from investment in affiliate.5 APB 18 (ASC 323-10-50-3b) requires disclosure of the aggregate value (i.e., fair value) of each identified investment in an affiliate when a quoted market price is available. I record this value as my measure of the fair value of an investment in a publicly-traded affiliate when it is available. However, I observe noncompliance with this disclosure requirement in 54.43% (768 out of 1,411 firm- years) of my sample. In those cases, I calculate the fair value of the investment in a

4 Some firms do not explicitly disclose the start and end dates of the application of the equity method to a particular investment. In those cases, I assume that the start date is the fiscal year-end date of the first fiscal year in which the investment appears as an equity method investment. I assume that the end date is the fiscal year-end date of the last fiscal year in which the investment appears as an equity method investment. If an investment is accounted for under the equity method before the start of the 1993 fiscal year, I assume that the start date is the first day of the 1993 fiscal year. If an investment is accounted for under the equity method after the end of the 2011 fiscal year, I assume that the end date is the last day of the 2011 fiscal year. 5 If the number of shares held or percentage of ownership is not disclosed, I calculate the amount based on disclosed information and publicly-available data. For example, if the percentage of own- ership is disclosed but the number of shares held is not, I calculate the number of shares held as the percentage of ownership multiplied by the number of shares outstanding recorded in CRSP.

12 publicly-traded affiliate using information disclosed by the investor (either the number of shares held in the affiliate or the percentage of shares held in the affiliate) and publicly-available data from CRSP (the share price of the affiliate and, if necessary, the total number of outstanding shares of the affiliate). If I cannot calculate the fair value of an equity method investment using publicly-available data (329/1,411 firm-years), I do not estimate or impute it. I also construct a measure of income from affiliates as if the investment in the affiliate were remeasured to fair value at each reporting date (“fair value income”), by multiplying the number of shares held at a reporting date by the change in the affiliate’s share price during the period.6 The additional data required for my analyses are from Compustat (accounting data), CRSP (stock price and returns data) and the Thomson Reuters Institutional Holdings Database (institutional ownership data). I use the institutional investor classification data available on Brian Bushee’s website to classify institutions as tran- sient; quasi-indexing; monitoring; and dedicated, non-independent.

6 If the equity method investment was acquired during the reporting period, I calculate fair value income as the number of shares held in the affiliate at the reporting date multiplied by the change in the price per share of the affiliate from the date that the investment was made to the reporting date.

13 4

Descriptive Statistics

4.1 Variables Specific to the Equity Method

Tables 4.1 and 4.2 provide descriptive statistics for the 283 equity method investors and 414 publicly-traded affiliates in my sample. As shown in Table 4.1, equity method investors invest in an average (median) of 3.90 (2.00) affiliates, including an average (median) of 1.51 (1.00) publicly-traded affiliates and 2.48 (1.00) private affiliates.1 Equity method investments comprise an average (median) of 11% (5%) of total assets, including average (median) carrying values of investments in publicly-traded affiliates of $541.40 million ($58.94 million) and in private affiliates of $445.34 million ($3.70 million). The absolute value of income from affiliates comprises an average (median) of 5% (1%) of the absolute value of net income, including average (median) income from public affiliates of $1.83 million ($0.05 million) and private affiliates of $4.98 million ($0.00 million). The average (median) difference between fair value and carrying value of publicly-traded affiliates is $517.76 million ($32.15 million). If income were

1 In an untabulated result, I find that 47.70% (135 out of 283) of the equity method investors in my sample have both publicly-traded and private affiliates.

14 calculated by remeasuring investments in publicly-traded affiliates to fair value each reporting period, some firms would report much lower income (25th percentile reports decrease in income of $22.81 million) and some firms would report much higher income (75th percentile reports increase in income of $18.23 million). I find that 22.61% (64 out of 283) of investors and 6.45% (91 out of 1,411) of investor firm-years in my sample report an impairment of a publicly-traded equity method investment (untabulated). As shown in Table 4.1, for those firm-years, the average (median) impairment totals $98.48 million ($23.70 million), which is an aver- age (median) of 44% (37%) of the lagged carrying value of the impaired investment.2 In an untabulated investigation, I find that equity method investors do not recognize impairments of their investments in 275 cases in which the fair value of the investment is below its carrying value at the reporting date. The investor often states that it believes that the decline in fair value is temporary in these cases. In 13.10% of these cases (36/275), an impairment of the investment is recognized in a future period. In untabulated results, I also find that 9.54% (27/283) of firms in my sample cease applying the equity method for at least one investment because of the recognition of losses in excess of the carrying value of the investment. This represents 4.96% (70/1,411) of available firm-year observations. Table 4.2 documents that for my sample of 414 publicly-traded affiliates, the average (median) equity method holding period during 1993-2011 is 4.17 years (3.25 years) and the average (median) percentage of equity method ownership is 29% (29%). In untabulated results, I find that 83 of the 392 affiliates with data available have a percentage of equity method ownership less than 20% and 7 of the 392 affiliates have a percentage of equity method ownership more than 50%. This suggests that, in some circumstances, firms “rebut” the presumption in APB 18 that significant influence

2 The number of observations for the Impairments of Public Affiliates/Lagged Book Value variable is less than 91 because the lagged book value of the affiliate that was impaired is not available in 41 cases.

15 Table 4.1: Descriptive Statistics for Full Sample of Equity Method Investors

Equity Method Investors with Publicly-Traded Affiliates Full Compustat Population

N Mean Std Dev p25 Median p75 N Mean Std Dev p25 Median p75

Total Assets (in millions) 1411 26240.64 103220.07 727.11 3697.00 16941.95 166,670 6439.22 64229.98 27.03 189.27 1077.69 Net Income (in millions) 1411 555.62 3957.32 -3.87 70.20 452.78 166,670 107.14 1087.54 -2.98 2.10 27.69 Return on Assets 1411 -0.02 0.44 -0.01 0.03 0.06 166,056 -2.40 337.19 -0.09 0.01 0.06 Market Value of Equity (in millions) 1357 17313.58 40307.02 436.88 2223.79 11318.16 144,355 2565.39 13976.06 24.57 127.53 744.76 Market-to-Book Ratio 1354 3.53 19.90 1.15 1.88 3.10 144,061 3.49 340.27 0.92 1.69 3.12 Debt 1408 0.33 0.41 0.14 0.29 0.44 165,363 1.13 69.85 0.03 0.19 0.39 PPE/Total Assets 1304 0.51 0.42 0.14 0.43 0.83 144,771 0.57 3.85 0.15 0.38 0.77 Dividends per share 1389 0.57 0.99 0.00 0.16 0.88 156,114 0.26 1.60 0.00 0.00 0.20 |Total Accruals|/Total Assets 1401 0.11 0.37 0.02 0.05 0.10 155,472 2.55 342.25 0.03 0.07 0.14 Analyst Coverage 1411 11.73 12.39 0.00 8.00 20.00 166,670 3.98 6.92 0.00 0.00 5.00 Firm Age 1411 24.44 17.01 10.00 20.00 39.00 166,670 13.31 12.87 4.00 9.00 18.00 TRA Ownership 965 0.11 0.09 0.04 0.09 0.15 92,506 0.10 0.19 0.01 0.06 0.15 QIX Ownership 965 0.30 0.17 0.16 0.34 0.42 92,918 0.23 1.14 0.05 0.18 0.36 DNI Ownership 916 0.01 0.02 0.00 0.00 0.00 84,429 0.01 0.03 0.00 0.00 0.00 MON Ownership 950 0.07 0.07 0.02 0.06 0.11 90,028 0.05 0.08 0.00 0.02 0.09 Total Institutional Ownership 988 0.50 0.27 0.28 0.56 0.70 97,973 0.39 1.27 0.10 0.33 0.64 Management Ownership 468 0.03 0.07 0.00 0.00 0.01 22,806 0.02 0.06 0.00 0.00 0.01 Total Number of Affiliates Owned 1052 3.90 5.89 1.00 2.00 4.00 16 Number of Public Affiliates 1397 1.51 1.42 1.00 1.00 2.00 Number of Private Affiliates 1046 2.48 5.60 0.00 1.00 3.00 Book Value of Affiliates (in millions) 1272 1145.77 3421.79 24.91 128.76 793.95 Book Value of Public Affiliates (in millions) 1007 541.40 1738.93 12.70 58.94 314.10 Book Value of Private Affiliates (in millions) 996 445.34 1659.46 0.00 3.70 160.59 Income from Affiliates (in millions) 1339 5.83 54.26 -0.24 0.25 3.74 Income from Public Affiliates (in millions) 859 1.83 15.90 -0.13 0.05 1.27 Income from Private Affiliates (in millions) 857 4.98 40.68 0.00 0.00 0.11 Book Value of Affiliates/Total Assets 1272 0.11 0.16 0.02 0.05 0.12 Book Value of Public Affiliates/Total Assets 1007 0.09 0.16 0.01 0.03 0.08 Book Value of Private Affiliates/Total Assets 996 0.03 0.07 0.00 0.00 0.03 |Income from Affiliates|/|NI| 1339 0.05 0.29 0.00 0.01 0.03 |Income from Public Affiliates|/|NI| 859 0.05 0.36 0.00 0.01 0.02 |Income from Private Affiliates|/|NI| 857 0.01 0.06 0.00 0.00 0.01 FV less BV of Public Affiliates (in millions) 1082 517.76 1654.60 0.94 32.15 202.65 FV less BV of Public Affiliates/Total Assets 1082 0.11 0.49 0.00 0.01 0.06 FV less Reported Public Affiliate Income (in millions) 659 -43.41 616.48 -22.81 -0.14 18.23 |FV less Reported Public Affiliate Income|/|NI| 659 3.81 36.44 0.07 0.33 1.09 Impairments of Public Affiliates (in millions) 91 98.48 178.12 4.25 23.70 107.88 Impairments of Public Affiliates/Lagged Book Value 50 0.44 0.37 0.19 0.37 0.64 |Impairments of Public Affiliates|/|NI| 91 0.49 1.07 0.05 0.10 0.51

Firm-years 1,411 166,670 Firms 283 19,196

This table reports pooled annual descriptive statistics for 283 U.S. firms with publicly-traded affiliates and for the full Compustat population (all observations with total assets and net income data available) from 1993-2011. Bold-faced font for the mean (median) values represents differences between the mean (median) value of that variable for my sample vs. the full Compustat population that are significant at a two-tailed p-value of 0.05 or better. The variables are defined following Table 4.2. Table 4.2: Descriptive Statistics for Full Sample of Affiliates

Period Before Becoming an Affiliate (“Pre” Period) Period as an Affiliate (“Event” Period) Paired t-tests for “Event” vs. “Pre” Periods N Mean Std Dev p25 Median p75 Mean Std Dev p25 Median p75 Difference t-stat p-value

Total Assets (in millions) 414 1073.55 3231.77 22.89 125.92 767.57 2248.27 6588.43 80.13 359.22 1521.35 1417.20 3.81 .001 Net Income (in millions) 414 7.44 160.09 -6.32 -0.22 17.48 44.81 371.97 -20.67 0.54 32.52 43.43 1.68 0.094 Return on Assets 414 -0.34 1.64 -0.21 -0.00 0.04 1.10 39.34 -0.15 0.00 0.04 2.25 0.73 0.467 Market Value of Equity (in millions) 384 1184.64 3374.23 44.36 201.43 790.92 1795.19 5321.37 72.06 325.96 1088.69 841.30 2.83 0.005 Market-to-Book Ratio 384 3.27 12.49 1.34 2.33 5.16 24.44 458.52 0.95 1.76 3.52 46.62 0.94 0.348 Debt 413 0.34 0.45 0.06 0.23 0.45 0.33 0.46 0.08 0.26 0.47 -0.03 -1.02 0.307 PPE/Total Assets 395 0.51 0.47 0.17 0.40 0.75 0.47 0.42 0.14 0.36 0.73 -0.04 -2.50 0.013 Dividends per share 404 0.15 0.40 0.00 0.00 0.00 0.22 0.55 0.00 0.00 0.12 0.09 3.03 0.003 |Total Accruals|/Total Assets 412 0.28 1.53 0.06 0.10 0.19 2.69 43.45 0.05 0.09 0.16 3.92 1.14 0.256 Analyst Coverage 414 1.97 3.97 0.00 0.00 2.40 4.13 5.13 0.00 2.00 6.25 2.44 8.54 .001 Firm Age 414 6.15 9.52 1.00 2.50 6.50 9.19 9.93 3.50 6.00 10.50 3.96 34.97 .001 TRA Ownership 309 0.07 0.08 0.01 0.04 0.10 0.08 0.08 0.02 0.06 0.13 0.02 2.44 0.016 QIX Ownership 309 0.14 0.17 0.02 0.10 0.21 0.16 0.14 0.05 0.13 0.25 0.04 2.83 0.006 DNI Ownership 302 0.01 0.05 0.00 0.00 0.00 0.01 0.06 0.00 0.00 0.00 0.01 1.71 0.091 MON Ownership 306 0.05 0.06 0.00 0.02 0.07 0.05 0.09 0.00 0.02 0.08 0.01 1.78 0.078 Total Institutional Ownership 312 0.27 0.27 0.05 0.20 0.45 0.32 0.25 0.10 0.29 0.50 0.08 3.94 .001

17 Management Ownership 65 0.02 0.05 0.00 0.00 0.02 0.02 0.04 0.00 0.00 0.01 -0.01 -2.09 0.049 Holding Period 414 4.17 3.27 1.84 3.25 5.38 Prior Ownership: Subsidiary 92 3.47 2.51 1.66 2.75 4.71 Less Than Significant Influence 29 3.91 3.58 1.33 2.99 5.19 None 184 3.90 3.09 1.84 2.97 5.00 Other 109 5.28 3.80 2.66 4.42 6.71 Subsequent Ownership: Subsidiary 90 3.86 2.98 1.72 3.01 5.00 Less Than Significant Influence 78 3.74 2.89 1.75 2.89 4.59 None 117 4.03 2.90 1.84 3.73 5.38 End of Sample Period 35 7.29 5.67 3.16 6.00 11.51 Other 94 3.82 2.39 1.79 3.00 5.35 Equity Method Percentage 392 0.29 0.13 0.21 0.29 0.38 Prior Ownership: Subsidiary 87 0.33 0.11 0.27 0.34 0.40 Less Than Significant Influence 28 0.26 0.11 0.21 0.24 0.34 None 176 0.29 0.14 0.20 0.28 0.39 Other 101 0.28 0.12 0.20 0.28 0.38 Subsequent Ownership: Subsidiary 84 0.35 0.13 0.26 0.36 0.43 Less Than Significant Influence 75 0.26 0.10 0.20 0.26 0.34 None 112 0.28 0.12 0.19 0.28 0.38 End of Sample Period 35 0.30 0.12 0.21 0.30 0.36 Other 86 0.29 0.15 0.18 0.28 0.38

Firms 414 Period After Becoming an Affiliate (“Post” Period) Paired t-tests for Paired t-tests for “Post” vs. “Event” Periods “Post” vs. “Pre” Periods Mean Std Dev p25 Median p75 Difference t-stat p-value Difference t-stat p-value Total Assets (in millions) 3740.15 14318.74 84.48 585.82 1934.52 1590.30 3.04 0.003 3536.70 2.48 0.014 Net Income (in millions) 10.45 867.61 -16.88 0.32 51.25 -25.95 -0.42 0.673 35.07 0.68 0.500 Return on Assets -0.42 1.93 -0.16 -0.00 0.04 -0.15 -1.31 0.190 -0.27 -1.31 0.193 Market Value of Equity (in millions) 1869.60 5423.78 52.76 268.79 1280.19 240.50 0.97 0.334 1685.50 2.71 0.008 Market-to-Book Ratio 4.65 31.75 0.78 1.63 2.84 1.94 0.89 0.373 1.49 0.63 0.529 Debt 0.94 6.75 0.11 0.28 0.47 0.61 1.39 0.167 0.92 1.21 0.228 PPE/Total Assets 0.55 0.66 0.15 0.42 0.81 0.09 2.21 0.028 0.11 1.70 0.091 Dividends per share 0.33 0.96 0.00 0.00 0.12 0.10 1.90 0.058 0.18 2.46 0.016 |Total Accruals|/Total Assets 0.50 2.31 0.06 0.10 0.17 0.26 1.79 0.074 0.11 1.37 0.173 Analyst Coverage 5.27 6.63 0.00 2.56 8.00 1.17 3.59 .001 3.38 6.33 .001 Firm Age 14.37 10.76 8.00 11.00 16.00 5.35 34.33 .001 8.81 37.52 .001 TRA Ownership 0.12 0.10 0.02 0.11 0.20 0.05 5.49 .001 0.09 5.77 .001 QIX Ownership 0.25 0.20 0.06 0.21 0.42 0.10 7.78 .001 0.20 6.92 .001 DNI Ownership 0.00 0.02 0.00 0.00 0.00 -0.01 -2.09 0.038 -0.01 -0.88 0.384 MON Ownership 0.06 0.08 0.00 0.04 0.09 0.02 3.77 .001 0.02 1.89 0.065 Total Institutional Ownership 0.45 0.33 0.11 0.40 0.76 0.15 8.06 .001 0.29 5.48 .001

18 Management Ownership 0.02 0.05 0.00 0.00 0.01 -0.00 -0.76 0.455 -0.02 -1.28 0.243

This table reports annual descriptive statistics for 414 U.S. publicly-traded firms from 1993-2011. The table reports separate measures for the period prior to the firms becoming affiliates (the “pre” period), the period in which the firms are affiliates (the “event” period), and the period after the firms are affiliates (the “post” period). The table presents the average of the average values for each firm. That is, the average value for a variable is calculated separately for a firm over each period (“pre”, “event”, and “post”). Then the table presents the averages of these values over the 414 firms in the sample. The table also presents the results of paired t-tests comparing the “event” period to the “pre” period, the “post” period to the “event” period, and the “post” period to the “pre” period. Bold-faced font for the mean (median) values during the “event” period represents differences between the mean (median) value of that variable for my sample vs. the full Compustat population that are significant at a two-tailed p-value of 0.05 or better. Descriptive statistics for the full Compustat population are presented in Table 4.1.

