Behind closed doors : unveiling earnings management in private subsidiaries of public firms

Purpose - This study examines the earnings quality of private-subsidiary firms using a large sample data from India. Design/methodology/approach - The impact of parent-subsidiary relationship on earnings quality is examined using two common proxies. Findings are robust to alternative research designs, including different earnings quality proxies, endogeneity and matching techniques. Findings - The study finds that private firms that are subsidiaries of listed firms tend to have lesser (greater) earnings quality (manipulation). Further, the study reports that this relationship is more pronounced when the parent firm is relatively larger than the subsidiaries. The study finds no evidence that Big 4 affiliation of the parent company improves earnings quality among private subsidiaries; instead, it exacerbates earnings manipulation in some cases. Finally, the authors document that subsidiary firms use tax management, as proxied by book tax differences, to engage in income-increasing earnings manipulation. Research limitations/implications - This study examines how affiliation with a listed entity as a subsidiary impacts the earnings quality of private companies. Future research could investigate the financial reporting practices of both private subsidiary firms and standalone private firms, comparing them in similar or differing regulatory environments across various countries. Practical implications - The findings of this study will help investors, bankers, creditors and regulators to understand the financial reporting of private firms. The study calls for enhanced audit quality at the subsidiary level by making the auditor of the parent firm responsible for auditing a subsidiary, a practice that is currently absent in India. Originality/value - The results contribute to the existing debate on how firms manage earnings using data of private firms in a large emerging market setting. Previous research has not paid enough attention to the earnings quality of private subsidiaries. The study also emphasizes the necessity for a more robust system of governance and supervision for private firms, particularly in India and generally in other countries.