The effects of legal protections and control-ownership divergences on investor perceptions of foreign earnings

Author:Chen-Lung Chin
Position:Department of Accounting, National Chengchi University, Taipei City, Taiwan

Purpose – The purpose of this paper is to investigate the impact of corporate internationalization, governance structures, and legal protections on the foreign earnings response coefficient (FERC). The FERC is a measure of the value-relevance of foreign earnings. Design/methodology/approach – Data were collected on 3,653 Taiwanese firms which had overseas investments. The authors... (see full summary)

1 Introduction

It is commonly understood that businesses pursue international diversification as part of a strategy to seek potential profit elsewhere. The international diversification may also result in more efficient capital allocation and greater economic growth. The public policy implications of this diversification, however, are less clear cut since diversification may result in capital being allocated to international locales where financial transparency and legal protections for investors are limited. The result of such an allocation may be greater profits for controlling owners and managerial personnel and a diversion of corporate resources from minority owners.

Research by Duru and Reeb (2002) and others has indicated that successful internationalization leads to both greater earnings growth rates and earnings persistence. There has been little work to date that examines whether the market's perception of the value relevance of foreign earnings varies among firms with different international diversification profiles. Previous research has focused on differences in the value relevance of foreign versus domestic earnings ( Bodnar et al., 2003 ; Bodnar and Weintrop, 1997 ). Failure to address the impact of differing international diversification profiles is an important deficit in current research. In order to address this deficit, we specifically investigate the association between the degree of international diversification, the impact of different amounts of control-ownership divergence, and the degree to which local legal regimes protect investor rights on the one hand, and the value relevance of foreign earnings on the other.

This paper makes several contributions. First, our study widens the sources of information used in studying perceptions of the relationship between internationalization and the value relevance of earnings by using Taiwanese data. Previous studies ( Bodnar and Weintrop, 1997 ; Bodnar et al., 2003 ) had focused on countries of Anglo-Saxon heritage1. Thus, our findings provide further understanding of the impact of internationalization factors on the value relevance of foreign earnings outside the Anglo-Saxon countries.

Our second contribution is to explore and document the effects of control divergence on the value relevance of foreign earnings. Given the opportunity for asset diversion that internationalization provides to management and/or controlling owners, it is important to understand the influence of control-ownership divergence on the value relevance of foreign earnings. Obviously, investing corporate assets overseas raises issues as to the proper jurisdiction within which to pursue legal claims. Therefore, our third contribution is to examine the effects of the legal regime governing investor protection in the investee companies on the value relevance of foreign earnings. Internationalization may threaten the firm with the possibility that domestic influences in foreign markets will impact the corporation's ability to assert control over its own investments. Certain aspects of the foreign legal system may influence the investor's concern about this. A combination of better control-ownership divergences and foreign legal regimes that protect the investor may lead to improved earnings informativeness, and therefore higher value relevance of foreign earnings. The importance of control divergences in impacting the behavior of corporate management can be seen in Young et al. (2008, p. 297) . Young et al. found that financial restatements were more likely “when there is a greater divergence between controlling shareholders' board seats control rights and ownership rights.” Firms with lower degrees of control divergence, that is, firms in which the controlling owner's percentage of board seats more closely matched its percentage ownership of the firm's equity, had fewer restatements than when there was greater divergence between percentage of board seats controlled by the controlling owner and the percentage of shares owned by the controlling owner. The Young et al. study vividly demonstrates the “potential” for accounting issues to arise when dominant stakeholders can sway corporate behavior in their own, preferred, direction should the dominant stakeholders (owners) prefer such behavior. Young et al. (2008, p. 297) stated that the “entrenchment incentive from controlling shareholders' excess control motivates firms to adopt aggressive accounting policies”. We argue here that investors may possess concerns about the use of aggressive accounting policies by the controlling owner when there are control divergences, and therefore the investors may see foreign earnings as having less value relevance when these control divergences exist.

Further, this study contributes to the literature showing the importance of financial transparency to investor decision making. Given the international scope of the investing – and therefore disclosure – pertinent to this study, our study demonstrates that segment disclosure has great value to investors in that the results help the investors evaluate the impact of foreign investments, and their attendant uncertainties, on the firm's expected future performance.

Our empirical results indicate that the market's perception of the value relevance of foreign earnings does not significantly differ from the value relevance of domestic earnings. We do find that the impact of foreign earnings on stock returns is significantly enhanced as the international diversification profiles of the firms in the sample increase. Diversification profiles were measured by country scope and the number of foreign investees. Furthermore, better quality corporate governance (i.e. a reduced difference between the percentage of board seats influenced by the ultimately controlling shareholders and their cash flow rights) was found to enhance the positive effects of internationalization on the value relevance of foreign earnings. Research by Haw et al. (2004) , Leuz et al. (2003) and Ball et al. (2000) all support this claim.

The rest of this paper is organized as follows. Section 2 discusses the relevant institutional background and reviews relevant literature. Section 3 presents our hypotheses. Section 4 describes the data, sample selection procedures, and research designs employed. Section 5 presents the empirical results and our tests of the robustness of those results, with our conclusions being presented in Section 6.

2 Institutional background and related literature
2. 1 Internationalization and foreign earnings

The increasing role that international operations play in the economics of many firms underlines the importance of understanding how foreign earnings are regarded by investors. Research by Bodnar et al. (2003) , for example, argues that foreign involvements may have both positive and negative effects on the value relevance of both domestic and foreign earnings. Further, Duru and Reeb (2002) present many factors that may impact income earned by corporations with extensive foreign operations. These include:

  • greater persistence of foreign earnings;
  • greater earnings growth rate;
  • the legal and regulatory environment;
  • profit transfers as a tool to arbitrage differences between tax rates in different countries of operation;
  • greater operational flexibility;
  • different cultural and legal environments; as well as
  • a broader array of competition.
  • Duru and Reeb (2002) note that these factors may make it more difficult to forecast firm's earnings. Further, overseas activities raise the risk that the firm will be unable to recoup its investments abroad as well as be unable to capture any positive impacts of its resource developing efforts on its financial statements. The result may be a higher risk premium being built into the stock price. Jiraporn et al. (2005) report that diversification may result in a value discount due to the associated agency costs of diversification. Accordingly, it can be argued that foreign operations may have a highly problematic impact on the value relevance of a firm's foreign earnings2. Given that foreign operations may affect the value relevance of earnings, here we study the impact of corporate governance systems and the nature of the legal system of the country within which the foreign earnings are earned on the value relevance of foreign earnings.

    2. 2 Corporate governance systems

    Research has pointed out the potential for corporate governance systems to impact the behaviors of firms and hurt minority shareholders ( Jaggi et al., 2009 ; Vafeas, 2000 ; Faccio et al., 2001 ; Chin et al., 2006, 2009 ; Young et al., 2008 ; see also Jiraporn et al., 2005 , on a related issue). This may be more likely in East Asia and other areas where there are greater divergences between voting rights and cash flow rights of the ultimately controlling owner than exists in the USA ( Anderson and Reeb, 2003 ; Chin et al., 2009 )3. We call the relationship between the controlling owner's voting rights and cash flow rights the control-ownership divergence. Since this control divergence gives controlling owners the ability to siphon off assets to their own benefit with a disproportionate cost to the minority...

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