The variables used in Tables 4.1 and 4.2 are defined as follows. Total Assets: total assets (AT) of firm j in year t. Net Income: net income (NI) of firm j in year t. Return on Assets: return on assets (NI/AT) of firm j in year t. Market Value of Equity: market value of equity (CSHO*PRCC F) of firm j in year t. Market-to-Book Ratio: market-to-book ratio (CSHO*PRCC F/CEQ) of firm j in year t. Debt: debt-to-assets ratio (DLTT+DLC/AT) of firm j in year t. PPE/Total Assets: ratio of PPE to total assets (PPEGT/AT) of firm j in year t. Dividends per share: dividends per share (DVPSX F) of firm j in year t. |Total Accruals|/Total Assets: ratio of the absolute value of total accruals to total assets (|NI-OANCF|/AT) of firm j in year t. Analyst Coverage: number of analysts in I/B/E/S issuring forecasts for firm j in year t. Firm Age: firm age, measured as the number of years that firm j has been listed on Compustat in year t. TRA Ownership: percentage ownership of firm j at the end of year t by institutional investors described as transient by Bushee (2001). QIX Ownership: percentage ownership of firm j at the end of year t by institutional investors described as quasi-indexing by Bushee (2001). DNI Ownership: percentage ownership of firm j at the end of year t by institutional investors described as dedicated by Bushee (2001) and non-independent by Brickley et al. (1988). MON Ownership: percentage ownership of firm j at the end of year t by institutional investors described as monitoring institutions in Ramalingegowda and Yu (2012) based on classification as dedicated by Bushee (2001) and independent by Brickley et al. (1988). Total Institutional Ownership: percentage ownership of firm j at the end of year t by all institutional investors. Management Ownership: percentage ownership (excluding options) of firm j at the end of year t by the CEO of firm j. Total Number of Affiliates Owned: total number of affiliates owned by firm j in year t. Book Value of Affiliates: book value (IVAEQ) of firm j’s investments in affiliates in year t. Income from Affiliates: income (ESUB) from firm j’s affiliates in year t. Book Value of Affiliates/Total Assets: book value (IVAEQ) of firm j’s investments in affiliates in year t divided by total assets (AT) of firm j in year t. |Income from Affiliates|/|NI|: absolute value of income (ESUB) from firm j’s affiliates in year t divided by the absolute value of net income (NI) of firm j in year t. FV less BV of Public Affiliates: fair value of firm j’s investments in publicly-traded affiliates less the carrying value of those affiliates in year t. FV less BV of Public Affiliates/Total Assets: FV less BV of Affiliate divided by total assets (AT) of firm j in year t. FV less Reported Public Affiliate Income: fair value income from firm j’s publicly-traded affiliates less reported income for those affiliates in year t, where fair value income is calculated as the number of shares held in an affiliate at the end of year t multiplied by the change in the fair value of the affiliate’s share price during year t. |FV less Reported Public Affiliate Income|/|NI|: absolute value of FV less Reported Affiliate Income divided by the absolute value of net income (NI) of firm j in year t. Impairments of Public Affiliates: impairments of publicly-traded affiliates reported by firm j in year t. Statistics include only those firms reporting an impairment. Impairments of Public Affiliates/Lagged Book Value: Impairments of Public Affiliates of firm j in year t divided by the book value of the impaired affiliates in year t - 1. |Impairments of Public Affiliates|/|NI|: absolute value of Impairments of Public Affiliates divided by the absolute value of net income (NI) of firm j in year t. Holding Period: number of years in which firm j is held as an affiliate in the period from 1993-2011. Equity Method Percentage: percentage ownership of firm j in year t by an equity method owner. exists when ownership is between 20-50%. I also analyze the relationships of the investors and affiliates prior to and after application of the equity method. The results are summarized in Table 4.3. I find that prior to application of the equity method, the investor has no holding in the affiliate in 44.44% of cases, a holding of less than significant influence in 7.00% of cases, and a subsidiary-level holding in 22.22% of cases. After application of the equity method, the investor retains no interest in the affiliate in 28.26% of cases, a holding of less than significant influence in 18.84% of cases, and a subsidiary-level holding in 21.74% of cases. Table 4.3: Investors’ Prior and Subsequent Ownership of Affiliates

Investors’ Prior Ownership of Affiliates # of Affiliates % of Affiliates Subsidiary 92 22.22 Less than significant influence 29 7.00 None 184 44.44 Debtholder 4 0.97 Held shares in another entity that was reorganized to form affiliate 13 3.14 Unknown: no previous investor 10Ks available 10 2.42 Unknown: could not determine from available investor 10Ks 82 19.81 Total 414

Investors’ Subsequent Ownership of Affiliates # of Affiliates % of Affiliates Subsidiary 90 21.74 Less than significant influence 78 18.84 None 117 28.26 Distributed to shareholders as dividend 5 1.21 Bankruptcy/dissolution of affiliate 10 2.42 Reorganization/transfer/exchange of shares of affiliate 8 1.93 Unknown: no further investor 10Ks available (prior to end of sample period) 38 9.18 Unknown: end of sample period 35 8.45 Unknown: could not determine from available investor 10Ks 33 7.97 Total 414

Table 4.4 shows the distribution of equity method investors and affiliates across industries. In untabulated results, I find that 50% (39%) of publicly-traded affiliates are in the same 1-digit (2-digit) SIC code as their investors.

19 Table 4.4: Industry Analysis

# of Full % of Full 1-digit # of % of # of % of Compustat Compustat Industry SIC Investors Investors Affiliates Affiliates Sample Sample

Agriculture, Forestry, and Fishing 0 0 0.00 3 0.72 51 0.26 Mining and Construction 1 18 6.36 23 5.56 919 4.79 Manufacturing 2 47 16.61 38 9.18 2,136 11.13 Manufacturing 3 44 15.55 62 14.98 3,724 19.40 Transportation and Public Utilities 4 56 19.79 73 17.63 1,706 8.89 Trade, Wholesale, and Retail 5 19 6.71 28 6.76 1,644 8.56 Finance, Insurance, and Real Estate 6 54 19.08 64 15.46 2,894 15.08 Services 7 27 9.54 79 19.08 3,024 15.75 Services 8 11 3.89 10 2.42 929 4.84 Public Administration 9 3 1.06 3 0.72 655 3.41 Missing - 4 1.41 31 7.49 1,514 7.89

Total 283 414 19,196 The full Compustat sample represents all Compustat firms from 1993-2011 with nonmissing total assets and net income.

4.2 Comparison of Equity Method Investors and Affiliates with the Full Compustat Population

Tables 4.1 and 4.2 also compare accounting, market, and ownership measures of equity method investors and affiliates with the full Compustat population (those observations with minimum data requirements of total assets and net income).3 Bold font in the mean and median columns of Table 4.1 and the “event” period of Table 4.2 represents the existence of a difference between investors (Table 4.1) or affiliates (Table 4.2) and the Compustat population that is significant at a two-tailed p-value of 0.05 or better. As shown in Table 4.1, equity method investors are larger than other firms in Compustat both in terms of total assets (average of $26,240.64 million compared to $6,439.22 million) and in terms of market value of equity (average of $17,313.58 million compared to $2,565.39 million). They are also more profitable in terms of net income (average of $555.62 million compared to $107.14 million) and return on assets (average of -0.02% compared to -2.40%). In addition, equity method

3 In untabulated results, I find that 31% of firms in Compustat (5,946/19,196) during the period 1993-2011 have an equity method investment. I compare my sample of equity method investors with publicly-traded affiliates to this sample of all equity method investors in Compustat. I find that my sample firms are an average of 8.3 years older and have an average of 4.2 more analysts following them relative to the full population of equity method investors. I also find that the ratio of the book value of affiliates to total assets for my sample firms is 5.5% higher on average than that for all equity method investors. I do not find differences in other measures, including total assets, net income, dividends per share, and institutional ownership at a two-tailed p-value of 0.10 or better.

20 investors have a higher institutional ownership percentage (average of 50% compared to 39%) and more analyst following (average of 11.73 analysts compared to 3.98 analysts). As shown in Table 4.2, although the average affiliate is smaller than the aver- age firm in the Compustat population (total assets of $2,248.27 million compared to $6,439.22 million), the median affiliate is larger than the median firm in the Com- pustat population (total assets of $359.22 million compared to $189.27 million). In addition, I find that the average affiliate is younger (firm age of 9.19 years compared to 13.31 years), has more analyst coverage (4.13 analysts compared to 3.98 analysts), and has less institutional ownership (32% compared to 39%) relative to the average firm in the Compustat population.

4.3 Analysis of Changes in Firms When Held As Affiliates

Finally, Table 4.2 documents accounting, market, and ownership measures for the period before a firm became an affiliate (the “pre” period), the period in which the firm is an affiliate (the “event” period), and the period after the firm is an affiliate (the “post” period). The results of paired t-tests indicate that firms become larger in the “event” period relative to the “pre” period both in terms of total assets (an average increase of $1,417.20 million, p-value 0.001) and market value of equity (an average increase of $841.30 million, p-value = 0.005). This trend continues in the “post” period, with an average additional growth in total assets of $1,590.30 million (p-value = 0.003). Firms also appear to attract more institutional ownership and more analyst attention when they become affiliates, with institutional ownership increasing an average of 8% (p-value 0.001) and analyst coverage increasing an average of 2.44 analysts per firm (p-value 0.001). This trend also continues during the “post” period, with institutional ownership increasing an average of an additional 15% (p-value 0.001) and analyst coverage increasing an average of an additional

21 1.17 analysts per firm (p-value 0.001). In contrast, firms do not exhibit changes in net income or return on assets from the “pre” period to the “post” period (two-tailed p-values = 0.500 and 0.193, respectively). I examine several potential manifestations of “significant influence” by equity method investors. First, I calculate a measure of leverage (debt-to-assets) to evaluate whether equity method owners are prompting changes in affiliates’ financing strate- gies. I do not find evidence supporting this type of influence (p-value = 0.307 for the paired t-test from the “pre” period to the “event” period). I find an average decrease of 4% in the ratio of property, plant, and equipment to total assets from the “pre” period to the “event” period (p-value = 0.013). This might reflect changes in the operating structure of the affiliate. I also find that dividends increase an average of $0.09 per share (p-value = 0.003), which represents a more than 50% increase from the average of $0.15 dividends per share in the “pre” period.4 This is consistent with concerns expressed during the development of APB 18 that firms with “significant influence” could affect the amounts and timing of dividend payments. However, the upward trend in dividends per share continues during the “post” period, with an average additional increase in dividends per share of $0.10 (p-value = 0.058), which might indicate that the increase in dividends is due to factors other than equity method ownership.

4 In my sample, 161 firms do not pay dividends prior to becoming affiliates. Of those 161 firms, 18 begin paying dividends when they become affiliates.

22 5

Value Relevance of Information Provided by the Equity Method

5.1 Related Literature and Hypotheses Development

Debate about the appropriate accounting for investments in affiliates predates the issuance of APB 18 over 40 years ago.1 APB 18 (para. 7) describes the concerns about the cost method as follows (see Appendix A for a description of the cost method): “Financial statements of an investor prepared under the cost method may not reflect substantial changes in the affairs of an investee. Dividends included in income of an investor for a period may be unrelated to the earnings (or losses) of an investee for that period. For example, an investee may pay no dividends for several periods

1 Nobes (2002) describes the international development of the equity method. He states that the earliest uses of the equity method were in the early 1900s as a way to include subsidiaries in parents’ financial statements before the practice of consolidation was fully established. After consolidated financial statements became common, some jurisdictions still required/permitted the use of the equity method in parent company financial statements. The equity method is described as a “useful arithmetic device for preparing consolidated balance sheets when there are several layers of subsidiaries” (Nobes, page 19). The application of the equity method to joint ventures and affiliates arose during the 1960s as this type of ownership structure became more common. Nobes (page 40) states that the “uses [of the equity method for inclusion of joint ventures and associates in investor statements or consolidated statements] seem to have arisen with little theoretical justification and no prior research into their usefulness.”

23 and then pay dividends substantially in excess of the earnings of a period. Losses of an investee of one period may be offset against earnings of another period because the investor reports neither in results of operations at the time they are reported by the investee. Some dividends received from an investee do not cover the carrying costs of an investment whereas the investor’s share of the investee’s earnings more than covers those costs. Those characteristics of the cost method may prevent an investor from reflecting adequately the earnings related to an investment in common stock—either cumulatively or in the appropriate periods.” However, APB 18 (para. 13) also indicates that some supported the cost method because “the investor is not entitled to recognize earnings on its investment until a right to claim the earnings arises, and that claim arises only to the extent dividends are declared. The investor is considered to have no earnings on its investment unless it is in a position to control the distribution of earnings. Likewise, an investment or an investor’s operations are not affected by losses of an investee unless those losses indicate a loss in value of the investment that should be recognized.” APB 18 (paras. 10 and 12) indicates that the Accounting Principles Board be- lieved that the equity method provides useful information to investors, stating “the equity method is an appropriate means of recognizing increases or decreases measured by generally accepted accounting principles in the economic resources underlying the investments. Furthermore, the equity method of accounting more closely meets the objectives of accrual accounting than does the cost method since the investor rec- ognizes its share of the earnings and losses of the investee in the periods in which they are reflected in the accounts of the investee. ... The equity method tends to be most appropriate if an investment enables the investor to influence the operating or financial decisions of the investee. The investor then has a degree of responsibility for the return on its investment, and it is appropriate to include in the results of operations of the investor its share of the earnings or losses of the investee.”

24 However, APB 18 also describes a market value method analogous to fair value measurement and states that the market value method “is considered to meet most closely the objective of reporting the economic consequences of holding the invest- ment” (para. 9). At the time that APB 18 was issued, the market value method was used only in special circumstances. APB 18 (para. 9) states, “While the Board believes the market value method provides the best presentation of investments in some situations, it concludes that further study is necessary before the market value method is extended beyond current practice.” The APB did not describe the nature of that further study. Since the issuance of APB 18 in 1971, accounting standard setters have required fair value measurement for certain financial assets (e.g., SFAS No. 12, Accounting for Certain Marketable Securities (1975); SFAS No. 115, Accounting for Certain Investments in Debt and Equity Securities (1993); SFAS No. 133, Accounting for Derivative Instruments and Hedging Activities (1998)). It is also the stated objective of the FASB to improve and simplify the accounting for financial instruments by requiring “all financial instruments to be measured at fair value with realized and unrealized gains and losses recognized in the period in which they occur.”2 However, the FASB has not required fair value measurement for investments in affiliates.3 One possibility is that the FASB is concerned about the reliability or difficulty of fair value measurements for investments in affiliates that are not publicly- traded (as discussed in Chapter 4.1, many firms in my sample have private affiliates).

2 FASB website, Accounting for Financial Instruments —Joint Project of the FASB and IASB. Available at http://www.fasb.org/cs/ContentServer?c=FASBContent C&pagename=FASB%2F FASBContent C%2FProjectUpdatePage&cid=1175801889654. 3 SFAS No. 159, The Fair Value Option for Financial Assets and Financial Liabilities (2007), permits entities to measure investments otherwise accounted for under the equity method at fair value with realized and unrealized gains and losses recognized in earnings at each reporting date. I have identified one firm (out of 283) applying the fair value option to an investment that otherwise would be accounted for under the equity method. The FASB’s 2013 Exposure Draft would remove the option to measure investments in affiliates at fair value and instead require investments in affiliates classified as held for sale to be measured at fair value.

25 However, APB 18 and the most recent FASB discussions on the equity method did not raise the reliability of fair value measurements as a basis for retaining the equity method. In fact, the 2013 Exposure Draft would require fair value measurement for investments in affiliates that an entity intends to sell regardless of whether the affiliate is public or private. Other standards on the accounting for financial assets issued since APB 18 tend to exclude investments in affiliates from their scopes. For example, SFAS 115 (para. 44) states, “The Board decided to limit the scope of the project because of its desire to expedite resolution of the problems with the current accounting and reporting practices for investment securities. Accordingly, the Board decided to address the accounting for only certain financial assets and not to change the accounting for financial liabilities nor include other assets.”4 In summary, if the continued existence of the equity method is based on the reluctance of the FASB to require fair value measurement for financial assets without active markets, the FASB has not articulated that as a basis. This raises questions about whether some distinctive feature of investments in which “significant influence” can be exercised makes fair value a less relevant mea- surement attribute than for other investments in equity securities. The FASB’s most recent discussions on the accounting for investments in affiliates reflect the possibility that management’s plan for realizing value from the investment (i.e., the business model) affects the relevance of various measurement attributes. For example, invest- ments in affiliates might be undertaken for long-term operating or strategic purposes, and thus, the method of value realization might differ from management’s method for realizing value from other investments in equity securities.

4 Similarly, IFRS 9 (para. BC2.1) states, “The scope of IAS 39 has not been raised as a matter of concern during the financial crisis and, hence, the Board believes that the scope of IFRS 9 should be based on that of IAS 39 until it considers the scope more generally in a later phase of the project to replace IAS 39.” The IASB is in the preliminary stages of a research project to fundamentally assess the usefulness of the equity method to investors and the difficulties that preparers face in implementing the equity method (http://www.ifrs.org/Current-Projects/IASB- Projects/equity-method-accounting/Pages/equity-method-accounting.aspx).

26 In its May 2010 Exposure Draft, Accounting for Financial Instruments and Revi- sions to the Accounting for Derivative Instruments and Hedging Activities, the FASB proposed restricting the application of the equity method to cases where the investor has significant influence over the investee and the operations of the investee are considered related to the investor’s consolidated operations (the “related operations criterion”). If these two criteria are not satisfied, the investment would be accounted for at fair value with all changes in fair value recognized in net income. The Basis for Conclusions (para. BC24) explains that the FASB “believes that an entity gen- erally should measure investments in equity securities at fair value with all changes recognized in net income because the only way to realize gains or losses from equity securities is to sell the equity securities. ... However, the Board decided that for those equity investments in which the entity has significant influence over the investee and the investee’s operations are related to those of the entity’s consolidated operations ... the equity method of accounting would provide the most appropriate representation of the underlying economic activity in the entity’s financial statements.” In its redeliberations, the FASB tentatively decided not to retain the “related operations criterion” because of concerns about interpretive and operational issues. Instead, the FASB’s 2013 Exposure Draft would require investments in affiliates to be accounted for under the equity method unless the investment is held for sale (i.e., the plan is to realize value by selling the investment). In that case, the investment should be measured at fair value with changes in fair value included in net income. The classification as a held-for-sale investment would be made upon the investment’s initial qualification for the equity method and could not be changed. This proposal reflects the notion that management’s intended method of value realization from the investment (i.e., sale or strategic operation) should determine whether the item is measured at fair value or using some other approach. I investigate this issue in the context of equity method investments by examining

27 the value relevance of information provided under the equity method relative to the value relevance of information resulting from measuring investments in affiliates at fair value.5 To do this, I treat investments in affiliates as if they were trading securities and measure them at fair value in each reporting period and calculate income based on changes in the fair values of the investments. Previous research generally supports the value relevance of balance sheet measures of fair values for investment securities, often in banks and often not in a context where the method of value realization is considered. For example, Barth (1994) finds that disclosed fair values of investment securities are incrementally associated with bank share prices for a sample of U.S. banks from 1971-1990. Three studies (Barth et al. (1996), Eccher et al. (1996), and Nelson (1996)) examine the value relevance of fair value disclosures made under SFAS No. 107, Disclosures about Fair Values of Financial Instruments, by a sample of U.S. banks from 1992-1993. All three studies find that the fair values of investment securities are incrementally informative relative to book values in explaining bank share prices in at least some specifications. A recent study by Song et al. (2010) confirms the value relevance of fair value measurements for investment securities disclosed under SFAS No. 157, Fair Value Measurements, using quarterly reports of U.S. banking firms in 2008. Evidence on the value relevance of unrealized gains and losses on investment se- curities is less definitive (see Rees and Shane (2012) for a summary). For example, Dhaliwal et al. (1999) find evidence of the value relevance of unrealized gains and losses on marketable securities only for the financial services industry. Chambers et al. (2007) find that unrealized gains and losses on available-for-sale (AFS) securities

5 I use an interpretation of value relevance from Francis and Schipper (1999, pages 326-327): “value relevance is measured by the ability of financial statement information to capture or summarize information, regardless of source, that affects share values.” My research design does not let me determine whether investors use the reported information provided under the equity method or disclosed about the fair value of affiliates. I cannot rule out that the accounting information I examine is merely correlated with information used by investors.

