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RAF
10,2 Corporate diversification
and earnings management
Imen Khanchel El Mehdi
176 Higher Institute of Technological Studies in Communications of Tunis,
Tunis, Tunisia, and
Souad Seboui
Higher School of Economic and Commercial Sciences of Tunis, Tunis, Tunisia

Abstract
Purpose The purpose of this paper is to find out whether corporate diversification provides a
favourable environment for earnings management (agency conflicts hypothesis) or whether it
mitigates this phenomenon (earnings volatility hypothesis).
Design/methodology/approach Based on a sample of US firms and making an explicit
distinction between industrial and geographic diversification, univariate and multivariate analyses are
used to test whether firm diversification has an impact on earnings management.
Findings Results show that the average diversified firm in the sample has somewhat more
earnings management problems than a similarly constructed portfolio of stand-alone firms chosen to
approximate the segments of the conglomerate. Consistent with the agency conflicts hypothesis, the
authors find that geographic diversification increases earnings management whereas industrial
diversification decreases it, consistent with earnings volatility hypothesis. Moreover, industrial and
geographic diversification combined reinforce this phenomenon. These findings are consistent with
the view that the costs of geographic diversification outweigh the benefits.
Originality/value The paper makes an important contribution to the accounting literature by
providing new and significantly different evidence on the relative roles of corporate diversification in
the earnings management. By linking two streams of research, earnings management and corporate
diversification, one is taken into the unexplored area of the sources of the difference in earnings
management between diversified and focussed firms. More specifically, this study provides evidence
that earnings management is more intensively practiced in geographically diversified firms and even
more so in firms that are both industrially and geographically diversified.
Keywords United States of America, Diversification, Organizational structure, Earnings
Paper type Research paper

Review of Accounting and Finance
Vol. 10 No. 2, 2011
pp. 176-196
q Emerald Group Publishing Limited
1475-7702
DOI 10.1108/14757701111129634
Introduction
Long before the recent financial scandals which shook up the accounting and financial
communities, the phenomenon of earnings management had drawn the attention of
academic researchers and regulators. The subject of earnings management in the
accounting literature has grown in popularity during the last decade. Numerous
published and unpublished papers investigate theoretically and empirically different
hypotheses related to earnings management. Some researchers simply provide evidence
of earnings management (Dechow et al., 2003; Nelson et al., 2002), others examine its role
The paper has benefited from the extensive comments and suggestions of the two anonymous
reviewers of the journal. The authors would like to thank Professor Howard Turetsky, Co-Editor
of the journal, for his generous assistance during the review and final preparation of the
manuscript for publication.
in agency settings (Lobo and Zhou, 2001; Richardson, 2000; Tendeloo and Vanstraelen, Earnings
2005) and its impacts on information asymmetry and financial markets (DeFond and management
Park, 2001; Xie, 2001).
Our basic aim in this paper is to find out whether diversification as a corporate
strategy provides a favourable environment for earnings management and whether
managers of diversified firms resort, more than others, to earnings management in their
reported performance. 177
Undoubtedly, corporate strategic choices are, to a large extent, responsible for the
performance of the organization. However, the degree of earnings management is more
likely to depend on operating performance (Chung et al., 2005; Yoon and Miller, 2002).
Moreover, corporate strategic choices provide conditions that can be either favourable to
earnings management (opportunistic behaviour, a culture of self-fulfilment that prizes
short-term gains at the expense of long-term stability and habits of selective and
subjective disclosure, etc.) or unfavorable (a culture encouraging transparency, integrity
and accountability). There is, therefore, a need to compare the conditions created by a
diversification strategy as opposed to a focussed strategy, and their impacts on earnings
management. We propose two competing hypotheses that potentially explain the
relation between corporate diversification and earnings management.
According to the agency conflicts hypothesis, the ability of managers to distort
information and manipulate earnings depends on the firms degree of organizational
complexity and on the potential for agency gains which may prove to be highly important.
Typically, large firms with complex organizations and agency problems are diversified
across more than one country and/or industry. It is largely documented that diversified
firms are generally larger, that they have more complex organizational structures, have
less transparent operations and that their analysis poses difficulties to investors and
analysts alike (Chang and Yu, 2004; Kim and Pantzalis, 2003; Liu and Qi, 2007;
Rodrguez-Perez and Van Hemmen, 2010). In addition, they are likely to exhibit agency
conflicts and informational asymmetry problems, which are considered conducive to the
practice of earnings management (Dye, 1988; Trueman and Titman, 1988). Moreover,
with regard to the corporate diversification literature, numerous studies suggest that
corporate diversification destroys shareholders wealth and that the shares of diversified
firms sell at a discount. It is argued that managers may seek to diversify to:
.
increase their compensation (Jensen and Murphy, 1990), power and prestige
(Jensen, 1986);
.
secure their position within the firm through manager-specific investments
(Shleifer and Vishny, 1990a and b); and/or
.
reduce the risk of their personal investment by reducing firm risk (Amihud and
Lev, 1981).