28 are positively associated with investor returns for a sample of S&P 500 firms from 1998-2003. However, the magnitude of the valuation coefficient on unrealized gains and losses on AFS securities in their study is significantly larger than that for other components of other comprehensive income and net income and the authors suggest that further study is needed to explain the result. It is not certain that the value relevance results for AFS securities will apply to investments in affiliates because of differences in the prominence of the presentation of information about the fair values of the investments. Hirst and Hopkins (1998) and Maines and McDaniel (2000) find evidence that the format presentation (e.g., performance statement, statement of shareholders’ equity, note disclosure) of other comprehensive income can affect how investors use that information. In the case of investments in publicly-traded affiliates, the fair value of the investment is disclosed in the notes (vs. presented on the face of the balance sheet for AFS securities) and the change in the fair value is not disclosed (vs. recognized in other comprehensive income for AFS securities). Therefore, it is possible that the value relevance results for AFS securities would not hold for investments in publicly-traded affiliates. Related to my study, Graham et al. (2003b) examine a sample of 55 U.S. investors with affiliates from 1993-1997 and find that both the carrying values reported under the equity method and the fair values of investments in publicly-traded affiliates have a positive association with stock prices and stock returns of investor firms. The authors also find (a) no association between income from investments in affiliates reported under the equity method and investors’ stock prices and returns and (b) a positive association between investors’ stock returns and the annual change in fair value of an equity method investment less the annual change in the income from the equity investment. Given the FASB’s recent discussions about expanding the use of fair value measurement for investments in affiliates, I revisit these findings for a larger sample and a longer and more recent time period. I also examine the value relevance

29 of income from investments in affiliates using fair value measurement by constructing a “levels” measure of fair value income from affiliates by multiplying the number of shares held at a reporting date by the change in the affiliate’s share price during the period. Based on the balance sheet results in Graham et al. (2003b), I expect fair value income from investments in affiliates to be incrementally value relevant relative to information provided under the equity method. The main focus of my value relevance analysis is on evaluating whether manage- ment’s plan for realizing value from an investment in an affiliate affects the relevance of fair value measurement. In particular, I separately analyze the incremental value relevance of fair value measures for investments in publicly-traded affiliates based on the distinguishing criteria proposed by the FASB in 2010 and 2013. The FASB’s 2010 Exposure Draft (para. BC24) suggests that the FASB “believes that an en- tity generally should measure investments in equity securities at fair value with all changes recognized in net income because the only way to realize gains or losses from equity securities is to sell the equity securities ... However, the Board decided that for those equity investments in which the entity has significant influence over the investee and the investee’s operations are related to those of the entity’s consolidated operations...the equity method of accounting would provide the most appropriate rep- resentation of the underlying economic activity in the entity’s financial statements.” This suggests that the FASB believes that there is something distinct about invest- ments in affiliates related to the investor’s operations (“strategic” investments in affiliates) that makes fair value a less relevant measurement attribute than for other investments in equity securities. I operationalize this proposal by identifying invest- ments in publicly-traded affiliates as “strategic” when the investor and affiliate have the same 2-digit SIC code and propose the following hypothesis (in alternative form):

H1A: Fair value measures of investments in publicly-traded affiliates identified

30 as “strategic” have less incremental value relevance relative to information provided under the equity method of accounting than fair value measures of other investments in publicly-traded affiliates.

The FASB’s 2013 Exposure Draft revised the proposals for investments in affiliates and would require the equity method unless the investment is classified as “held for sale” upon the investment’s initial qualification for the equity method. In that case, the investment would be measured at fair value with changes in fair value included in net income. This suggests that the FASB believes that fair value is a more relevant measurement attribute for investments in affiliates classified as held for sale than for other investments in affiliates. I operationalize this proposal by identifying investments in publicly-traded affiliates as “held for sale” when they are sold either in part or in entirety after application of the equity method and propose the following hypothesis (in alternative form):

H1B: Fair value measures of investments in publicly-traded affiliates iden- tified as “held for sale” have more incremental value relevance relative to information provided under the equity method of accounting than fair value measures of other investments in publicly-traded affiliates.

In contrast, fair value might be the appropriate measurement attribute for all in- vestments in affiliates regardless of how management intends to realize value from the investment. For example, Leisenring et al. (2012) suggest that basing measurement on management intent impairs comparability by permitting alternative accounting models for the same economic phenomenon (unless management’s intended method of value realization is considered to alter the economic characteristics of the under- lying equity securities held). The authors suggest (page 339) that “both relevance and comparability are achievable by basing recognition on the rights and obligations in an item or arrangement and not on management’s plans for those rights and obli-

31 gations, and by applying the same measurement attribute to rights and obligations that are similar, regardless of management’s intentions. Differences in presentation, not differences in measurement, can be used to convey management’s intent for the use, disposition or settlement of items.”

5.2 Research Design

The design of my value relevance tests is based on the residual income valuation model (Edwards and Bell (1961); Peasnell (1982)), as further developed by Ohlson (1995) and used in the value relevance literature (e.g., Song et al. (2010), Graham et al. (2003b)).6 I examine the value relevance of information provided under the equity method relative to the value relevance of information resulting from measuring investments in affiliates at fair value as follows:

MVEj ,t  β0 β1 BVotherj ,t β2 BVpublicaffiliatej ,t β3 FV ¡ BVpublicaffiliatej ,t

β4 INCotherj ,t β5 INCpublicaffiliatej ,t β6 FVINC ¡ INCpublicaffiliatej ,t

εj ,t (5.1) where (all variables are on a per-share basis):

MVEj ,t : market value of equity (CSHO * PRCC F) of firm j three months after the end of fiscal year t;

BVotherj ,t : book value (CEQ) of firm j less the book value of its investments in publicly-traded affiliates at the end of year t;

BVpublicaffiliatej ,t : book value of firm j’s investments in publicly-traded affiliates at the end of year t;

6 See Chapter 5.4.2 for additional details on the theoretical values predicted under such a model.

32 FV-BVpublicaffiliatej ,t : fair value less book value of investments in publicly- traded affiliates of firm j at the end of year t;

INCotherj ,t : income before extraordinary items (IB) less reported income from publicly-traded affiliates of firm j in year t;

INCpublicaffiliatej ,t : reported income from publicly-traded affiliates of firm j in year t; and

FVINC-INCpublicaffiliatej ,t : fair value income less reported income of publicly- traded affiliates of firm j in year t, where the fair value income of an affiliate is calculated as the number of shares held in the affiliate at the end of year t multiplied by the change in the price per share of the affiliate from the end of year t - 1 to the end of year t.

I scale all variables by number of shares outstanding as Barth and Clinch (2009) show that this deflator generally performs better than other deflators in mitigating scale effects in this type of regression. I am interested in the value relevance of information provided by the equity method, captured by β2 and β5. A positive β2 (β5) indicates that the balance sheet (income statement) information about investments in affiliates is associated with in- vestors’ share prices. I am also interested in whether fair value measurement of invest- ments in affiliates is incrementally value relevant relative to the information provided

under the equity method, captured by β3 and β6. A positive β3 (β6) indicates that the balance sheet (income statement) measurement of affiliates at fair value has an incre- mental association with investors’ share prices relative to the carrying value (income) derived under the equity method. In addition, I examine whether the incremental value relevance of fair value mea- sures of investments in affiliates depends on the investor’s intended method of realizing the value from an investment. In particular, I examine the incremental value rele-

33 vance of fair value measures separately for strategic and held-for-sale investments in affiliates as follows:

MVEj ,t  β0 β1 BVotherj ,t β2 BVpublicaffiliatej ,t β3 FV ¡ BVstrategicpublicaffiliatej ,t

β4 FV ¡ BVnon¡strategicpublicaffiliatej ,t β5 INCotherj ,t

β6 INCpublicaffiliatej ,t β7 FVINC ¡ INCstrategicpublicaffiliatej ,t

β8 FVINC ¡ INCnon¡strategicpublicaffiliatej ,t εj ,t (5.2)

MVEj ,t  β0 β1 BVotherj ,t β2 BVpublicaffiliatej ,t β3 FV ¡ BVheld¡for¡salepublicaffiliatej ,t

β4 FV ¡ BVnon¡held¡for¡salepublicaffiliatej ,t β5 INCotherj ,t

β6 INCpublicaffiliatej ,t β7 FVINC ¡ INCheld¡for¡salepublicaffiliatej ,t

β8 FVINC ¡ INCnon¡held¡for¡salepublicaffiliatej ,t εj ,t (5.3) where (other variables defined above):

FV-BVstrategicpublicaffiliatej ,t : fair value less book value of investments in publicly- traded affiliates of firm j at the end of year t classified as strategic;

FV-BVnon¡strategicpublicaffiliatej ,t : fair value less book value of investments in publicly-traded affiliates of firm j at the end of year t not classified as strategic;

FV-BVheld¡for¡salepublicaffiliatej ,t : fair value less book value of investments in publicly-traded affiliates of firm j at the end of year t classified as held-for- sale;

FV-BVnon¡held¡for¡salepublicaffiliatej ,t : fair value less book value of investments in publicly-traded affiliates of firm j at the end of year t not classified as held-for-sale;

34 FVINC-INCstrategicpublicaffiliatej ,t : fair value income less reported income of publicly-traded affiliates of firm j in year t classified as strategic;

FVINC-INCnon¡strategicpublicaffiliatej ,t : fair value income less reported income of publicly-traded affiliates of firm j in year t not classified as strategic;

FVINC-INCheld¡for¡salepublicaffiliatej ,t : fair value income less reported income of publicly-traded affiliates of firm j in year t classified as held-for-sale;

FVINC-INCnon¡held¡for¡salepublicaffiliatej ,t : fair value income less reported in- come of publicly-traded affiliates of firm j in year t not classified as held-for- sale;

As noted in Chapter 5.1, I identify an affiliate as “strategic” when the investor and affiliate have the same 2-digit SIC code. I identify an affiliate as “held for sale” when it is sold either in part or in entirety after application of the equity method. In this analysis, I am interested in the incremental value relevance of fair value measures of investments in affiliates, both on the balance sheet (β3-β4) and on the income statement (β7-β8). A positive coefficient indicates that the balance sheet (in- come statement) measurement of affiliates at fair value has an incremental association with investors’ share prices relative to the carrying value (income) derived under the equity method. I am also interested in comparing the relative magnitudes of β3-β4 and β7-β8, respectively.

5.3 Empirical Results

I test the value relevance of information provided under the equity method and the incremental value relevance of fair value measures of investments in publicly-traded affiliates by estimating Equation 5.1 using pooled OLS regression for all firm-years from 1993-2011 for the 221 equity method investors in my sample with the required data available. I winsorize all variables at the 1st and 99th percentiles and include

35 firm and year fixed effects in the regression. The related descriptive statistics and correlation coefficients are presented in Tables 5.1 and 5.2. The estimation results are reported in Table 5.3.

Table 5.1: Descriptive Statistics for the Analysis of the Relation between Investors’ Stock Prices and Balance Sheet and Income Measures of Investments in Affiliates

Mean Std Dev p25 Median p75

MVEj ,t 30.038 26.683 9.610 23.875 42.750 BVotherj ,t 12.353 14.498 3.748 9.190 17.362 BVpublicaffiliatej ,t 1.659 3.289 0.033 0.597 1.754 FV-BVpublicaffiliatej ,t 1.574 3.864 0.015 0.295 1.515 FV-BVstrategicpublicaffiliatej ,t 0.309 1.497 0.000 0.000 0.119 FV-BVnon¡strategicpublicaffiliatej ,t 1.227 3.321 0.000 0.032 0.907 FV-BVheld¡for¡salepublicaffiliatej ,t 0.610 2.116 0.000 0.000 0.200 FV-BVnon¡held¡for¡salepublicaffiliatej ,t 0.968 3.041 0.000 0.000 0.651 INCotherj ,t 1.018 3.059 -0.093 0.955 2.149 INCpublicaffiliatej ,t 0.088 0.463 -0.018 0.017 0.140 FVINC-INCpublicaffiliatej ,t -0.159 2.601 -0.378 -0.002 0.300 FVINC-INCstrategicpublicaffiliatej ,t -0.023 0.875 0.000 0.000 0.000 FVINC-INCnon¡strategicpublicaffiliatej ,t -0.063 1.779 -0.107 0.000 0.074 FVINC-INCheld¡for¡salepublicaffiliatej ,t -0.004 1.213 0.000 0.000 0.000 FVINC-INCnon¡held¡for¡salepublicaffiliatej ,t -0.088 1.550 -0.095 0.000 0.026 Firm-years 857

The table reports descriptive statistics for the variables used in the estimation of Equations 5.1, 5.2, and 5.3 for the 221 equity method investors in my sample with the required data available from 1993-2011. The variables are defined as follows. All variables are on a per-share basis and winsorized at the 1st and 99th percentiles. MVEj ,t : market value of equity (CSHO * PRCC F) of firm j three months after the end of fiscal year t. BVotherj ,t : book value (CEQ) of firm j less the book value of its investments in publicly-traded affiliates at the end of year t. BVpublicaffiliatej ,t : book value of firm j’s investments in publicly-traded affiliates at the end of year t. FV- BVpublicaffiliatej ,t : fair value less book value of investments in publicly-traded affiliates of firm j at the end of year t. FV-BVstrategicpublicaffiliatej ,t : fair value less book value of investments in publicly-traded affiliates of firm j at the end of year t classified as strategic. FV-BVnon¡strategicpublicaffiliatej ,t : fair value less book value of investments in publicly-traded affiliates of firm j at the end of year t not classified as strategic. FV-BVheld¡for¡salepublicaffiliatej ,t : fair value less book value of investments in publicly-traded affiliates of firm j at the end of year t classified as held for sale. FV-BVnon¡held¡for¡salepublicaffiliatej ,t : fair value less book value of investments in publicly-traded affiliates of firm j at the end of year t not classified as held for sale. INCotherj ,t : income before extraordinary items (IB) less reported income from publicly-traded affiliates of firm j in year t. INCpublicaffiliatej ,t : reported income from publicly-traded affiliates of firm j in year t. FVINC-INCpublicaffiliatej ,t : fair value income less reported income of publicly-traded affiliates of firm j in year t, where the fair value income of an affiliate is calculated as the number of shares held in the affiliate at the end of year t multiplied by the change in the price per share of the affiliate from the end of year t - 1 to the end of year t. FVINC-INCstrategicpublicaffiliatej ,t : fair value income less reported income of publicly-traded affiliates of firm j in year t classified as strategic. FVINC-INCnon¡strategicpublicaffiliatej ,t : fair value income less reported income of publicly-traded affiliates of firm j in year t not classified as strategic. FVINC- INCheld¡for¡salepublicaffiliatej ,t : fair value income less reported income of publicly-traded affiliates of firm j in year t classified as held for sale. FVINC-INCnon¡held¡for¡salepublicaffiliatej ,t : fair value income less reported income of publicly-traded affiliates of firm j in year t not classified as held for sale.

36 Table 5.2: Correlation Coefficients for the Analysis of the Relation between Investors’ Stock Prices and Balance Sheet and Income Measures of Investments in Affiliates

(1) (2) (3) (4) (5) (6) (7) (8) (9) (10) (11) (12) (13) (14) (15)

MVEj ,t (1) 0.638 0.214 0.273 0.336 0.129 0.208 0.209 0.560 0.276 0.046 0.071 0.077 0.042 0.071 BVotherj ,t (2) 0.616 0.275 0.211 0.277 0.085 0.257 0.108 0.505 0.276 -0.055 0.005 -0.010 0.007 -0.035 BVpublicaffiliatej ,t (3) 0.061 0.027 0.311 0.204 0.244 0.305 0.177 0.211 0.589 0.013 -0.017 0.086 0.085 0.014 FV-BVpublicaffiliatej ,t (4) 0.180 0.094 0.463 0.860 0.611 0.769 0.276 0.291 0.212 0.141 0.265 0.210 0.183 FV-BVstrategicpublicaffiliatej ,t (5) 0.189 0.098 -0.193 0.429 -0.025 0.262 0.356 0.243 0.256 0.146 0.254 0.023 0.088 0.152

37 FV-BVnon¡strategicpublicaffiliatej ,t (6) 0.165 0.059 0.031 0.732 -0.120 0.564 0.643 0.170 0.207 0.164 0.027 0.295 0.216 0.117 FV-BVheld¡for¡salepublicaffiliatej ,t (7) 0.090 0.129 -0.139 0.461 0.296 0.373 0.008 0.242 0.281 0.166 0.049 0.245 0.338 0.015 FV-BVnon¡held¡for¡salepublicaffiliatej ,t (8) 0.218 0.042 -0.035 0.662 0.380 0.542 -0.179 0.180 0.152 0.086 0.138 0.098 -0.038 0.183 INCotherj ,t (9) 0.665 0.538 0.113 0.279 0.134 0.140 0.069 0.179 0.179 0.030 -0.001 0.102 0.079 0.019 INCpublicaffiliatej ,t (10) 0.242 0.173 0.465 0.297 0.051 0.188 0.056 0.172 0.212 -0.012 0.010 0.032 0.101 -0.047 FVINC-INCpublicaffiliatej ,t (11) 0.176 0.061 0.045 0.228 0.147 0.149 0.168 0.115 0.129 0.006 0.486 0.818 0.608 0.769 FVINC-INCstrategicpublicaffiliatej ,t (12) 0.141 0.051 0.019 0.163 0.212 0.037 0.097 0.103 0.063 0.052 0.547 0.024 0.302 0.440 FVINC-INCnon¡strategicpublicaffiliatej ,t (13) 0.116 0.024 0.025 0.157 0.051 0.191 0.142 0.082 0.092 -0.024 0.801 0.078 0.591 0.652 FVINC-INCheld¡for¡salepublicaffiliatej ,t (14) 0.085 0.033 0.012 0.161 0.089 0.120 0.251 -0.015 0.033 -0.002 0.605 0.416 0.519 0.069 FVINC-INCnon¡held¡for¡salepublicaffiliatej ,t (15) 0.137 0.044 0.021 0.129 0.119 0.086 0.038 0.146 0.103 -0.011 0.742 0.479 0.633 0.060

The table reports correlation coefficients for the variables used in the estimation of Equations 5.1, 5.2, and 5.3 for the 221 equity method investors in my sample with the required data available from 1993-2011. Pearson (Spearman) correlation coefficients are presented in the upper-right (lower-left) corner. Bold text indicates two-tailed p-values at the 0.10 level or better. The variables are defined in Table 5.1. All variables are on a per-share basis and winsorized at the 1st and 99th percentiles. The correlation coefficients presented in Table 5.2 indicate a positive univariate correlation between investors’ market value of equity and both the carrying value of investments in publicly-traded affiliates reported under the equity method [Spearman (Pearson) coefficient = 0.061 (0.214)] and the difference between fair value and book value of investments in publicly-traded affiliates [Spearman (Pearson) coefficient = 0.180 (0.273)]. This provides preliminary confirmation of the results from Graham et al. (2003b). There is also a positive univariate correlation between investors’ market value of equity and both income from publicly-traded affiliates reported under the equity method [Spearman (Pearson) coefficient = 0.242 (0.276)] and the difference between fair value and reported income from publicly-traded affiliates [Spearman (Pearson) coefficient = 0.176 (0.046)]. This provides preliminary evidence supporting the incremental value relevance of fair value measures of income from affiliates relative to the equity method. There is also a positive correlation between reported income from affiliates and investors’ other income [Spearman (Pearson) coefficient = 0.212 (0.179)], which might be due to similarities in the industries of some investors and affiliates. Regression (1) in Table 5.3 presents results of the multivariate regression anal- ysis. Turning first to the balance sheet measures for investments in affiliates, the coefficient on the carrying value of investments in publicly-traded affiliates under the

7 equity method, BVpublicaffiliatej ,t , is positive (β2 = 1.113, t-statistic = 3.673). The coefficient on FV-BVpublicaffiliatej ,t is also positive (β3 = 0.712, t-statistic = 3.726). The coefficient on income from publicly-traded affiliates reported under the equity method, INCpublicaffiliatej ,t , is not distinguishable from zero (β5 = 2.132, t-statistic = 1.591). These results are consistent with the findings in Graham et al. (2003b), for a

7 Unless otherwise indicated, the empirical results discussed in Chapters 5.3 and 6.3 have two-tailed p-values of 0.10 or better.

38 smaller sample (55 firms) and shorter time period (1993-1997).8 I also find evidence supporting the incremental value relevance of fair value measures of income from

publicly-traded affiliates. In particular, the coefficient on FVINC-INCpublicaffiliatej ,t is

positive (β6 = 0.396, t-statistic = 2.186). I then extend this analysis to examine whether the incremental value relevance of fair value measures of investments in affiliates depends on the investor’s intended method of realizing the value from an investment. I estimate Equation 5.2 identifying investments in affiliates as either strategic or non-strategic. Regression (2) in Table

5.3 presents the results. The coefficients on FV-BVstrategicpublicaffiliatej ,t (β3 = 1.293, t-

statistic = 2.530) and FVINC-INCstrategicpublicaffiliatej ,t (β7 = 1.420, t-statistic = 2.482) are positive. In addition, tests of the equality of these coefficients with the related coefficients for non-strategic affiliates reveal that they are not statistically different

from one another (p-value of 0.1626 for test of β3 = β4 and p-value of 0.1021 for

test of β7 = β8). I then estimate Equation 5.3 identifying investments in affiliates as either held-for-sale or non-held-for-sale. Regression (3) in Table 5.3 presents the

results. The coefficient on FV-BVheld¡for¡salepublicaffiliatej ,t (β3 = 0.794, t-statistic =

2.443) is positive, but the coefficient on FVINC-INCheld¡for¡salepublicaffiliatej ,t (β7 = 0.472, t-statistic = 1.178) is indistinguishable from zero. Tests of the equality of these coefficients with the related coefficients for non-held-for-sale affiliates reveal that they are not statistically different from one another (p-value of 0.9986 for test

of β3 = β4 and p-value of 0.7761 for test of β7 = β8).

8 The finding of an insignificant coefficient on income reported under the equity method might be due to a lack of power. In untabulated results, I estimate Equation 5.1 for the full Compustat population of equity method investors (non-zero IVAEQ or ESUB) from 1993-2011, excluding the FV-BVpublicaffiliatej ,t and FVINC-INCpublicaffiliatej ,t terms. I find that the coefficient on INCaffiliatej ,t (β5 = 0.648, t-statistic = 8.500) is positive.

39 Table 5.3: Relation between Investors’ Stock Prices and Balance Sheet and Income Measures of Investments in Affiliates

MVEj ,t  β0 β1 BVotherj ,t β2 BVpublicaffiliatej ,t β3 FV ¡ BVpublicaffiliatej ,t β4 INCotherj ,t β5 INCpublicaffiliatej ,t (5.1) β6 FVINC ¡ INCpublicaffiliatej ,t εj ,t

MVEj ,t  β0 β1 BVotherj ,t β2 BVpublicaffiliatej ,t β3 FV ¡ BVstrategicpublicaffiliatej ,t β4 FV ¡ BVnon¡strategicpublicaffiliatej ,t β5 INCotherj ,t (5.2) β6 INCpublicaffiliatej ,t β7 FVINC ¡ INCstrategicpublicaffiliatej ,t β8 FVINC ¡ INCnon¡strategicpublicaffiliatej ,t εj ,t

MVEj ,t  β0 β1 BVotherj ,t β2 BVpublicaffiliatej ,t β3 FV ¡ BVheld¡for¡salepublicaffiliatej ,t β4 FV ¡ BVnon¡held¡for¡salepublicaffiliatej ,t β5 INCotherj ,t (5.3) β6 INCpublicaffiliatej ,t β7 FVINC ¡ INCheld¡for¡salepublicaffiliatej ,t β8 FVINC ¡ INCnon¡held¡for¡salepublicaffiliatej ,t εj ,t

(1) (2) (3) Dependent variable = MVEj ,t Dependent variable = MVEj ,t Dependent variable = MVEj ,t

Coefficient t-value Coefficient t-value Coefficient t-value

¦¦¦ ¦¦¦ ¦¦¦ BVotherj ,t 0.774 10.092 0.766 10.007 0.760 9.836 ¦¦¦ ¦¦¦ ¦¦¦ BVpublicaffiliatej ,t 1.113 3.673 1.190 3.921 1.088 3.615 ¦¦¦ FV-BVpublicaffiliatej ,t 0.712 3.726 ¦¦ FV-BVstrategicpublicaffiliatej ,t 1.293 2.530 ¦¦¦ FV-BVnon¡strategicpublicaffiliatej ,t 0.561 2.636 ¦¦

40 FV-BVheld¡for¡salepublicaffiliatej ,t 0.794 2.443 ¦¦¦ FV-BVnon¡held¡for¡salepublicaffiliatej ,t 0.793 3.205 ¦¦¦ ¦¦¦ ¦¦¦ INCotherj ,t 0.811 4.285 0.789 4.121 0.794 4.190 INCpublicaffiliatej ,t 2.132 1.591 1.922 1.432 2.102 1.561 ¦¦ FVINC-INCpublicaffiliatej ,t 0.396 2.186 ¦¦ FVINC-INCstrategicpublicaffiliatej ,t 1.420 2.482 FVINC-INCnon¡strategicpublicaffiliatej ,t 0.413 1.577 FVINC-INCheld¡for¡salepublicaffiliatej ,t 0.472 1.178 ¦¦ FVINC-INCnon¡held¡for¡salepublicaffiliatej ,t 0.615 2.060 Intercept 14.408¦¦¦ 5.560 14.749¦¦¦ 5.708 14.600¦¦¦ 5.641

Year fixed effects Included Included Included Firm fixed effects Included Included Included Firm-years 857 857 857 Adjusted R2 0.828 0.830 0.829

Tests of Equality of Coefficients: p-value

FV-BVstrategicpublicaffiliatej ,t = FV-BVnon¡strategicpublicaffiliatej ,t .1626 FV-BVheld¡for¡salepublicaffiliatej ,t = FV-BVnon¡held¡for¡salepublicaffiliatej ,t .9986 FVINC-INCstrategicpublicaffiliatej ,t = FVINC-INCnon¡strategicpublicaffiliatej ,t .1021 FVINC-INCheld¡for¡salepublicaffiliatej ,t = FVINC-INCnon¡held¡for¡salepublicaffiliatej ,t .7761

The table reports the results of estimation of Equations 5.1, 5.2, and 5.3 using pooled OLS regression with annual data from 1993-2011 for the 221 equity method investors in my sample with the required data available. Two-tailed p-values are reported as follows: ¦ p 0.10, ¦¦ p 0.05, ¦¦¦ p 0.01. The variables are defined in Table 5.1. All variables are on a per-share basis and winsorized at the 1st and 99th percentiles. These results suggest that the incremental value relevance of fair value measures for investments in affiliates exists for both investments identified as held for sale and those identified as strategic. The results do not provide evidence in support of H1A (fair value measures of investments in publicly-traded affiliates identified as “strategic” have less incremental value relevance relative to information provided under the equity method of accounting than fair value measures of other investments in publicly-traded affiliates) and H1B (fair value measures of investments in publicly- traded affiliates identified as “held for sale” have more incremental value relevance relative to information provided under the equity method of accounting than fair value measures of other investments in publicly-traded affiliates). In summary, I find that balance sheet measures of investments in affiliates provided under the equity method are associated with investors’ stock prices and that fair value balance sheet and income measures of investments in affiliates are incrementally associated with investors’ stock prices after controlling for information provided under the equity method. Income from affiliates recognized under the equity method is not associated with investors’ stock prices. These results support the incremental value relevance of fair value measurement of investments in affiliates relative to the equity method. I also find that the incremental value relevance of fair value measures for investments in affiliates exists for both investments identified as held for sale and those identified as strategic, with no evidence that the incremental value relevance is higher (lower) for investments identified as held for sale (strategic). This result suggests that the FASB’s 2010 and 2013 proposals to distinguish between investments in affiliates based on management’s intended method of value realization are not supported by differences in the relative value relevance of fair value measures for these types of investments.

41 5.4 Supplementary Analyses

5.4.1 Correlation between Investor and Affiliate Returns

I investigate whether the results in Table 5.3 of a positive association between investors’ stock prices and the fair value measures (both balance sheet and income statement) of investments in affiliates simply capture the correlation between investor and affiliate stock returns. This concern arises because of the overlap in industry mem- berships of investors and affiliates noted in Chapter 4.1. To do this, I first calculate the correlation of investor and affiliate monthly stock returns for each investor-affiliate pair in my sample during the period in which the equity method is applied. The av- erage (median) number of monthly observations used to calculate this correlation is 43.59 (32.00):

Variable N Mean Std Dev P25 Median P75

Number of monthly observations used to calculate correlations 253 43.59 39.99 17.00 32.00 56.00

The average Pearson (Spearman) correlation of monthly stock returns of investors and affiliates across firms in my sample is 0.322 (0.329):

Variable N Mean Std Dev P25 Median P75

Pearson correlation between monthly stock returns of investors and publicly-traded affiliates during the period in which the equity method is applied 253 0.322 .0272 0.138 0.327 0.511 Spearman correlation between monthly stock returns of investors and publicly-traded affiliates during the period in which the equity method is applied 253 0.329 0.260 0.154 0.335 0.500

I then include in my value relevance analysis an indicator variable (and related interaction terms) equal to one when the investor-affiliate correlation is above the sample median. As shown in Table 5.4, I find that the incremental value relevance of fair value balance sheet measures exists in the low correlation group (coefficient

on FV-BVpublicaffiliatej ,t = 0.965, t-statistic = 2.931) and that the incremental value relevance of fair value income statement measures is not higher for the high correlation

42 group than the low correlation group (untabulated test of equality of coefficients on

FVINC-INCpublicaffiliatej ,t and FVINC-INCpublicaffiliatej ,t + FVINC-INCpublicaffiliatej ,t *

HIGH CORRELATIONj ,t has p-value of 0.8910). Together, this suggests that my results do not seem to be driven by the correlation in investor returns and affiliate returns. Table 5.4: Effect of the Correlation of Investor and Affiliate Stock Returns on the Relation between Investors’ Stock Prices and Balance Sheet and Income Measures of Investments in Affiliates

MVEj ,t  β0 β1 BVotherj ,t β2 BVpublicaffiliatej ,t β3 FV ¡ BVpublicaffiliatej ,t β4 INCotherj ,t (5.1) β5 INCpublicaffiliatej ,t β6 FVINC ¡ INCpublicaffiliatej ,t εj ,t

Dependent variable = MVEj ,t Dependent variable = MVEj ,t

Coefficient t-value Coefficient t-value

¦¦¦ ¦¦¦ BVotherj ,t 0.774 10.092 0.763 8.377 BVotherj ,t * HIGH CORRELATIONj ,t ¡0.004 ¡0.035 ¦¦¦ ¦¦ BVpublicaffiliatej ,t 1.113 3.673 1.159 2.444 BVpublicaffiliatej ,t * HIGH CORRELATIONj ,t ¡0.079 ¡0.134 ¦¦¦ ¦¦¦ FV-BVpublicaffiliatej ,t 0.712 3.726 0.965 2.931 FV-BVpublicaffiliatej ,t * HIGH CORRELATIONj ,t ¡0.304 ¡0.793 ¦¦¦ ¦¦¦ INCotherj ,t 0.811 4.285 0.870 3.605 ¦¦ INCotherj ,t * HIGH CORRELATIONj ,t 5.815 2.135 INCpublicaffiliatej ,t 2.132 1.591 ¡1.061 ¡0.542 ¦¦ INCpublicaffiliatej ,t * HIGH CORRELATIONj ,t 5.815 2.135 ¦¦ FVINC-INCpublicaffiliatej ,t 0.396 2.186 0.353 1.163 FVINC-INCpublicaffiliatej ,t * HIGH CORRELATIONj ,t 0.051 0.137 HIGH CORRELATIONj ,t ¡1.792 ¡0.670 Intercept 14.408¦¦¦ 5.560 15.405¦¦¦ 5.327

Year fixed effects Included Included Firm fixed effects Included Included Firm-years 784 784 Adjusted R2 0.833 0.839

The table incorporates into Equation 5.1 the correlation of montly stock returns of equity method investors and affiliates. HIGH CORRELATIONj ,t : indicator variable equal to 1 if firm j has a correlation of its monthly stock returns with those of its publicly-traded affiliates that is above the sample median. Additional variables are defined in Table 5.1. Two-tailed p-values are reported as follows: ¦ p 0.10, ¦¦ p 0.05, ¦¦¦ p 0.01.

5.4.2 Theoretical Values in a Residual Income Model

The design of the value relevance tests is based on the residual income valuation model (Edwards and Bell (1961); Peasnell (1982)). In particular, I use a modified version of the valuation framework derived in Equation (7) of Ohlson (1995):

Pt  kpφxtq p1 ¡ kqyt (5.4)

43 where:

Pt: the market value, or price, of the firm’s equity at date t;

xt: earnings for the period t - 1 to t;

yt: (net) book value at date t;

Rf : the risk-free rate plus one;

a  a ω: persistence of abnormal earnings, i.e., xt 1 ωxt ε1t 1;

a xt : xt -(Rf - 1) yt¡1;

p ¡ q k: Rf 1 ω ; and Rf ¡ω

φ: Rf . Rf ¡1

For my sample period, the average monthly risk-free rate of return (one-month treasury bill rate) is .00259474, which implies an average annual risk-free rate of return of approximately 3.11%. I also calculate an average persistence of abnormal a  a earnings for my sample firms. In particular, I estimate xt 1 ωxt vt ε1t 1 for each sample firm and calculate the average ω across firms. I do this in two ways: (a) using all fiscal years from 1993-2011 for my sample firms and (b) using only those fiscal years which appear in my value relevance regression. I calculate an average ω of 0.517 and 0.806, respectively.9 Therefore, the theoretical value for the balance sheet variables in my value rel- evance regression should be either 0.969 or 0.889 based on the average persistence measures calculated and the following formula:

pR ¡ 1qω 1 ¡ k  1 ¡ f (5.5) Rf ¡ ω

9 In a t-test, I find no statistical difference between these average persistence values (p-value of 0.286).

44 The theoretical value for the income statement variables in my value relevance regression should be either 1.037 or 3.692 based on the average persistence measures calculated and the following formula:

pR ¡ 1qω R kφ  f f (5.6) Rf ¡ ω Rf ¡ 1

As shown in Table 5.5, in general, the valuation coefficients are indistinguishable from their theoretical values in at least one of the specifications. Table 5.5: Evaluation of Theoretical Values of Coefficients Relating Investors’ Stock Prices to Balance Sheet and Income Measures of Investments in Affiliates

MVEj ,t  β0 β1 BVotherj ,t β2 BVpublicaffiliatej ,t β3 FV ¡ BVpublicaffiliatej ,t β4 INCotherj ,t (5.1) β5 INCpublicaffiliatej ,t β6 FVINC ¡ INCpublicaffiliatej ,t εj ,t

Dependent variable p-values for tests MVEj ,t of equality with theoretical values

Rf = 1.0311 Rf = 1.0311 Coefficient ω = 0.517 ω = 0.806 BV = 0.969 BV = 0.889 INC = 1.037 INC = 3.692

BVotherj ,t 0.774 .0112 .1337 BVpublicaffiliatej ,t 1.113 .6355 .4605 BVpublicaffiliatej ,t + FV-BVpublicaffiliatej ,t 1.825 .0043 .0018 INCotherj ,t 0.811 .2335 .0000 INCpublicaffiliatej ,t 2.132 .4142 .2445 INCpublicaffiliatej ,t + FVINC-INCpublicaffiliatej ,t 2.528 .2749 .3938 Year fixed effects Included Firm fixed effects Included Firm-years 857 Adjusted R2 0.828 The table evaluates the coefficients derived from estimating Equation 5.1 with their theoretical values as described in Section 5.4.2. Variables are defined in Section 5.4.2 and Table 5.1. Two- tailed p-values are reported as follows: ¦ p 0.10, ¦¦ p 0.05, ¦¦¦ p 0.01.

45 6

Earnings Management by Investors with Significant Influence

6.1 Related Literature and Hypotheses Development

I also examine the neutrality of income reported under the equity method. Specif- ically, I investigate whether the equity method achieves its objective of reducing earn- ings management. During the development of APB 18, concern was expressed that when investors can exercise significant influence, the cost method might invite earn- ings management through the timing of dividend payments (e.g., Miller and Bahnson (2007)).1 Earnings management is inconsistent with neutral financial reporting. The FASB’s Conceptual Framework (SFAC No. 8, para. QC12) confirms the importance of neutrality by including it as a component of faithful representation, one of the fundamental qualitative characteristics of decision useful financial information.2 However, the equity method does not eliminate all opportunities for earnings

1 Under the cost method, income recognition only occurs through dividend payments (or impair- ments of investments, when required). 2 SFAC No. 8 (para. QC14) states, “A neutral depiction is without bias in the selection or presentation of financial information. A neutral depiction is not slanted, weighted, emphasized, deemphasized, or otherwise manipulated to increase the probability that financial information will be received favorably or unfavorably by users.”

46 management. Because a proportionate share of the affiliates’ income flows into the investors’ net income, investors might use their “significant influence” to manage the earnings of affiliates for the investors’ benefit. I explore whether the equity method achieves its objective of reducing earnings management by examining the effect of equity method ownership on the signed discretionary accruals of affiliates.3,4 There is an extensive literature examining earnings management (see, for example, Dechow et al. (2010) for a review). The literature (e.g., Libby and Seybert (2009)) suggests a variety of factors that might drive earnings management, including capital market pressures, individual reputation concerns, tax savings, and bonus compensa- tion. For example, Graham et al. (2005) survey more than 400 chief financial officers and find more than 80% of participants believe that meeting earnings benchmarks builds credibility with the capital market and helps maintain or increase the firm’s stock price (Table 4). The authors (page 28) also find that more than 75% of partici- pants “agree or strongly agree that a manager’s concern about her external reputation helps explain the desire to hit the earnings benchmark” with interviews confirming that “the desire to hit the earnings target appears to be driven less by short-run compensation motivations than by career concerns.” This paper does not attempt to isolate the specific motivation(s) driving management of income from affiliates. The one-line balance sheet and income statement presentation of information about investments in affiliates might make managing income from this source less transparent than managing income from other sources. For example, Lee et al. (2013) find that analysts’ annual earnings forecasts are less accurate and more dispersed for firms with affiliates relative to firms without affiliates for a sample of 21,336 U.S firm-

3 In future work, I plan to examine whether equity method investors influence operating decisions of affiliates (“real actions”) for the investors’ benefit (e.g., to achieve earnings targets). 4 Accounting for investments in affiliates similar to trading securities or available-for-sale securities would result in recognizing dividends received as income. Therefore, those methods would not elim- inate concerns about earnings management, but the effects would appear in the timing of dividends, rather than in discretionary accruals.

47 year observations from 1985-2010. The authors suggest that this is due to the lack of disclosure of components of affiliate earnings under the equity method. Previous literature documents two ex ante actions taken by firms to manage earn- ings in relation to equity method investments. First, Comiskey and Mulford (1986, 1988) find evidence that the requirements of the equity method affect the level of ownership taken by investor firms. In particular, they find that for a sample of 1,255 investment positions taken in U.S firms in 1982, a statistically significant concentra- tion of positions were taken just under and just over 20 percent, and investees that were owned in the 19-19.99 percent range (applying the cost method) reported net losses significantly more often than investees that were owned in the 20-20.99 percent range (applying the equity method). Second, Morris and Gordon (2006) examine the reporting choices of Australian firms holding investments in affiliates before and after the first accounting standard on the subject was implemented in 1984. They find that firms choose to show the effects of the equity method in a third column on the face of the financial statements if doing so increases reported earnings, but in a footnote if the equity method decreases reported earnings. I extend this literature by examining whether investors manage earnings from affiliates ex post. That is, once firms make investments with “significant influence” and apply the equity method of accounting, do those investors manage reported earnings from affiliates? I propose the following hypothesis (in alternative form):

H2A: Signed discretionary accruals of affiliates are higher when equity method investors have an incentive to manage income from affiliates.

Equity method investors might also affect the discretionary accruals of affiliates for reasons apart from a desire to achieve their own earnings targets. For example, the literature examining the effects of large shareholders (mainly institutional investors) on the financial reporting of investees suggests monitoring or the consumption of

48 private benefits by large shareholders as two possible examples of factors affecting financial reporting. The monitoring effect exists when large shareholders can mitigate the effects of self-interested actions taken by an affiliate’s management (e.g., reporting higher discretionary accruals during their tenure and deferring the recognition of losses until after their tenure) by monitoring the actions of affiliate’s management. Previous research (e.g., Chung et al. (2002), Yeo et al. (2002), Velury and Jenkins (2006), Koh (2007), Hadani et al. (2011)) documents a negative relation between earnings management and the presence of large shareholders. The private benefits effect exists when insiders use their positions of influence to benefit themselves at the expense of other shareholders (e.g., Shleifer and Vishny (1997) and La Porta et al. (1999)) and then manage reported amounts so as to deter or impede scrutiny. This includes engaging in self-serving transactions, transferring assets to the insider or another firm owned by the insider, or consuming perquisites. Previous research documents the effects of concealing private benefits consumption through a positive relation between earnings management and the presence of “insiders” (e.g., Leuz et al. (2003), Haw et al. (2004), Gopalan and Jayaraman (2012)). The list of factors above is not exhaustive. In addition, it is possible that there will be no association between an equity method investor and the financial reporting of an affiliate. Equity method investors might not use or wish to influence the external financial reporting of affiliates. By definition, equity method investors have “signif- icant influence” over the operating and financial policies of affiliates. This implies that equity method investors have access to information necessary to affect operating and financial decisions of affiliates and might not need to rely on external financial reporting to monitor affiliates’ management. In addition, as discussed in Chapter 5.1, equity method investments are undertaken for a variety of reasons (including strategic operational benefits) unrelated to influencing the financial reporting of affiliates. The focus of my analysis of the relation between equity method ownership and

49 signed discretionary accruals of affiliates is to identify the existence of earnings man- agement (if any) arising under the equity method of accounting. I do not attempt to isolate the factors affecting the relation between equity method ownership and signed discretionary accruals of affiliates in periods when investors have weaker incentives to manage income from affiliates and therefore make no prediction about which factors will dominate:

H2B: There is no association between signed discretionary accruals of af- filiates and equity method ownership when equity method investors have no/weaker incentives to manage income from affiliates.