Diversification may therefore not only motivate managers to manipulate accounting

figures, but may also create favourable conditions to make it difficult to detect earnings
management. Thus, based on these arguments, one can think that firms operating in a single
line of business (single-segment firms) and exclusively in the domestic market are likely to
have less opportunity for earnings management than industrially diversified
(multi-segment firms) or geographically diversified firms (multinationals) or both combined.
Recently, the literature on corporate diversification has explored the earnings
volatility hypothesis which argues that corporate diversification is expected to result
RAF in lower variability of earnings because earnings generated from the firms various units
10,2 are less than perfectly correlated. Therefore, the managers find difficulties to manipulate
earnings through accruals because accruals generated from different units which are
imperfectly correlated tend to cancel out. Thus, the earnings volatility hypothesis
predicts an inverse relation between earnings management and corporate
diversification, i.e. diversification can reduce earnings management.
178 Empirical evidence on the role of corporate diversification (geographic and industrial
diversification) in alleviating or exacerbating earnings management is sparse and
inconclusive. In fact, to our knowledge, only the work of Jiraporn et al. (2008) attempts to
address this issue. So, by linking two streams of research, earnings management and
corporate diversification, our study hopes to contribute to the relevant literature in
various ways. First, taking into account both dimensions of diversification (industrial
and geographic), we attempt to test whether corporate diversification affects earnings
management positively or negatively. Second, we should also attempt to find out
whether earnings management is more intensively practiced in firms that are both
industrially and geographically diversified.
Our paper differs from Jiraporn et al.s in several important respects. First, our study
takes us into the unexplored area of the sources of the difference in earnings
management between diversified and focussed firms. By comparing a sample of
diversified firms to their counterparts (carefully selected portfolios of stand-alone
focussed firms each of which matching in size and industry belongingness to a
corresponding diversified firm), we identify the specific characteristics of the conditions
created by diversification conducive to increased/decreased earnings management.
Second, by using a different approach from that of Jiraporn et al. (2008), we provide new
and significantly different evidence on the relative roles of corporate diversification in
the earnings management. Our results show that although industrial diversification
mitigate earnings management (consistent with Jiraporn et al. (2008) results), geographic
diversification alone or combined with industrial diversification accentuate this
phenomenon (inconsistent with Jiraporn et al. (2008) results).
The remainder of this paper is organised as follows.
In the following section, we review the relevant literature. In the third section,
we describe our data and define our variables. In the fourth section, we develop the main
hypothesis of our study and present our econometric approach. In the fifth section,
we discuss our results and in the last section, we conclude and suggest possible future
research extensions.