6.2 Research Design

I follow prior research examining the relation between earnings management and ownership characteristics (e.g., Gopalan and Jayaraman (2012)) and analyze the rela- tion between equity method ownership and signed discretionary accruals of affiliates using the following model:

DISC ACCk,t  β0 β1 AF F ILIAT Ek,t β2 AF F ILIAT Ek,t ¦ INCENTIVEINV EST ORk,t

β3 INCENTIVEAF F ILIAT Ek,t β4 INCENT IV EREV ERSALINV EST ORk,t

β5 INCENT IV EREV ERSALAF F ILIAT Ek,t β6 OP CY CLEk,t

β7 CAP IT ALk,t β8 DEBTk,t β9 MTBk,t

β10 SALESGROW T Hk,t β11 LOSSk,t β12 ASSET Sk,t

β13 SALESV OLk,t β14 T RAOW Nk,t β15 QIXOW Nk,t

β16 DNIOWNk,t β17 MONOWNk,t εk,t (6.1) where:

DISC ACCk,t : discretionary accruals of firm k in quarter t estimated using the Jones (1991) model (estimation described in detail below);

50 AFFILIATEk,t: indicator variable equal to 1 if firm k is an affiliate (i.e., has an equity method investor) during quarter t, and 0 otherwise;

INCENTIVEINV EST ORk,t: indicator variable equal to 1 if income from affili- ates allows the equity method investor of firm k to meet one of three earnings targets (non-negative income, non-negative change in income, analysts’ fore- casted earnings) in year t, and 0 otherwise;

CONTROLS:

INCENTIVEAF F ILIAT Ek,t: indicator variable equal to 1 if firm k just meets one of three earnings targets (non-negative income, non-negative change in income, analysts’ forecasted earnings) in quarter t, and 0 otherwise;5

INCENTIVE REVERSALINV EST ORk,t: indicator variable equal to 1 if quar-

ter t is identified as the reversal period for accruals from an INCENTIVEINVESTOR period using the Baber et al. (2011) methodology;

INCENTIVE REVERSALAF F ILIAT Ek,t: indicator variable equal to 1 if quar-

ter t is identified as the reversal period for accruals from an INCENTIVEAF F ILIAT E period using the Baber et al. (2011) methodology;

OPCYCLEk,t : length of the operating cycle of firm k in quarter t, measured as days receivable plus days inventory less days payable at the beginning of the quarter, as defined in Zang (2012);

CAPITALk,t : capital intensity of firm k in quarter t, measured as the ratio of noncurrent assets (ATQ - ACTQ) to lagged total assets;

5 In particular, INCENTIVEAF F ILIAT Ek,t = 1 when an affiliate has small positive earnings, a small positive change in earnings, or just meets analyst expectations. To define “small”, I calculate the ratio of the absolute value of net income to total assets for my sample. Firms are then defined as having “small” positive earnings (change in earnings) if their earnings (change in earnings) divided by total assets in period t are less than the 10th percentile of this ratio for my overall sample of firms. I define “just meeting” analyst expectations as situations in which actual I/B/E/S earnings per share less the median analyst forecast (using the most recent forecast for each analyst within 90 days of the earnings announcement) is greater than zero and less than or equal to 0.01.

51 LEVk,t : leverage ((DLTTQ + DLCQ)/(CSHOQ * PRCCQ) of firm k at the end of quarter t;

MTBk,t : market-to-book ratio (CSHOQ*PRCCQ/CEQQ) of firm k in quar- ter t;

SALESGROWTHk,t : quarterly sales (SALEQ) growth rate of firm k from quarter t - 1 to quarter t;

LOSSk,t : an indicator variable equal to 1 if firm k has a loss in quarter t;

ASSETSk,t : logarithm of total assets (ATQ) of firm k in quarter t;

SALESVOLk,t : sales volatility, measured as the standard deviation of quar- terly sales (SALEQ) of firm k in quarter t based on the most recent five quarterly observations;

TRAOWNk,t : percentage ownership of firm k at the end of quarter t by institutional investors described as transient by Bushee (2001);

QIXOWNk,t : percentage ownership of firm k at the end of quarter t by insti- tutional investors described as quasi-indexing by Bushee (2001);

DNIOWNk,t : percentage ownership of firm k at the end of quarter t by institutional investors described as dedicated by Bushee (2001) and non- independent by Brickley et al. (1988); and

MONOWNk,t : percentage ownership of firm k at the end of quarter t by in- stitutional investors described as monitoring institutions in Ramalingegowda and Yu (2012) based on classification as dedicated by Bushee (2001) and independent by Brickley et al. (1988).

The main coefficient of interest is β2, which investigates whether earnings man- agement (investors using the flow-through of affiliate income to investor income to achieve their own earnings targets) exists in my sample. I include an interaction term

52 representing situations when it is likely that equity method investors would have an incentive to manage the earnings of affiliates. I capture this construct by identifying situations in which income from an affiliate allows an equity method investor to meet an earnings target (non-negative income, non-negative change in income, or analysts’ forecasted earnings). That is, I identify situations in which the earnings of an eq- uity method investor without incorporating income from an affiliate are below the earnings target, but the inclusion of income from the affiliate in the investor’s earn- ings results in the investor meeting or exceeding its earnings target. A positive β2 indicates that affiliates have higher signed discretionary accruals when income from an affiliate allows their equity method investors to meet an earnings target and thus provides evidence of earnings management. I also investigate the relation between equity method ownership and discretionary accruals of affiliates in periods when investors have weaker incentives to manage in- come from affiliates. A negative (positive) β1 indicates that firms have lower (higher) signed discretionary accruals when they are affiliates. As discussed in Chapter 6.1, this relation might arise due to the effects of monitoring, concealment of private benefits, or other factors related to equity method ownership. I measure discretionary accruals using the Jones (1991) model. I estimate Equa- tion 6.2 for each firm in my sample, using all quarterly observations for that firm from 1993-2011 in periods in which the firm is not an affiliate (with a minimum of 10 observations required).6,7 This approach allows me to control for firm-specific factors affecting accruals. I control for time-specific factors affecting accruals by including year fixed effects in my regression.

6 The use of a “non-event” period to develop firm-specific estimates of discretionary accruals is discussed, for example, by Dechow et al. (1995). 7 In untabulated tests, I find that my main results are robust to excluding the intercept in Equation 6.2, estimating discretionary accruals using the modified Jones model (Dechow et al. (1995)), and using annual data rather than quarterly data.

53 1 T ACCk,t  α0 α1 α2 4SALESk,t α3 PPEk,t µk,t (6.2) ASSETSk,t¡1 where:

TACCk,t : total accruals of firm k in quarter t, calculated as net income (NIQ) less cash flows from operations (OANCF), scaled by lagged total assets;

ASSETSk,t¡1 : total assets (ATQ) of firm k in quarter t - 1;

4SALESk,t : change in firm k’s sales (SALEQ) from quarter t - 1 to quarter t, scaled by lagged total assets; and

PPEk,t : firm k’s gross property, plant and equipment (PPEGTQ) in quarter t, scaled by lagged total assets.

The coefficient estimates from Equation 6.2 are used to estimate firm-specific

discretionary accruals (DISC ACCk,t ) for each firm-quarter as follows:

1 DISC ACCk,t  T ACCk,t ¡ αx0 αx1 αx2 4SALESk,t αx3 PPEk,t ASSETSk,t¡1 (6.3)

I include the following firm-specific control variables in Equation 6.1. First, I include a proxy for the affiliate’s own incentives to manage earnings to meet or beat earnings targets (INCENTIVEAF F ILIAT Ek,t). I also include indicator variables

(INCENTIVE REVERSAL INV EST ORk,t and INCENTIVE REVERSALAF F ILIAT Ek,t) identifying “accruals reversal periods” associated with any build-up of discretionary accruals created in periods in which the investor or affiliate had an incentive to man- age earnings to meet an earnings target. In particular, I follow the methodology in Baber et al. (2011) and for each firm, I estimate:

54 DISC ACCk,t  αk,t ρmDISC ACCk,t m εk,t (6.4)

for m = 1 to 16 quarters. Following Proposition 1 in Baber et al. (2011), the minimum

value of ρm is achieved in the period in which period t discretionary accruals reverse. Prior studies (e.g., Dechow (1994), Dechow and Dichev (2002), Hribar and Nichols (2007)) find that accruals can be affected by differences in the following factors:

operating cycle (OPCYCLEk,t ), capital intensity (CAPITALk,t ), leverage (LEVk,t ),

size (ASSETSk,t ), and sales volatility (SALESVOLk,t ). I also control for differences

in growth opportunities (MTBk,t and SALESGROWTHk,t ). Finally, I control for the effects of various types of institutional ownership (TRAOWNk,t , QIXOWNk,t ,

DNIOWNk,t , MONOWNk,t ) as monitoring or other actions taken by these investors might also affect discretionary accruals (e.g., Chung et al. (2002), Yeo et al. (2002)).

6.3 Empirical Results

I investigate the relation between equity method ownership and signed discre- tionary accruals of affiliates (H2) by estimating Equation 6.1 using a pooled OLS regression for all firm-quarters from 1993-2011 for the publicly-traded affiliates in my sample with the required data available. I include year and firm fixed effects in the regression and winsorize all variables at the 1st and 99th percentiles. The related descriptive statistics and correlation coefficients are presented in Tables 6.1 and 6.2. The estimation results are reported in Table 6.3.

As shown in Table 6.1, the mean of INCENTIVEINV EST ORk,t indicates that in 3.5% of my firm-quarter observations (175/4,937), the firm has an equity method investor and income from the firm calculated under the equity method allows the eq- uity method investor to meet an earnings target (non-negative income, non-negative change in income, or analysts’ forecasted earnings). This translates into equity

55 Table 6.1: Descriptive Statistics for the Discretionary Accruals Analysis

Mean Std Dev p25 Median p75

DISC ACCk,t -0.009 0.121 -0.019 0.000 0.021 AFFILIATEk,t 0.260 0.438 0.000 0.000 1.000 INCENTIVEINV EST ORk,t 0.035 0.185 0.000 0.000 0.000 INCENTIVEAF F ILIAT Ek,t 0.262 0.440 0.000 0.000 1.000 INCENTIVE REVERSALINV EST ORk,t 0.031 0.174 0.000 0.000 0.000 INCENTIVE REVERSALAF F ILIAT Ek,t 0.222 0.415 0.000 0.000 0.000 OPCYCLEk,t 57.063 168.541 -5.130 39.702 95.480 CAPITALk,t 0.587 0.272 0.386 0.594 0.797 LEVk,t 0.880 2.244 0.052 0.274 0.741 MTBk,t 2.942 6.907 1.128 1.962 3.381 SALESGROWTHk,t 0.080 0.436 -0.060 0.025 0.124 LOSSk,t 0.384 0.486 0.000 0.000 1.000 ASSETSk,t 6.052 2.018 4.484 6.131 7.424 SALESVOLk,t 64.898 173.401 2.561 9.282 43.067 TRAOWNk,t 0.110 0.110 0.016 0.075 0.175 QIXOWNk,t 0.231 0.189 0.073 0.183 0.375 DNIOWNk,t 0.012 0.053 0.000 0.000 0.001 MONOWNk,t 0.063 0.074 0.000 0.038 0.100 Firm-quarters 4,937 Firms 202

The table reports descriptive statistics for the variables used in the analysis of the level of discretionary accruals of affiliates (Equation 6.1) for the 202 U.S. publicly-traded affiliates in my sample with the required quarterly data available from 1993-2011. The variables are defined as follows. All variables (except indicator variables) are win- sorized at the 1st and 99th percentiles. DISC ACCk,t : discretionary accruals of firm k in quarter t estimated using the Jones (1991) model (estimation described in detail below). AFFILIATEk,t: indicator variable equal to 1 if firm k is an affiliate (i.e., has an equity method investor) during quarter t, and 0 otherwise. INCENTIVEINV EST ORk,t: indicator variable equal to 1 if income from affiliates allows the equity method investor of firm k to meet one of three earnings targets (non-negative income, non-negative change in income, analysts’ forecasted earnings) in year t, and 0 otherwise. INCENTIVEAF F ILIAT Ek,t: indicator variable equal to 1 if firm k just meets one of three earnings targets (non-negative income, non-negative change in income, analysts’ forecasted earnings) in quarter t, and 0 otherwise. INCENTIVE REVERSALINV EST ORk,t: indicator variable equal to 1 if quarter t is identified as the reversal period for accruals from an INCENTIVEINVESTOR period using the Baber et al. (2011) method- ology. INCENTIVE REVERSALAF F ILIAT Ek,t: indicator variable equal to 1 if quarter t is identified as the reversal period for accruals from an INCENTIVEAF F ILIAT E period using the Baber et al. (2011) methodology. OPCYCLEk,t : length of the operating cycle of firm k in quarter t, measured as days receivable plus days inventory less days payable at the beginning of the quarter, as defined in Zang (2012). CAPITALk,t : capital intensity of firm k in quarter t, measured as the ratio of noncurrent assets (ATQ - ACTQ) to lagged total assets. LEVk,t : leverage ((DLTTQ + DLCQ)/(CSHOQ * PRCCQ) of firm k at the end of quarter t. MTBk,t : market-to-book ratio (CSHOQ*PRCCQ/CEQQ) of firm k in quarter t. SALESGROWTHk,t : quarterly sales (SALEQ) growth rate of firm k from quarter t - 1 to quarter t. LOSSk,t : an indicator variable equal to 1 if firm k has a loss in quarter t. ASSETSk,t : logarithm of total assets (ATQ) of firm k in quarter t. SALESVOLk,t : sales volatility, measured as the standard deviation of quarterly sales (SALEQ) of firm k in quarter t based on the most recent five quarterly observations. TRAOWNk,t : percentage ownership of firm k at the end of quarter t by institutional investors described as transient by Bushee (2001). QIXOWNk,t : percentage ownership of firm k at the end of quarter t by institutional investors described as quasi-indexing by Bushee (2001). DNIOWNk,t : percentage ownership of firm k at the end of quarter t by institutional investors described as dedicated by Bushee (2001) and non-independent by Brickley et al. (1988). MONOWNk,t : percentage ownership of firm k at the end of quarter t by institutional investors described as monitoring institutions in Ramalingegowda and Yu (2012) based on classification as dedicated by Bushee (2001) and independent by Brickley et al. (1988). ESTIMATION OF DISCRETIONARY ACCRUALS: Discretionary accruals are measured as the residuals from the Jones (1991) model, with parameters estimated at the firm level using all quarters from 1993-2011 in which the firm is not an affiliate with a minimum of 10 observations required. ¢ 1 TACCk,t = α0 + α1 + α24SALESk,t + α3PPEk,t + µk,t (6.2) ASSETSk,t¡1

TACCk,t : total accruals of firm k in quarter t, calculated as net income (NIQ) less cash flows from operations (OANCF), scaled by lagged total assets. ASSETSk,t¡1 : total assets (ATQ) of firm k in quarter t - 1. 4SALESk,t : change in firm k’s sales (SALEQ) from quarter t - 1 to quarter t, scaled by lagged total assets. PPEk,t : firm k’s gross property, plant and equipment (PPEGTQ) in quarter t, scaled by lagged total assets.

56 Table 6.2: Correlation Coefficients for the Discretionary Accruals Analysis

(1) (2) (3) (4) (5) (6) (7) (8) (9) (10) (11) (12) (13) (14) (15) (16) (17) (18)

DISC ACCk,t (1) -0.083 0.027 0.068 0.010 0.043 -0.051 0.100 -0.066 0.032 0.020 -0.185 0.096 0.027 0.072 0.060 0.019 0.055 AFFILIATEk,t (2) -0.029 0.324 0.016 0.166 -0.023 0.021 -0.032 -0.015 -0.037 0.014 0.027 -0.037 -0.080 0.174 -0.155 0.126 0.014 INCENTIVEINV EST ORk,t (3) 0.024 0.324 0.005 0.148 -0.005 -0.033 0.102 -0.012 0.020 0.000 -0.093 0.083 0.011 -0.058 -0.052 0.043 0.054 INCENTIVEAF F ILIAT Ek,t (4) 0.031 0.016 0.005 -0.017 0.100 -0.029 0.090 -0.039 -0.019 -0.036 -0.247 0.169 0.059 0.050 0.136 0.002 0.080 INCENTIVE REVINV EST ORk,t (5) 0.001 0.166 0.148 -0.017 0.019 -0.025 0.073 -0.002 -0.017 -0.001 -0.044 0.075 -0.001 -0.011 0.021 0.000 0.119 INCENTIVE REVAF F ILIAT Ek,t (6) 0.017 -0.023 -0.005 0.100 0.019 -0.015 0.056 0.011 -0.010 -0.032 -0.128 0.175 0.098 0.084 0.174 0.009 0.094 OPCYCLEk,t (7) -0.015 0.068 -0.042 -0.033 -0.028 -0.033 -0.262 -0.005 -0.016 -0.052 0.075 -0.129 -0.012 -0.063 -0.012 0.002 -0.044 57 CAPITALk,t (8) 0.003 -0.049 0.111 0.094 0.080 0.056 -0.397 0.106 -0.057 0.089 -0.167 0.547 0.165 0.169 0.176 -0.028 0.170 LEVk,t (9) -0.050 0.051 0.044 0.027 0.087 0.039 0.028 0.400 -0.087 -0.009 0.121 0.131 0.022 -0.046 -0.032 0.052 -0.017 MTBk,t (10) 0.030 -0.049 -0.004 0.021 -0.009 -0.007 -0.077 -0.038 -0.394 0.029 -0.009 -0.029 -0.021 0.053 -0.010 -0.039 0.004 SALESGROWTHk,t (11) 0.015 0.014 -0.004 0.019 -0.023 -0.019 -0.112 0.065 -0.036 0.089 -0.045 0.003 0.037 0.021 -0.029 -0.013 0.021 LOSSk,t (12) -0.177 0.027 -0.093 -0.247 -0.044 -0.128 0.042 -0.174 -0.030 -0.139 -0.111 -0.301 -0.126 -0.142 -0.206 -0.050 -0.150 ASSETSk,t (13) 0.005 -0.027 0.094 0.163 0.090 0.173 -0.186 0.582 0.391 0.008 0.019 -0.291 0.503 0.370 0.496 0.110 0.326 SALESVOLk,t (14) 0.007 0.009 0.118 0.103 0.117 0.135 -0.113 0.404 0.378 0.021 0.014 -0.297 0.853 1.000 0.052 0.241 0.014 0.072 TRAOWNk,t (15) 0.022 -0.139 -0.033 0.091 0.001 0.104 -0.106 0.212 -0.011 0.195 0.043 -0.171 0.449 0.406 0.559 -0.002 0.318 QIXOWNk,t (16) 0.006 -0.105 -0.024 0.145 0.040 0.169 -0.033 0.185 0.086 0.095 -0.008 -0.208 0.506 0.436 0.668 0.037 0.462 DNIOWNk,t (17) 0.009 0.005 0.042 0.102 0.062 0.095 -0.090 0.197 0.002 0.106 0.016 -0.175 0.434 0.372 0.351 0.429 0.058 MONOWNk,t (18) 0.034 0.012 0.040 0.110 0.104 0.106 -0.072 0.206 0.077 0.079 0.010 -0.202 0.417 0.368 0.479 0.572 0.372

The table reports Pearson (Spearman) correlation coefficients in the upper-right (lower-left) corner for the variables used in the analysis of the level of discretionary accruals of affiliates (Equation 6.1) for the 202 U.S. publicly-traded affiliates in my sample with the required quarterly data available from 1993-2011. Bold text indicates two-tailed p-values at the 0.10 level or better. The variables are defined in Table 6.1. All variables (except indicator variables) are winsorized at the 1st and 99th percentiles. method investors having an incentive to manage earnings from affiliates in 13.7% (175/1,282) of the firm-quarters in which an equity method relationship exists. In unt- abulated results, I find evidence of meeting the non-negative income target in 12.6% (22/175) of the cases, the non-negative change in income target in 17.1% (30/175) of the cases, and analysts’ forecasted earnings in 80.0% (140/175) of the cases.8 Table 6.2 shows that there is a positive correlation between signed discretionary accruals and

INCENTIVEINV ESTORk,t [Spearman (Pearson) coefficient = 0.024 (0.027)], providing preliminary evidence that equity method investors manage earnings of affiliates to achieve their own income targets. There is also a negative correlation between signed discretionary accruals and equity method ownership [Spearman (Pearson) coefficient = -0.029 (-0.083)]. The data required to calculate the control variables included in Equation 6.1 re- duce the sample from 250 affiliates to 202 affiliates. In the first two columns of Table

6.3, I report the results of an estimation of the coefficients on AFFILIATEk,t and

AFFILIATEk,t * INCENTIVEINV ESTORk,t including control variables for the affiliate having an incentive to manage its own discretionary accruals

(INCENTIVEAF F ILIAT Ek,t) and for the reversal of any build-up of discretionary ac- cruals created in periods in which the investor or affiliate had an incentive to manage earnings to meet an earnings target (INCENTIVE REVERSALINV EST ORk,t and IN-

CENTIVE REVERSALAF F ILIAT Ek,t). The coefficient on AFFILIATEk,t

* INCENTIVEINV EST ORk,t is positive (β2 = 0.030, t-statistic = 2.929). This result indicates that signed discretionary accruals of affiliates are higher when income from affiliates allows equity method investors to meet earnings targets. This result provides evidence that equity method investors take advantage of the mechanics of the equity method (the flow-through of affiliate income to investor income) to manage earnings

8 The total exceeds 100% because in 17 cases income from the affiliate allows the investor to meet two earnings targets.

58 of affiliates to achieve their own income targets. When I include all of the control variables (third and fourth columns of Table 8), the coefficient on AFFILIATEk,t *

INCENTIVEINV ESTORk,t remains positive (β2 = 0.015, t-statistic = 1.724). Table 6.3: Relation between Equity Method Ownership and Discretionary Accruals of Affiliates

DISC ACCk,t  β0 β1 AF F ILIAT Ek,t β2 AF F ILIAT Ek,t ¦ INCENTIVEINV EST ORk,t

β3 INCENTIVEAF F ILIAT Ek,t β4 INCENT IV EREV ERSALINV EST ORk,t

β5 INCENT IV EREV ERSALAF F ILIAT Ek,t β6 OP CY CLEk,t

β7 CAP IT ALk,t β8 DEBTk,t β9 MTBk,t (6.1)

β10 SALESGROW T Hk,t β11 LOSSk,t β12 ASSET Sk,t

β13 SALESV OLk,t β14 T RAOW Nk,t β15 QIXOW Nk,t

β16 DNIOWNk,t β17 MONOWNk,t εk,t

Dependent variable Dependent variable DISC ACCk,t DISC ACCk,t

Coefficient t-statistic Coefficient t-statistic

¦¦¦ ¦¦¦ AFFILIATEk,t ¡0.016 ¡3.972 ¡0.014 ¡3.579 ¦¦¦ ¦ AFFILIATEk,t*INCENTIVEINV EST ORk,t 0.030 2.929 0.015 1.724 ¦¦¦ INCENTIVEAF F ILIAT Ek,t 0.015 3.942 0.003 1.090 INCENTIVE REVERSALINV EST ORk,t 0.002 0.165 0.003 0.360 INCENTIVE REVERSALAF F ILIAT Ek,t ¡0.005 ¡1.229 ¡0.001 ¡0.422 ¦¦¦ OPCYCLEk,t ¡0.000 ¡2.851 CAPITALk,t 0.009 0.950 ¦¦¦ LEVk,t ¡0.003 ¡3.748 MTBk,t 0.000 0.092 SALESGROWTHk,t ¡0.003 ¡1.065 ¦¦¦ LOSSk,t ¡0.037 ¡10.179 ASSETSk,t ¡0.001 ¡0.455 SALESVOLk,t ¡0.000 ¡1.004 TRAOWNk,t 0.017 0.874 QIXOWNk,t ¡0.005 ¡0.337 DNIOWNk,t 0.036 0.897 MONOWNk,t ¡0.011 ¡0.379 Intercept ¡0.021¦¦ ¡2.492 0.007 0.474 Year fixed effects Included Included Firm fixed effects Included Included Firm-quarters 11,446 4,937 Firms 250 202 Adjusted R2 0.140 0.474 The table reports the results of estimation of Equation 6.1 using pooled OLS regression with quarterly data from 1993-2011 for the U.S. publicly-traded affiliates in my sample with the required data available. Two-tailed p-values are reported as follows: ¦ p 0.10, ¦¦ p 0.05, ¦¦¦ p 0.01. The variables are defined in Table 6.1. All variables (except indicator variables) are winsorized at the 1st and 99th percentiles.

I also find that the coefficient on AFFILIATEk,t is negative (β1= -0.016, t-statistic

= 3.972 with limited control variables; β1= -0.014, t-statistic = 3.579 with the full set of control variables), indicating that equity method ownership is negatively associated

59 with signed discretionary accruals of affiliates. One possible explanation is that equity method investors monitor management actions and mitigate the effects of actions taken by affiliates’ management to inflate reported earnings. I do not further explore or isolate the cause of the negative association in this paper. In summary, I find that signed discretionary accruals of affiliates are higher when income from affiliates allows equity method investors to meet earnings targets. I also find a negative relation between equity method ownership and signed discretionary accruals of affiliates in other periods. The result provides evidence that the equity method does not eliminate concerns about earnings management, such as those ex- pressed in relation to the cost method; it changes the mechanism through which earnings are managed. The result also suggests that an incentive to manage the earnings of affiliates can change the effect of equity method ownership on signed dis- cretionary accruals of affiliates and confirms the importance of considering investors’ characteristics in studies of the effects of large shareholders on investees.

6.4 Supplementary Analyses

6.4.1 Effect of “True” Significant Influence

In this section, I investigate whether there is a difference between “nominal” signif- icant influence and “true” significant influence in my sample and re-run my earnings management tests to examine whether the results exist only in, or are stronger in, the portion of the sample with “true” significant influence. There is a presumption in APB 18 (para. 17, ASC 323-10-15-8) that, absent evidence to the contrary, an investment of 20% or more indicates the ability to exercise significant influence over the operating and financial policies of an investee. As a result, it is possible that the equity method is applied in situations where ownership is between 20-50%, but significant influence is not exercised (“nominal” significant influence). APB 18 (para. 17, ASC 323-10-15-6) identifies the following factors that might

60 indicate an ability to exercise significant influence:

Representation on the board of directors

Participation in policy-making processes

Material intra-entity transactions9

Interchange of managerial personnel

Technological dependency

Extent of ownership by an investor in relation to the concentration of other shareholdings (but substantial or majority ownership of the voting stock of an investee by another investor does not necessarily preclude the ability to exercise significant influence by the investor).

I use these factors to investigate whether there is a difference between “nominal” significant influence and “true” significant influence in my sample. In particular, I collect data on the following manifestations of these factors in my sample:10

Existence of a subsidiary relationship with the affiliate either prior to or after the application of the equity method (proxy for participation in policy- making processes). I expect that if an investor plans to acquire an affiliate in the future or previously had control of an affiliate, that investor is more likely to exert “true” significant influence.

Material transactions between the equity method investor and affiliate (mea- sured as the magnitude of eliminations from the investor’s proportionate

9 I interpret the phrase “material intra-entity transactions” in APB 18 to mean material transac- tions between the equity method investor and affiliate. 10 In future work, I plan to extend my analysis to collect data on the investor’s representation on the board of directors and management of the affiliate. Investors are not required to disclose this information in their 10-K reports, except if it is the basis for the investor’s application of the equity method when owning less than 20% of the affiliate. I plan to collect background information on affiliates’ directors from the affiliates’ annual proxy statements.

61 share of the affiliate’s reported net income, including gains/losses arising from transactions between the equity method investor and affiliate, used to calculate income from an affiliate). I expect a positive relation between “true” significant influence and the level of transactions between the equity method investor and affiliate.

Level of ownership of affiliate (less than 20% vs. greater than 20%). I expect that ownership of less than 20% indicates “true” significant influence because investors at that ownership level are required to demonstrate the existence of significant influence in order to apply the equity method. I do not have a prediction for the relation between “true” significant influence and level of ownership above 20%.

Holding period. I expect a positive relation between “true” significant influ- ence and holding period.

I calculate each of these variables at the affiliate level. That is, I calculate the average value for a variable separately for each affiliate over the sample period. I then present descriptive statistics for each of the variables averaged across my sample:

Variable N Mean Std Dev P25 Median P75 Affiliate is subsidiary prior to application of equity method (indicator variable) 414 0.22 0.41 0.00 0.00 0.00 Affiliate is subsidiary after application of equity method (indicator variable) 414 0.22 0.42 0.00 0.00 0.00 |Equity method investor’s proportionate share of affiliate’s reported net income - income from affiliate recognized by investor| (in $ millions) 353 26.94 83.26 0.73 4.03 17.04 Percentage of ownership of affiliate 392 0.29 0.13 0.21 0.29 0.38 Number of years in which firm is held as an affiliate 414 4.17 3.27 1.84 3.25 5.38

The variation in these variables indicates that it is possible that there is a difference between “nominal” significant influence and “true” significant influence in my sample. I re-run my earnings management tests splitting my sample on these factors and find some evidence that the results exist only in, or are stronger in, the portion of the

62 sample with “true” significant influence. As shown in Table 6.4, I find that the earnings management results are stronger for the subsample of firms (a) that were subsidiaries prior to becoming affiliates (p-value for test of equality of coefficients of 0.0000), (b) with ownership percentage less than 20% (p-value of 0.0000), and (c) with longer holding periods (p-value of 0.0001). These results are consistent with the intuition that earnings management should be stronger for those investors that exercise “true” significant influence. I do not find the predicted results for the existence of a subsidiary relationship after the application of the equity method or material transactions between the equity method investor and affiliate. It is possible that the measure of material transactions between the equity method investor and affiliate is too noisy to capture the effect even if one exists. This is because the measure includes effects (e.g., treating any difference between the acquisition cost of the investment and the investor’s share of the underlying equity in the net assets of the affiliate as if the affiliate were a consolidated subsidiary) other than the elimination of gains/losses arising from transactions between the equity method investor and affiliate.

6.4.2 Differences in Earnings Management of Public Affiliates and Private Affiliates

I also consider whether there are differences in the incentives of equity method investors to exercise significant influence over a private affiliate rather than a public affiliate and the related implications for my earnings management findings.11 In Chapter 6.1, I suggest that one motivation for equity method investors to choose to

11 In addition, it might be easier to exercise significant influence over the financial reporting of an affiliate when there is a well-defined channel through which the influence can be exerted. One example of a well-defined channel is overlap in the management of the equity method investor and the affiliate (e.g., the affiliate’s CEO is appointed by/associated with the equity method investor). Unfortunately, I do not have data available to permit me to assess whether managerial overlap be- tween equity method investors and affiliates is more common for private affiliates or public affiliates. If it is the case that there is more managerial overlap for private affiliates, I would expect that it is easier for equity method investors to manage earnings from private affiliates.

63 Table 6.4: Effect of “True” Significant Influence on the Relation between Equity Method Ownership and Discretionary Accruals of Affiliates

DISC ACCk,t  β0 β1 AF F ILIAT Ek,t β2 AF F ILIAT Ek,t ¦ INCENTIVEINV EST ORk,t

β3 INCENTIVEAF F ILIAT Ek,t β4 INCENT IV EREV ERSALINV EST ORk,t

β5 INCENT IV EREV ERSALAF F ILIAT Ek,t εk,t

Dependent variable Dependent variable Dependent variable Test of Equality DISC ACCk,t DISC ACCk,t DISC ACCk,t of Coefficients

Coefficient t-stat Coefficient t-stat Coefficient t-stat p-value

Subsidiary Prior to Affiliate Relationship Full Sample Indicator = 0 Indicator = 1 ¦¦¦ ¦¦¦ ¦¦¦ AFFILIATEk,t ¡0.016 ¡3.972 ¡0.014 ¡3.034 ¡0.027 ¡3.412 .0003 ¦¦¦ ¦¦ ¦¦¦ AFFILIATEk,t*INCENTIVEINV EST ORk,t 0.030 2.929 0.024 2.053 0.061 3.167 .0000 ¦¦¦ ¦¦¦ INCENTIVEAF F ILIAT Ek,t 0.015 3.942 0.017 3.744 0.011 1.412 .3733 INCENTIVE REVERSALINV EST ORk,t 0.002 0.165 0.004 0.305 ¡0.008 ¡0.440 .5167 INCENTIVE REVERSALAF F ILIAT Ek,t ¡0.005 ¡1.229 ¡0.006 ¡1.333 ¡0.001 ¡0.121 .3356 ¦¦ ¦¦ Intercept ¡0.021 ¡2.492 ¡0.023 ¡2.460 ¡0.015 ¡0.880 Year fixed effects Included Included Included Firm fixed effects Included Included Included Firm-quarters 11,446 9,180 2,082 Adjusted R2 0.140 0.140 0.170

Subsidiary After Affiliate Relationship Full Sample Indicator = 0 Indicator = 1 ¦¦¦ ¦¦¦ ¦ AFFILIATEk,t ¡0.016 ¡3.972 ¡0.024 ¡5.116 0.012 1.729 .0001 ¦¦¦ ¦¦¦ AFFILIATEk,t*INCENTIVEINV EST ORk,t 0.030 2.929 0.043 3.387 ¡0.008 ¡0.502 .0000 ¦¦¦ ¦¦¦ INCENTIVEAF F ILIAT Ek,t 0.015 3.942 0.018 3.978 0.004 0.522 .0238 INCENTIVE REVERSALINV EST ORk,t 0.002 0.165 0.002 0.179 ¡0.005 ¡0.317 .1214 INCENTIVE REVERSALAF F ILIAT Ek,t ¡0.005 ¡1.229 ¡0.004 ¡0.924 ¡0.010 ¡1.239 .3351 ¦¦ ¦¦ Intercept ¡0.021 ¡2.492 ¡0.025 ¡2.375 ¡0.013 ¡1.023 Year fixed effects Included Included Included Firm fixed effects Included Included Included Firm-quarters 11,446 9,048 2,214 Adjusted R2 0.140 0.156 0.026

Material Intra-Entity Transactions Full Sample Median ¡ Median ¦¦¦ ¦¦¦ AFFILIATEk,t ¡0.016 ¡3.972 ¡0.023 ¡3.736 ¡0.008 ¡1.428 .0000 ¦¦¦ ¦¦ ¦ AFFILIATEk,t*INCENTIVEINV EST ORk,t 0.030 2.929 0.035 2.337 0.023 1.676 .0004 ¦¦¦ ¦¦¦ INCENTIVEAF F ILIAT Ek,t 0.015 3.942 0.027 4.390 0.006 1.241 .0109 INCENTIVE REVERSALINV EST ORk,t 0.002 0.165 ¡0.001 ¡0.081 0.005 0.338 .4507 INCENTIVE REVERSALAF F ILIAT Ek,t ¡0.005 ¡1.229 ¡0.006 ¡0.909 ¡0.004 ¡0.714 .2237 ¦¦ ¦¦¦ Intercept ¡0.021 ¡2.492 ¡0.031 ¡2.589 ¡0.009 ¡0.792 Year fixed effects Included Included Included Firm fixed effects Included Included Included Firm-quarters 11,446 5,524 5,922 Adjusted R2 0.140 0.167 0.108

Ownership Percentage Full Sample 20% ¡20% ¦¦¦ ¦¦¦ ¦ AFFILIATEk,t ¡0.016 ¡3.972 ¡0.040 ¡5.465 ¡0.009 ¡1.771 .0000 ¦¦¦ ¦¦ ¦¦ AFFILIATEk,t*INCENTIVEINV EST ORk,t 0.030 2.929 0.059 2.555 0.023 1.985 .0000 ¦¦¦ ¦¦¦ INCENTIVEAF F ILIAT Ek,t 0.015 3.942 0.038 5.570 0.006 1.353 .0000 INCENTIVE REVERSALINV EST ORk,t 0.002 0.165 0.006 0.238 0.000 0.000 .0566 INCENTIVE REVERSALAF F ILIAT Ek,tr ¡0.005 ¡1.229 ¡0.001 ¡0.176 ¡0.006 ¡1.278 .3606 ¦¦ ¦¦¦ Intercept ¡0.021 ¡2.492 ¡0.055 ¡3.674 ¡0.008 ¡0.805 Year fixed effects Included Included Included Firm fixed effects Included Included Included Firm-quarters 11,446 2,987 8,275 Adjusted R2 0.140 0.243 0.111

Length of Holding Period Full Sample Median ¡ Median ¦¦¦ ¦¦¦ AFFILIATEk,t ¡0.016 ¡3.972 ¡0.000 ¡0.055 ¡0.025 ¡5.193 .0391 ¦¦¦ ¦¦¦ AFFILIATEk,t*INCENTIVEINV EST ORk,t 0.030 2.929 ¡0.002 ¡0.067 0.039 3.579 .0001 ¦¦¦ ¦¦¦ ¦¦¦ INCENTIVEAF F ILIAT Ek,t 0.015 3.942 0.017 2.681 0.014 2.850 .4413 INCENTIVE REVERSALINV EST ORk,t 0.002 0.165 ¡0.005 ¡0.201 0.003 0.300 .1247 INCENTIVE REVERSALAF F ILIAT Ek,t ¡0.005 ¡1.229 ¡0.007 ¡1.001 ¡0.004 ¡0.708 .0990 ¦¦ ¦ Intercept ¡0.021 ¡2.492 ¡0.021 ¡1.690 ¡0.017 ¡1.534 Year fixed effects Included Included Included Firm fixed effects Included Included Included Firm-quarters 11,446 5,155 6,291 Adjusted R2 0.140 0.000 0.243 The table evaluates the effect of “true” significant influence on the relation between equity method ownership and discretionary accruals of affiliates. The table reports the results of estimation using pooled OLS regression with quarterly data from 1993-2011 for the U.S. publicly-traded affiliates in my sample with the required data available. Two-tailed p-values are reported as follows: ¦ p 0.10, ¦¦ p 0.05, ¦¦¦ p 0.01. The variables are defined in Table 6.1 and Chapter 6.4.1. manage income from affiliates as opposed to other avenues of earnings management is the lack of transparent information available about affiliates. This arises because of the one-line presentation of the affiliate in the investor’s balance sheet and income statement and the potential lack of disaggregated information about affiliates in the notes to the investor’s financial statements. As a result, it might be difficult for users

64 of the investor’s financial statements to identify/detect earnings management in the affiliate. In the case of public affiliates, this lack of transparent information provided by the investor could be mitigated by reviewing the publicly-available financial statements of the affiliate. Therefore, equity method investors might have a stronger incentive to manage income from private affiliates because it would be more difficult to detect the earnings management. In addition, it is possible that some private affiliates are subject to less scrutiny from auditors. For example, a 50-50 joint venture with no debt financing might not have a demand for audited financial statements. Therefore, it might be easier to avoid detection of earnings management when no auditor is reviewing the related financial statements of the affiliate. An affiliate might also have its own incentives to manage its earnings. If these incentives conflict with the investor’s desire to manage earnings, it might be more difficult for the investor to affect the financial reporting of the affiliate. To the extent that these incentives arise more often in public affiliates (e.g., the public affiliate might desire to manage its earnings for an SEO), an equity method investor might be more likely to try to manage earnings from a private affiliate than a public affiliate. This discussion suggests that it might be easier/more likely for an equity method investor to manage the earnings of a private affiliate than a public affiliate. I investi- gate this issue by evaluating whether evidence of earnings management exists only for (or is stronger for) the subsample of equity method investors with no private affiliates. In that case, equity method investors do not have the option of using private affiliates to manage their earnings and thus might be more likely to manage the earnings of public affiliates. I find some preliminary evidence to support this argument as shown in Table 6.5.