Corporate diversification and earnings management

In this section, we discuss whether diversification exacerbates or attenuates earnings
management. Two important hypotheses can explain the relationship between
earnings management and diversification: the agency conflicts hypothesis and the
earnings volatility hypothesis. The former hypothesis indicates that diversified firms
provide more favourable conditions for earnings management. It is based on information
asymmetry, investment misallocation and cultural diversity. The second hypothesis
suggests that diversification can attenuate earnings management. It is based on reported
earnings and incurred risk of diversified firms. These two hypotheses imply that,
for many reasons, we tend to think that differences in earnings management between
diversified and focussed firms may exist. These hypotheses are detailed below.
Agency conflicts hypothesis Earnings
This hypothesis is based on certain streams of research concluding that diversification management
may amplify information asymmetry, cause cultural diversity and induce misallocation
investments. These conclusions imply that diversification can constitute a favourable
ground to earnings management phenomenon.
Information asymmetry. A considerable literature suggests that corporate
diversification is a leading example of the agency relationship between shareholders 179
and managers and therefore, diversified firms are subject to larger asymmetric
information problems more than focussed firms are (Burch and Nanda, 2003; Denis et al.,
1997; Doukas et al., 2000; Doukas and Pantzalis, 2003; Rajan et al., 2000; Scharfstein and
Stein, 2000; Rodrguez-Perez and Van Hemmen, 2010). The source of the difference in
asymmetry is that diversified firms are less transparent than focussed firms are
(Thomas, 2002; Rodrguez-Perez and Van Hemmen, 2010). For instance, while managers
of diversified firms can observe divisional cash flows, outsiders can observe only crude
estimates of divisional cash flows. Thus, the problems of account translation and
consolidation make company reports less transparent to outsiders, and reported
earnings will convey less value-relevant information. To the extent that accounting
figures for diversified firms are less transparent compared to those of focussed firms,
they provide a greater incentive for difficult to detect earnings management.
Moreover, several studies in accounting manipulation have indicated that the
existence of information asymmetry between firm management and firm shareholders is
a necessary condition for the practice of earnings management (Dye, 1988; Trueman and
Titman, 1988). Thus, when information asymmetry is high, stakeholders do not have the
necessary information to look through the manipulated earnings. Earnings
management also results when shareholders, as is the case for highly diversified
firms, have insufficient resources, incentives, or access to relevant information to
monitor managerial actions which may intensify the practice of earnings management
(Warfield et al., 1995).
Investment misallocation. Investment decisions in diversified firms are known to
incur three types of risks. The first is the opportunism in the choice of investment
projects (Ahn and Denis, 2004; Goldman, 2005; Rajan et al., 2000; Scharfstein and Stein,
2000). Various studies suggest that corporate diversification is associated with a
substantial reduction in firm value (Tong, 2009). An underlying theme of this literature
is that diversified firms tend to misallocate their investment funds by cross subsidizing
poorly performing divisions. Berger and Ofek (1995), for example, document that
diversified firms are prone to cross-subsidize investments in divisions with poor growth
opportunities. Consistent with this view, Rajan et al. (2000) model the presence of power
struggles among the firms divisions and show that diversification causes resources to
flow to inefficient investments. Similarly, Scharfstein and Stein (2000) explain how
rent-seeking divisional managers can subvert the internal capital allocation decision.
These studies paint diversified firms as organizations that divert funds from stronger
divisions to weaker ones and thereby misallocate their investment capital.
The second type of risk is the possibility that investments and divestitures can
satisfy objectives of accounting earnings management and disclosure of desired
earnings. Dranikoff et al. (2002) argue that the decision to divest is nearly always in
response to pressure as the example of the divested business suffering heavy losses,
the parent having a suffocating debt burden, or Wall Street analysts turning negative.
RAF They indicate that among 50 of the largest divestitures completed over a period of four
10,2 years, more than three-quarters were completed under pressure, most of them only after
long delays, when problems became so obvious that action was unavoidable. Similarly,
Haynes et al. (2003) suggest that divestment is a purposeful response to financial,
corporate governance and strategic variables and, as such, appears broadly consistent
with both the agency theoretical and strategic views of the firm. Partly, reacting to this,
180 Standard and Poors proposed its standard operating number: core earnings. The
latter adjusted net income to include expenses from stock-option grants, restructuring
charges from ongoing operations, write-downs of depreciable or amortizable operating
assets, pension costs, and purchased research and development expenses.
It is not clear whether such a standard will reduce the earnings management
opportunities provided by corporate investments and divestures which are likely to
provide further favourable conditions for earnings management through discretionary
accruals.
The third risk is due to investments in research and development (R&D) which is likely
to be more important in large diversified firms (Hage and Aiken, 1970). R&D investment
can increase the problem of information asymmetry, increase agency problems (Hall, 2002)
and decrease transparency. It is also worth underlining that R&D investments can be used
to manipulate earnings. In this context, Nagy and Neal (2001) suggest that both USA and
Japanese managers use R&D investments to smooth income and that Japanese managers
do so at a significantly greater degree. Similarly, Dowdell and Press (2004) assess the
SECs difficult-to-prove charge that companies managed earnings with in-process
research and development expenses. Healy et al. (2002) argue that the accounting of
research and development remains a tradeoff between objectivity and relevance.
Cultural diversity. Culture relates to core organizational values. In turn, values are
paramount factors to organizations and underpin attitudes, decisions and behaviour.
An increasing number of successful organizations have, at least partly, attributed their
success to effective culture management. The firm can base its employee values on the
principals of respect, integrity, transparency and excellence. Inversely, a firm can make of
the pursuit of profit, at any cost, its dominant and even unique value (Arnold and Lange,
2004; Thomas, 2002). This latter case creates a culture of self-fulfilment and only those
who are prepared to act in a like-minded manner remain with the firm. Opportunism will
thus be encouraged and various agency problems emerge among which that of earnings
management.
The problem of diversified firms is that they have numerous subsidiaries and that
each subsidiary may have a particular culture that can diverge from that of other
subsidiaries. The problem of cultural diversity is worsened if industrially diversified
firms are also geographically diversified. Indeed, the faraway operations are more
difficult to control, notably because they put firms in contact with other cultures
(Sambharya, 1996) and shareholders will be incapable of controlling agents actions.
Therefore, the cultural issue seems to accentuate further agency problems and earnings
management in diversified firms.