In particular, I find that the coefficient on AFFILIATEk,t * INCENTIVEINV EST ORk,t is larger when the equity method investor does not have any private affiliates (p-value

65 for test of equality of coefficients of 0.0058). However, the coefficient on AFFILIATEk,t

* INCENTIVEINV EST ORk,t is still significantly different from zero in the subsample of equity method investors with both public and private affiliates (β2 = 0.030, t-statistic = 2.266). Table 6.5: Effect of Existence of Private Affiliates on the Relation between Equity Method Ownership and Discretionary Accruals of Affiliates

DISC ACCk,t  β0 β1 AF F ILIAT Ek,t β2 AF F ILIAT Ek,t ¦ INCENTIVEINV EST ORk,t

β3 INCENTIVEAF F ILIAT Ek,t β4 INCENT IV EREV ERSALINV EST ORk,t

β5 INCENT IV EREV ERSALAF F ILIAT Ek,t εk,t

Dependent variable Dependent variable Dependent variable Test of Equality DISC ACCk,t DISC ACCk,t DISC ACCk,t of Coefficients

Coefficient t-stat Coefficient t-stat Coefficient t-stat p-value

Investor has only Public Affiliates Full Sample Indicator = 0 Indicator = 1 ¦¦¦ ¦¦ ¦¦¦ AFFILIATEk,t ¡0.016 ¡3.972 ¡0.013 ¡2.499 ¡0.027 ¡3.878 .0006 ¦¦¦ ¦¦ ¦¦ AFFILIATEk,t*INCENTIVEINV EST ORk,t 0.030 2.929 0.030 2.266 0.034 2.088 .0058 ¦¦¦ ¦¦¦ ¦¦ INCENTIVEAF F ILIAT Ek,t 0.015 3.942 0.015 3.100 0.015 2.314 .6825 INCENTIVE REVERSALINV EST ORk,t 0.002 0.165 0.010 0.749 ¡0.016 ¡1.020 .5308 INCENTIVE REVERSALAF F ILIAT Ek,t ¡0.005 ¡1.229 ¡0.007 ¡1.368 ¡0.002 ¡0.326 .2352 ¦¦ ¦¦ Intercept ¡0.021 ¡2.492 ¡0.026 ¡2.475 ¡0.013 ¡0.919 Firm fixed effects Included Included Included Firm-quarters 11,446 7,220 4,042 Adjusted R2 0.140 0.176 0.072 The table evaluates the effect of the existence of private affiliates on the relation between equity method ownership and discretionary accruals of affiliates. The table reports the results of estimation using pooled OLS regression with quarterly data from 1993-2011 for the U.S. publicly-traded affiliates in my sample with the required data available. Two-tailed p-values are reported as follows: ¦ p 0.10, ¦¦ p 0.05, ¦¦¦ p 0.01. The variables are defined in Table 6.1 and Chapter 6.4.2.

6.4.3 Potential for Mechanical Relation Between Investor Incentive and Outcome Variables

I consider whether a purely mechanical relation exists between the incentive mea- sures and the outcome measures in my analyses of meeting earnings targets. Income from affiliates is one component of an equity method investor’s net income. All other things equal, higher income from affiliates leads to higher investor net income. How- ever, higher income from affiliates in a period does not necessarily equate to being more likely to meet a specified earnings target if analysts have already factored the higher income from affiliates into their forecasted earnings. I also investigate this concern by re-defining my investor incentive variable as an investor just meeting or beating an earnings target. Higher income from affiliates does not have a mechanical relation with just meeting or beating an earnings target because higher income from

66 affiliates could also lead to the investor far exceeding an earnings target. As shown in Table 6.6, I find qualitatively similar earnings management results in that specifi-

cation (β2 = 0.026, t-statistic = 3.705), suggesting that a mechanical relation is not driving my results. I do not choose to use that definition of investor incentive because it does not capture whether income from affiliates is large enough to be “important” to investors. Table 6.6: Effect of Defining Investor Incentive Variable as Just Meeting or Beating an Earnings Target on the Relation between Equity Method Ownership and Discre- tionary Accruals of Affiliates

DISC ACCk,t  β0 β1 AF F ILIAT Ek,t β2 AF F ILIAT Ek,t ¦ INCENTIVEINV EST ORk,t

β3 INCENTIVEAF F ILIAT Ek,t β4 INCENT IV EREV ERSALINV EST ORk,t

β5 INCENT IV EREV ERSALAF F ILIAT Ek,t εk,t

Dependent variable DISC ACCk,t

Coefficient t-statistic

¦¦¦ AFFILIATEk,t ¡0.019 ¡4.495 ¦¦¦ AFFILIATEk,t*INCENTIVEINV EST ORk,t 0.026 3.705 ¦¦¦ INCENTIVEAF F ILIAT Ek,t 0.015 3.884 INCENTIVE REVERSALINV EST ORk,t ¡0.003 ¡0.420 INCENTIVE REVERSALAF F ILIAT Ek,t ¡0.005 ¡1.087 Intercept ¡0.020¦¦ ¡2.480 Firm fixed effects Included Firm-quarters 11,446 Adjusted R2 0.140 The table evaluates the effect of defining the investor incentive variable as just meeting or beating and earnings target on the relation between equity method ownership and discretionary accruals of affiliates. The table reports the results of estimation using pooled OLS regression with quarterly data from 1993-2011 for the U.S. publicly-traded affiliates in my sample with the required data available. Two-tailed p-values are reported as follows: ¦ p 0.10, ¦¦ ¦¦¦ p 0.05, p 0.01. INCENTIVEINV EST ORk,t: indicator variable equal to 1 if the equity method investor of firm k just meets one of three earnings targets (non-negative income, non-negative change in income, analysts’ forecasted earnings) in quarter t, and 0 otherwise. Other variables are defined in Table 6.1.

6.4.4 Additional Investigation into Effects of Accruals Reversal

As described in Chapter 6.3, equity method ownership is negatively associated with signed discretionary accruals of affiliates in periods when investors have weaker incentives to manage income from affiliates. To address the concern that this relation is the result of a reversal of an accumulated earnings reserve that was built up using accruals-based earnings management, I include control variables in my analysis to

67 capture the expected reversal period of any build-up of discretionary accruals. I also consider the behavior of discretionary accruals for the portion of my sample that never has an equity method investor with a non-zero incentive variable (189 out of 250 affiliates with required data available). In this subsample, there is still a negative and statistically significant relation between equity method ownership and discretionary accruals of affiliates (see Table 6.7; β1 = -0.018, t-statistic = -3.516). This suggests that some factor other than accruals reversal is driving the negative relation between equity method ownership and discretionary accruals of affiliates.

6.4.5 Other Potential Methods of Managing Earnings from Investments in Affiliates

I also examine whether there are opportunities for equity method investors to man- age earnings related to investments in affiliates other than influencing discretionary accruals.12

Small changes in ownership around 20%

As noted above, there is a presumption in APB 18 that, absent evidence to the contrary, an investment of 20% or more indicates the ability to exercise significant and an investment of less than 20% indicates a lack of significant influence unless such influence can be demonstrated. Therefore, if an investor were purely applying the

12 A potential channel for earnings management is the original measurement of individual affili- ate assets and liabilities at fair value. These individual measurements are not observable in the investor’s financial statements. Individual assets and liabilities of the affiliate (including goodwill) are not tested for impairment and thus reducing potential future impairment losses is not a reason to manipulate original measurements of assets and liabilities. However, any difference between the acquisition cost of the investment and the investor’s share of the underlying equity in the net assets of the affiliate is treated as if the affiliate were a consolidated subsidiary. Prior to the issuance of SFAS 142, Goodwill and Other Intangible Assets, the residual was treated like purchased goodwill and amortized. Therefore, there might have been an incentive for investors to reduce the amount of goodwill recognized as much as possible to mitigate goodwill amortization charges in future periods. Since the issuance of SFAS 142, investors might try to increase the amount of goodwill recognized as much as possible and lower the fair values assigned to other depreciable assets (e.g., property, plant, and equipment that will be depreciated in the investor’s financial statements based on the assigned fair value at the time of the equity method acquisition). Unfortunately, I cannot observe these potential effects using publicly-available data.

68 Table 6.7: Relation between Equity Method Ownership and Discretionary Accruals of Affiliates for Investors with INCENTIVEINV EST ORk,t = 0 in All Periods

DISC ACCk,t  β0 β1 AF F ILIAT Ek,t β2 AF F ILIAT Ek,t ¦ INCENTIVEINV EST ORk,t

β3 INCENTIVEAF F ILIAT Ek,t β4 INCENT IV EREV ERSALINV EST ORk,t

β5 INCENT IV EREV ERSALAF F ILIAT Ek,t β6 OP CY CLEk,t

β7 CAP IT ALk,t β8 DEBTk,t β9 MTBk,t

β10 SALESGROW T Hk,t β11 LOSSk,t β12 ASSET Sk,t

β13 SALESV OLk,t β14 T RAOW Nk,t β15 QIXOW Nk,t

β16 DNIOWNk,t β17 MONOWNk,t εk,t

Dependent variable DISC ACCk,t

Coefficient t-statistic

¦¦¦ AFFILIATEk,t ¡0.018 ¡3.516 INCENTIVEAF F ILIAT Ek,t 0.005 1.080 INCENTIVE REVERSALAF F ILIAT Ek,t ¡0.005 ¡1.113 ¦¦ OPCYCLEk,t ¡0.000 ¡2.055 ¦¦ PAYABLEk,t 0.025 2.009 CAPITALk,t 0.002 0.219 ¦¦¦ LEVk,t ¡0.004 ¡4.164 MTBk,t ¡0.000 ¡0.065 SALESGROWTHk,t ¡0.001 ¡0.273 ¦¦¦ LOSSk,t ¡0.043 ¡8.746 ASSETSk,t 0.002 0.491 SALESVOLk,t ¡0.000 ¡0.220 TRAOWNk,t 0.017 0.693 QIXOWNk,t ¡0.019 ¡0.894 DNIOWNk,t 0.041 0.679 MONOWNk,t ¡0.011 ¡0.292 Intercept ¡0.019 ¡0.977 Year fixed effects Included Firm fixed effects Included Firm-quarters 3,564 Adjusted R2 0.495

The table evaluates the relation between equity method ownership and discretionary accruals of affiliates when investors do not have an incentive to manage income from affiliates. The table reports the results of estimation using pooled OLS regression with quarterly data from 1993-2011 for the U.S. publicly-traded affiliates in my sample with the required data available and with equity method investors with INCENTIVEINV EST ORk,t = 0 in all periods. Two-tailed p-values are reported as follows: ¦ p 0.10, ¦¦ p 0.05, ¦¦¦ p 0.01. The variables are defined in Table 6.1. quantitative thresholds in APB 18, a small change in ownership around 20% would result in a change in accounting method (for my sample of public firms, from fair value measurement to the equity method or vice versa). This presents an opportunity for the investor to manage its earnings. For example, it is possible for an investee to have a positive change in its fair value during a reporting period but recognize a loss. In that situation, the investor might want to change its ownership to 19%, measure

69 its investment at fair value, and recognize positive income from the investment. In contrast, the investee might recognize positive net income during a reporting period, but suffer a significant decline in fair value. In that situation, the investor might want to increase its ownership above 20%, apply the equity method, and recognize positive income from the investment. I investigate the occurrence of this type of earnings management in my sample by examining the periods in which an investor changed from ownership in an investee below significant influence (e.g., AFS security) to the equity method or vice versa. In an untabulated result using the Fisher’s exact test, I find no statistically significant relation between the sign of investee net income and the sign of changes in investee’s fair value during the reporting period in which a change to the equity method is made (p-value of 0.245). I find a statistically significant relation between the sign of investee net income and the sign of changes in investee’s fair value during the reporting period in which a change from the equity method to fair value is made (p-value of 0.065), but not in the direction predicted under a hypothesis of earnings management. Change from ownership in an investee below significant influence (e.g., AFS secu- rity) to the equity method:

Change in Investee’s Fair Value during Reporting Period Negative Positive Total Negative 11 3 14

Positive 8 7 15 Reporting Period Investee’s Net Income during Total 19 10 29

Change from the equity method to ownership in an investee below significant influence (e.g., AFS security):

70 Change in Investee’s Fair Value during Reporting Period Negative Positive Total Negative 39 9 48

Positive 18 12 30 Reporting Period Investee’s Net Income during Total 57 21 78

Aligning or misaligning the fiscal-year-ends of investors and investees

Paragraph 19(g) of APB 18 states, “If financial statements of an investee are not sufficiently timely for an investor to apply the equity method currently, the investor ordinarily should record its share of the earnings or losses of an investee from the most recent available financial statements. A lag in reporting should be consistent from period to period.” An investor makes a decision at the initial application of the equity method about whether to use current or lagged results of the affiliate. That decision does not change the overall amount of income from the affiliate recognized in the investor’s net income, but it can change the timing of the income that is recognized. Therefore, an oppor- tunity for earnings management exists. For example, assume (a) an investor knows that it is going to just meet its earnings target for the period without incorporating income from its newly-acquired affiliate and (b) incorporating the results of the affil- iate would cause the investor to miss its earnings target. The investor might decide to use the lagged results and incorporate the loss from its affiliate in the next period. I identified 29 investor-affiliate pairs where a lagged reporting date for the affiliate was used. In those cases, net income of the affiliate in the initial ownership period was negative 65.52% (19/29) of the time. The occurrence of negative affiliate income in the application period when the investor does not choose to use a lagged reported

71 period was 62.24% (305/490). An untabulated Fisher’s exact test suggests that there is no association between the incidence of negative net income of the affiliate and the decision to use a lagged reporting date (p-value = .844). This suggests that the alignment of fiscal year ends does not seem to be a tool for earnings management.

6.4.6 Reverse Causality/Endogeneity

My results are consistent with equity method investors influencing affiliates to report lower signed discretionary accruals. It is possible instead that firms with lower signed discretionary accruals attract equity method investors (a reverse causality explanation). I investigate the change in signed discretionary accruals in the period prior to equity method ownership. In an untabulated result, I find that there is no change in the signed discretionary accruals (p-value = 0.341) of affiliates in the year prior to equity method ownership. This result mitigates concerns about reverse causality. It is also possible that unidentified characteristics of the firms in my sample are correlated with signed discretionary accruals and also make them attractive equity method investments. My within-firm research design mitigates this issue by showing discretionary accruals are lower in periods when a firm is an affiliate relative to periods when a firm is not an affiliate.13

6.4.7 Effect of Equity Method Ownership on Accounting Conservatism of Affiliates

As noted in Chapter 6.3, I find that equity method ownership is negatively as- sociated with signed discretionary accruals of affiliates when investors have weaker incentives to manage income from affiliates. I suggest that this result is consistent with the effects of monitoring by large shareholders, but do not further explore or

13 Another way to mitigate concerns about endogeneity would be use a two-stage test with a determinant model for equity method investments as the first stage. However, there is no well-defined determinant model for equity method investments in the literature. I am considering developing such a model as an extension to my paper.

72 isolate the cause of the negative association. In this section, I examine another manifestation of monitoring studied in the large shareholder literature: accounting conservatism. Previous research suggests that “monitoring” shareholders demand ac- counting conservatism because it provides more timely indications of bad news, which allows shareholders to influence management’s decisions and/or discipline manage- ment earlier (e.g., Watts (2003), Chen et al. (2009), Ahmed and Duellman (2011), Ramalingegowda and Yu (2012)). Accounting conservatism and earnings management are related in that both vio- late the concept of neutrality from Chapter 3, Qualitative Characteristics of Useful Financial Information, of the FASB’s Conceptual Framework. Paragraph QC14 of SFAC No. 8 states, “A neutral depiction is without bias in the selection or presen- tation of financial information. A neutral depiction is not slanted, weighted, em- phasized, deemphasized, or otherwise manipulated to increase the probability that financial information will be received favorably or unfavorably by users.” The Basis for Conclusions (para. BC3.27) explicitly explains that conservatism is not included as an aspect of faithful representation because it would be inconsistent with neutral- ity. My earnings management tests focus on biasing reported results by increasing reported performance, while accounting conservatism decreases reported performance. However, an equity method investor might not need to rely on public financial reports in the same way as other investors (e.g., institutional investors) studied in the large shareholder literature. By definition, an equity method investor has “significant influence” over the operating and financial policies of an affiliate. This implies that equity method investors have access to information necessary to affect operating and financial decisions of affiliates. Such information likely is not available through public financial reporting channels. Therefore, I might not expect to find a positive relation between equity method ownership and accounting conservatism of affiliates. I follow prior research examining the relation between accounting conservatism

73 and ownership characteristics (e.g., Ramalingegowda and Yu (2012)) by using the Basu (1997) model, modified as follows:

NIk,t  β0 β1 NEGk,t β2 RETk,t β3 RETk,t ¦ NEGk,t β4 AF F ILIAT Ek,t

β5 NEGk,t ¦ AF F ILIAT Ek,t β6 RETk,t ¦ AF F ILIAT Ek,t

β7 RETk,t ¦ NEGk,t ¦ AF F ILIAT Ek,t β8 ¡17 CONT ROLSk,t¡1

β18 ¡27 NEGk,t ¦ CONT ROLSk,t¡1 β28 ¡37 RETk,t ¦ CONT ROLSk,t¡1

β38 ¡47 RETk,t ¦ NEGk,t ¦ CONT ROLSk,t¡1 εk,t (6.5) where:

NIk,t : income before extraordinary items (IBQ) of firm k in quarter t, scaled by the market value of equity (CSHOQ*PRCCQ) at the end of quarter t - 1;

NEGk,t : indicator variable equal to 1 if RETk,t is negative, and 0 otherwise;

RETk,t : buy-and-hold stock returns of firm k over quarter t;

AFFILIATEk,t: an indicator variable equal to 1 if firm k is an affiliate (i.e., has an owner using the equity method to account for its investment in firm k) in quarter t, and 0 otherwise;

MONOWNk,t¡1 : percentage ownership of firm k at the end of quarter t - 1 by institutional investors described as monitoring institutions in Ramalinge- gowda and Yu (2012) based on classification as dedicated by Bushee (2001) and independent by Brickley et al. (1988);

TRAOWNk,t¡1 : percentage ownership of firm k at the end of quarter t - 1 by institutional investors described as transient by Bushee (2001);

QIXOWNk,t¡1 : percentage ownership of firm k at the end of quarter t - 1 by institutional investors described as quasi-indexing by Bushee (2001);

74 DNIOWNk,t¡1 : percentage ownership of firm k at the end of quarter t - 1 by institutional investors described as dedicated by Bushee (2001) and non- independent by Brickley et al. (1988);

STD RETk,t¡1 : standard deviation of daily stock returns of firm k over quar- ter t - 1;

AGEk,t¡1 : age of firm k at the end of quarter t - 1, measured as the number of years a firm is listed on Compustat;

MVEk,t¡1 : market value of equity (CSHOQ*PRCCQ) of firm k at the end of quarter t - 1;

MTBk,t¡1 : market-to-book ratio (MVE/CEQQ) of firm k at the end of quar- ter t - 1;

LEVk,t¡1 : leverage ((DLTTQ + DLCQ)/MVE) of firm k at the end of quarter t - 1; and

LITk,t¡1 : indicator variable equal to 1 if firm k is in one of the following industries at the end of quarter t - 1: biotechnology (SIC codes 2833-2836 and 8731-8734), computers (SIC codes 3570-3577 and 7370-7374), electronics (SIC codes 3600-3674), and retail (SIC codes 5200-5990), and 0 otherwise.

I estimate Equation 6.5 using pooled OLS regression for all firm-quarters from 1993-2011 for the U.S. publicly-traded affiliates in my sample with the required data available. I winsorize all variables at the 1st and 99th percentiles and include year and firm fixed effects in the regression. The estimation results are reported in Table

6.8. The coefficient on RETk,t * NEGk,t * AFFILIATEk,t is positive (β7 = 0.112, t-statistic = 3.830 for model without control variables; β7= 0.123, t-statistic = 3.288 for model with control variables), indicating a positive association between equity method ownership and the incremental timeliness of earnings with respect to bad

75 news. This result is consistent with the view, expressed by Ramalingegowda and Yu (2012) and others, that large shareholders use conservative financial reporting to assist them in monitoring/disciplining management by providing more timely indications of bad news.

76 Table 6.8: Relation between Equity Method Ownership and Accounting Conservatism of Affiliates

NIk,t  β0 β1 NEGk,t β2 RETk,t β3 RETk,t ¦ NEGk,t β4 AF F ILIAT Ek,t β5 NEGk,t ¦ AF F ILIAT Ek,t

β6 RETk,t ¦ AF F ILIAT Ek,t β7 RETk,t ¦ NEGk,t ¦ AF F ILIAT Ek,t β8 ¡17 CONT ROLSk,t¡1

β18 ¡27 NEGk,t ¦ CONT ROLSk,t¡1 β28 ¡37 RETk,t ¦ CONT ROLSk,t¡1

β38 ¡47 RETk,t ¦ NEGk,t ¦ CONT ROLSk,t¡1 εk,t (6.5)

Dependent variable=NIk,t Dependent variable=NIk,t

Coefficient t-statistic Coefficient t-statistic

NEGk,t 0.005 0.966 0.014 0.915 ¦¦¦ RETk,t ¡0.035 ¡3.660 ¡0.013 ¡0.434 ¦¦¦ ¦¦ RETk,t *NEGk,t 0.152 7.964 0.124 2.037 AFFILIATEk,t 0.009 1.578 0.005 0.651 NEGk,t *AFFILIATEk,t ¡0.000 ¡0.056 0.003 0.276 ¦¦¦ ¦¦¦ RETk,t *AFFILIATEk,t ¡0.056 ¡3.696 ¡0.051 ¡2.724 ¦¦¦ ¦¦¦ RETk,t *NEGk,t *AFFILIATEk,t 0.112 3.830 0.123 3.288 CONTROLS Included NEGk,t *CONTROLS Included RETk,t *CONTROLS Included ¦¦ RETk,t *NEGk,t *MONOWNk,t¡1 ¡0.667 ¡2.151 ¦ RETk,t *NEGk,t *TRAOWNk,t¡1 ¡0.387 ¡1.944 RETk,t *NEGk,t *QIXOWNk,t¡1 0.044 0.336 RETk,t *NEGk,t *DNIOWNk,t¡1 ¡0.385 ¡0.792 RETk,t *NEGk,t *STD RETk,t¡1 0.971 1.300 RETk,t *NEGk,t *AGEk,t¡1 ¡0.000 ¡0.139 RETk,t *NEGk,t *MVEk,t¡1 ¡0.000 ¡1.375 ¦¦¦ RETk,t *NEGk,t *MTBk,t¡1 ¡0.009 ¡3.604 ¦¦ RETk,t *NEGk,t *LEVk,t¡1 0.015 2.201 RETk,t *NEGk,t *LITk,t¡1 ¡0.023 ¡0.587 Intercept ¡0.002 ¡0.214 0.021 0.917 Firm effects Included Included Year effects Included Included Firm-quarters 12,749 7,398 Firms 384 359 Adjusted R2 0.159 0.363 The table reports results of the estimation of Equation 6.5 using pooled OLS regression with quarterly data from 1993-2011 for the 359 U.S. publicly-traded affiliates in my sample with the required data available. For brevity, I do not report coefficients for stand-alone control variables or the two-way interactions of control variables with NEG and RET, but they are included in the estimation. Two-tailed p-values are reported as follows: ¦ p 0.10, ¦¦ p 0.05, ¦¦¦ p 0.01. The variables are defined as follows. All variables (except indicator variables) are winsorized at the 1st and 99th percentiles. NIk,t : income before extraordinary items (IBQ) of firm k in quarter t, scaled by the market value of equity (CSHOQ*PRCCQ) at the end of quarter t - 1. NEGk,t : indicator variable equal to 1 if RETk,t is negative, and 0 otherwise. RETk,t : buy-and-hold stock returns of firm k over quarter t. AFFILIATEk,t: an indicator variable equal to 1 if firm k is an affiliate (i.e., has an owner using the equity method to account for its investment in firm k) in quarter t, and 0 otherwise. MONOWNk,t¡1 : percentage ownership of firm k at the end of quarter t - 1 by institutional investors described as monitoring institutions in Ramalingegowda and Yu (2012) based on classification as dedicated by Bushee (2001) and independent by Brickley et al. (1988). TRAOWNk,t¡1 : percentage ownership of firm k at the end of quarter t - 1 by institutional investors described as transient by Bushee (2001). QIXOWNk,t¡1 : percentage ownership of firm k at the end of quarter t - 1 by institutional investors described as quasi-indexing by Bushee (2001). DNIOWNk,t¡1 : percentage ownership of firm k at the end of quarter t - 1 by institutional investors described as dedicated by Bushee (2001) and non-independent by Brickley et al. (1988). STD RETk,t¡1 : standard deviation of daily stock returns of firm k over quarter t - 1. AGEk,t¡1 : age of firm k at the end of quarter t - 1, measured as the number of years a firm is listed on Compustat. MVEk,t¡1 : market value of equity (CSHOQ*PRCCQ) of firm k at the end of quarter t - 1. MTBk,t¡1 : market-to-book ratio (MVE/CEQQ) of firm k at the end of quarter t - 1. LEVk,t¡1 : leverage ((DLTTQ + DLCQ)/MVE) of firm k at the end of quarter t - 1. LITk,t¡1 : indicator variable equal to 1 if firm k is in one of the following industries at the end of quarter t - 1: biotechnology (SIC codes 2833-2836 and 8731-8734), computers (SIC codes 3570-3577 and 7370-7374), electronics (SIC codes 3600-3674), and retail (SIC codes 5200-5990), and 0 otherwise. 77 7

Link between Value Relevance and Earnings Management

At a conceptual level, the value relevance and earnings management tests in my paper are linked because both address the decision usefulness of the equity method of accounting as described in Chapter 3, Qualitative Characteristics of Useful Fi- nancial Information, of the FASB’s Conceptual Framework. In particular, the value relevance tests can be thought of as a joint test of the relevance and representational faithfulness of information provided by measuring investments in affiliates under the equity method or at fair value. The earnings management tests are an investigation of the neutrality of information reported by equity method investors, which is one component of representational faithfulness. I also investigate whether there is an empirical link between my value relevance and earnings management tests. In particular, I examine whether the existence of an incentive for investors to manage income from affiliates affects the valuation co- efficients of income reported under the equity method. As shown in Table 7.1, I do not find evidence of differences in valuation coefficients in my main value relevance specification depending on the incentives of investors to manage earnings (coefficients

78 on interaction terms all indistinguishable from zero). I then refine the analysis based on the discussion in Chapter 6.4.2 that it might be more likely for an equity method investor to manage the earnings of a private affiliate than a public affiliate.1 In par- ticular, if investors believe that a firm with significant influence might manage income from private affiliates more than income from public affiliates, we might expect the valuation coefficients on amounts reported under the equity method to be smaller for private affiliates than public affiliates. As shown in Table 7.2, I do not find significant differences in the coefficients for the balance sheet and income statement amounts reported under the equity method for private and public affiliates (p-value of 0.3769

for test of equality of BVprivateaffiliatej ,t = BVpublicaffiliatej ,t ; p-value of 0.4328 for test of equality of INCprivateaffiliatej ,t = INCpublicaffiliatej ,t ). However, I do find that when in- vestors have an incentive to manage income from affiliates, the valuation coefficient on income from private affiliates is lower (coefficient on INCprivateaffiliatej ,t * EARNINGS

MGMTj ,t = -6.676, t-statistic = -2.161). One explanation is that investors under- stand the incentive and ability of firms with significant influence to manage income from private affiliates and therefore adjust the valuation of that income accordingly.

1 I also investigate whether there are differences in valuation coefficients based on the length of holding period since I find that equity method investors with longer holding periods also have stronger earnings management results (see Chapter 6.4.1). In an untabulated result, I do not find differences in any valuation coefficients based on length of holding period.

79 Table 7.1: Effect of Earnings Management by Investors on the Relation between Investors’ Stock Prices and Balance Sheet and Income Measures of Investments in Affiliates

MVEj ,t  β0 β1 BVotherj ,t β2 BVpublicaffiliatej ,t β3 FV ¡ BVpublicaffiliatej ,t β4 INCotherj ,t (5.1) β5 INCpublicaffiliatej ,t β6 FVINC ¡ INCpublicaffiliatej ,t εj ,t

Dependent variable = MVEj ,t Dependent variable = MVEj ,t

Coefficient t-value Coefficient t-value

¦¦¦ ¦¦¦ BVotherj ,t 0.774 10.092 0.746 9.516 BVotherj ,t * EARNINGS MGMTj ,t 0.115 1.100 ¦¦¦ ¦¦¦ BVpublicaffiliatej ,t 1.113 3.673 1.107 3.572 BVpublicaffiliatej ,t * EARNINGS MGMTj ,t ¡0.391 ¡0.687 ¦¦¦ ¦¦¦ FV-BVpublicaffiliatej ,t 0.712 3.726 0.750 3.705 FV-BVpublicaffiliatej ,t * EARNINGS MGMTj ,t ¡0.085 ¡0.225 ¦¦¦ ¦¦¦ INCotherj ,t 0.811 4.285 0.824 4.131 INCotherj ,t * EARNINGS MGMTj ,t 0.112 0.200 INCpublicaffiliatej ,t 2.132 1.591 1.066 0.629 INCpublicaffiliatej ,t * EARNINGS MGMTj ,t 3.577 1.040 ¦¦ FVINC-INCpublicaffiliatej ,t 0.396 2.186 0.264 1.335 FVINC-INCpublicaffiliatej ,t * EARNINGS MGMTj ,t i 0.679 1.355 EARNINGS MGMTj ,t 0.028 0.013 Intercept 14.408¦¦¦ 5.560 14.640¦¦¦ 5.586

Year fixed effects Included Included Firm fixed effects Included Included Firm-years 857 857 Adjusted R2 0.828 0.828

The table incorporates into Equation 5.1 the effect of investors’ incentives to manage income from affiliates. EARNINGS MGMTj ,t : indicator variable equal to 1 if income from affiliates causes firm j to meet one of three earnings targets (non-negative income, non-negative change in income, analysts’ forecasted earnings) in year t, and 0 otherwise. Additional variables are defined in Table 5.1. Two-tailed p-values are reported as follows: ¦ p 0.10, ¦¦ p 0.05, ¦¦¦ p 0.01.

80 Table 7.2: Effect of Separating Publicly-Traded and Private Affiliates on the Re- lation between Investors’ Stock Prices and Balance Sheet and Income Measures of Investments in Affiliates

MVEj ,t  β0 β1 BVotherj ,t β2 BVpublicaffiliatej ,t β3 FV ¡ BVpublicaffiliatej ,t β4 INCotherj ,t (5.1) β5 INCpublicaffiliatej ,t β6 FVINC ¡ INCpublicaffiliatej ,t εj ,t

Dependent variable = MVEj ,t Dependent variable = MVEj ,t

Coefficient t-value Coefficient t-value

¦¦¦ ¦¦¦ BVnonaffiliatej ,t 0.770 9.373 0.756 9.134 BVnonaffiliatej ,t * EARNINGS MGMTj ,t ¡0.192 ¡1.504 ¦¦¦ ¦¦¦ BVpublicaffiliatej ,t 1.195 3.926 1.372 4.383 BVpublicaffiliatej ,t * EARNINGS MGMTj ,t ¡0.225 ¡0.372 ¦¦¦ ¦¦¦ BVprivateaffiliatej ,t 0.857 3.798 0.644 2.749 ¦¦¦ BVprivateaffiliatej ,t * EARNINGS MGMTj ,t i 1.678 3.286 ¦¦¦ ¦¦¦ FV-BVpublicaffiliatej ,t 0.599 3.055 0.600 2.919 FV-BVpublicaffiliatej ,t * EARNINGS MGMTj ,t ¡0.036 ¡0.097 ¦¦¦ ¦¦¦ INCnonaffiliatej ,t 0.818 4.036 0.786 3.719 INCnonaffiliatej ,t * EARNINGS MGMTj ,t 0.820 1.299 INCpublicaffiliatej ,t 1.877 1.369 0.951 0.561 INCpublicaffiliatej ,t * EARNINGS MGMTj ,t ¡1.253 ¡0.302 ¦ INCprivateaffiliatej ,t 0.678 0.647 2.022 1.772 ¦¦ INCprivateaffiliatej ,t * EARNINGS MGMTj ,t ¡6.676 ¡2.161 ¦¦ FVINC-INCpublicaffiliatej ,t 0.415 2.284 0.264 1.342 FVINC-INCpublicaffiliatej ,t * EARNINGS MGMTj ,t 0.626 1.255 EARNINGS MGMTj ,t 1.072 0.516 Intercept 13.467¦¦¦ 5.098 13.406¦¦¦ 5.046

Year fixed effects Included Included Firm fixed effects Included Included Firm-years 784 784 Adjusted R2 0.834 0.837

Tests of Equality of Coefficients: p-value

BVpublicaffiliatej ,t = BVprivateaffiliatej ,t .3769 INCpublicaffiliatej ,t = INCprivateaffiliatej ,t .4328

The table incorporates into Equation (1) the effect of separately identifying publicly-traded affiliates and private affiliates and the effect of investors’ incentives to manage income from affiliates. BVnonaffiliatej ,t : book value (CEQ) of firm j less the book value of its investments in affiliates (IVAEQ) at the end of year t. INCnonaffiliatej ,t : income before extraordinary items (IB) less reported income from affiliates (ESUB) of firm j in year t. EARNINGS MGMTj ,t : indicator variable equal to 1 if income from affiliates causes firm j to meet one of three earnings targets (non-negative income, non-negative change in income, analysts’ forecasted earnings) in year t, and 0 otherwise. Additional regression details and variables are defined in Table 4. Two-tailed p-values are reported as follows: ¦ p 0.10, ¦¦ p 0.05, ¦¦¦ p 0.01.

81 8

Conclusion

This paper examines the decision usefulness of the equity method of accounting. For a sample of 221 U.S. investors with publicly-traded affiliates during 1993-2011, I find that fair value balance sheet and income measures of investments in publicly- traded affiliates are incrementally associated with investors’ stock prices after control- ling for information provided under the equity method. This result suggests that fair value provides incremental relevant information, relative to the equity method, for in- vestments in affiliates. In addition, I find that the incremental value relevance of fair value measures exists for both investments in affiliates classified as held for sale and those classified as strategic, with no evidence that the incremental value relevance is higher (lower) for investments in affiliates identified as held for sale (strategic). The result speaks to the ongoing debate at the FASB about whether measurement attributes should be based on management’s intended method of value realization for the items in question or whether the same measurement attribute should be applied to similar items regardless of management’s intent. In particular, the result suggests that significant influence might not be a basis for measuring investments in affiliates that an entity does not intend to sell differently from other investments in marketable

82 equity securities (which are required to be measured at fair value under U.S. GAAP). I also find evidence that the equity method does not achieve its objective of reducing earnings management by investors with significant influence. For a sample of 202 publicly-traded U.S. firms that were affiliates for a portion of the period 1993- 2011, I find that signed discretionary accruals of affiliates are higher when income from affiliates allows investors to meet earnings targets. This result indicates that the equity method does not eliminate concerns about earnings management by investors with significant influence (such as those expressed about the timing of dividends under the cost method); instead, it changes the mechanism through which earnings are managed.

83 Appendix A

Description of the Cost Method

APB 18 (para. 6) describes the cost method as follows: “An investor records an investment in the stock of an investee at cost, and recognizes as income dividends received that are distributed from net accumulated earnings of the investee since the date of acquisition by the investor. The net accumulated earnings of an investee sub- sequent to the date of investment are recognized by the investor only to the extent distributed by the investee as dividends.” In contrast, under the equity method, divi- dends received reduce the carrying amount of the investment and income recognition by the investor is based on the investor’s share of the net income of the investee (ad- justed as described in Chapter 2) and also results in a change in the carrying amount of the investment. Impairment requirements are similar under the cost and equity methods. The cost method is distinct from amortized cost used to measure investments in held-to-maturity debt securities under SFAS 115. Under the amortized cost method (as described on page 570 of Stickney et al. (2010)), “A firm initially records these debt securities at acquisition cost. This acquisition cost will differ from the maturity

84 value of the debt if the coupon rate on the bonds differs from the required market yield on the bonds at the time the firm acquired them. The firm must use the effective interest method to amortize any difference between acquisition cost and maturity value over the life of the debt as an adjustment to interest revenue. ... The amortization procedure involves the following steps: (1) The holder of the debt securities (the investor) records interest revenue each period at an amount equal to the carrying value of the debt at the start of the period multiplied by the market rate of interest applicable to that debt on the day the firm acquired the debt. It debits the Marketable Securities account and credits Interest Revenue, which after closing entries increases Retained Earnings. (2) If the investor receives cash each period, it debits Cash and credits the Marketable Securities account. The result of this process is a new carrying value (called the amortized cost) for use in the computations during the next period.” The key difference between the amortized cost method and the equity method is the basis for income recognition. Under the amortized cost method, income recog- nition is based on the amortization of any difference between acquisition cost and maturity value over the life of the debt security held as interest revenue. The amor- tized cost method cannot be applied to investments in equity securities because equity securities do not have maturity dates. The impairment guidance for debt securities differs from that for equity securi- ties. After it has been determined that an other-than-temporary impairment exists for equity securities, the entire difference between the investment’s cost and its fair value is recognized in earnings (ASC 320-10-35-34). For debt securities (ASC 320- 10-35-34D), the other-than-temporary impairment is separated into (a) the amount representing the credit loss (exists when present value of cash flows expected to be collected is less than the amortized cost basis of the security), which is recognized in earnings, and (b) the amount related to all other factors, which is recognized in other

85 comprehensive income. The guidance for other-than-temporary impairments for debt securities changed during my sample period. Prior to reporting periods ending after June 15, 2009, once it was determined that an other-than-temporary impairment ex- isted, the entire amount of the impairment was recognized in earnings. In addition, the previous requirement to avoid recognizing an other-than-temporary impairment was for an investor to assert that it has both the intent and the ability to hold a security for a period of time sufficient to allow for an anticipated recovery in its fair value to its amortized cost basis. Now, an entity must assess whether it (a) has the intent to sell the debt security or (b) more likely than not will be required to sell the debt security before its anticipated recovery. If either of these conditions is met, the investor must recognize an other-than-temporary impairment. (FASB Staff Position No. FAS 115-2 and FAS 124-2, para. 7)

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93 Biography

Amanda Lee (Quiring) Gonzales was born on April 24, 1980, in Aurora, Nebraska. She earned a Bachelor of Arts degree in Professional Accounting and Mathematics from Hastings College (Hastings, Nebraska) in 2002, a Master’s degree in Professional Ac- countancy from the University of Nebraska—Lincoln in 2003, and a Ph.D. in Business Administration from Duke University in 2013. Prior to attending Duke University, she worked as a project manager at the International Accounting Standards Board and as a postgraduate technical assistant at the U.S. Financial Accounting Standards Board. At Duke University, she received recognition as a James B. Duke Fellow and University Scholar.

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