Earnings volatility hypothesis

This hypothesis is based on a stream of research indicating that corporate
diversification is expected to result in lower variability of earnings because earnings
generated from the firms various units are less than perfectly correlated.
It permits to deduce that earnings management through accruals is very limited because Earnings
accruals tend to cancel out. management
Earnings volatility is often used as a proxy for business risk (the cost of financial
distress or the expected cost of bankruptcy). However, even in the case of unlevered
firms, earnings volatility is important since it may result in more noise, and thus, higher
stock price variability. Portfolio theory implies that earnings volatility is inversely
affected by the degree of a firms diversification because a diversified firms earnings, 181
from its different operational units, will be less than perfectly correlated with each other.
Moreover, the mode (geographic vs industrial) of diversification may be an important
factor because correlation among firm units earnings may differ depending on whether
operational units are located in different countries and/or whether they are in different
industry segments (Kim et al., 2001).
Lewellen (1971) and Stulz (1990) argue that diversified firms, because of the
imperfectly correlated cash flows from the various segments, are characterized by less
variability in aggregate cash flows. Hermalin and Katz (2003) argue that this coinsurance
may be important not only to bondholders, but also to managers and shareholders.
When accruals in disparate operating segments are managed at the entire firms
level, managers have flexibility to apply accruals across business segments. Since the
accruals in various divisions are less than perfectly correlated and, therefore, tend to
cancel out, the resulting total accruals at the whole firm level are less volatile, leading
to a lower degree of abnormal accruals, which proxy for earnings management.

Sample selection and variables measurement

In this section, we present our sample and we define the variables used in our empirical
analysis.

Sample selection
Our initial sample is drawn from EDGARSCAN, covering the 1998-2005 period.
Ettredge et al. (2005) provide evidence that SFAS 131 changes the segment reporting
practices of firms and, as a result, many firms that report single segment prior to SFAS 131
report multiple segments afterwards. We start the sample from 1998 to avoid this issue of
non-comparability across 1997. We exclude from consideration regulated firms as well as
financial institutions (SIC codes between 4900 and 4999 and those between 6000 and 6999).
We restrict our attention to those firms with data available from EDGARSCAN and
YAHOO FINANCE[1] on the number of business segments for which the firm reports
operating, financial and stock market data. We also exclude firms with total sales less than
$20 million.
From the annual reports, for each firm year, we hand collect diversification data
(number of industrial and geographic segments and foreign sales). Financial data are
extracted from the financial statements (balance sheets, income statements, statements
of cash flows, financial footnotes, etc.), available on the same site. Stock market data
are collected from YAHOO FINANCE.
Table I details the sample. It gives observations by year and firm-type.

Measurement of discretionary accruals

Total accruals (TA) are defined as net income (NI) before extraordinary items less operating
cash flows (OCF). TA can be decomposed into discretionary and non-discretionary accruals.
RAF
Year Multiple segment Single segment Total observations
10,2
1998 402 712 1,114
1999 398 744 1,142
2000 408 746 1,154
2001 422 776 1,198
182 2002 420 860 1,280
2003 413 920 1,333
2004 416 916 1,332
2005 416 919 1,335
Total 3,295 6,593 9,888
Table I. Notes: This sample includes firms with data available from EDGARSCAN and YAHOO FINANCE
Frequency for the 1998-2005 period; we exclude from consideration regulated firms and financial institutions
of observations by (SIC codes between 4900 and 4999 and those between 6000 and 6999) as well as firms with total sales
year and firm-type less than $20 million

The discretionary component of TA is believed to represent the degree of earnings

management. A model is needed to separate the discretionary component from TA.
Dechow et al. (2003) provide a good modified version of Jones model according to whom,
this model:
.
has far greater explanatory power than the cross-section modified Jones model;
.
identifies discretionary accruals that are less persistent than other components
of earnings;
.
identifies discretionary accruals that detect earnings manipulation identified in
SEC enforcement actions; and
.
identifies discretionary accruals associated with lower future earnings and lower
future stock returns.
This model is the following:
TA a b1 DSales 2 1 2 kDREC b2 PPE b3 LagTA b4 GR_Sales 1
where (DSales 2 (1 2 k) DREC) is the difference between the change in total sales
(DSales: the change in total sales from the previous year to the current year) and
expected change in accounts receivable (DREC is the difference in accounts receivable
from the start to the end of the year). This expected change is determined via the slope
coefficient (k) from this regression:
DREC a kDSales 1
k captures the expected change in accounts receivable for a given change in sales.
We call this the non-discretionary portion of credit sales.
PPE is the end of the year property, plant and equipment, LagTA is the predictable
proportion of accruals based on last years accruals and GR_Sales is future sales growth,
measured as the change in sales from one year to the next scaled down by current sales.
All variables are scaled down by beginning total assets. All our models are
estimated yearly for each two-digit SIC. We require at least ten observations in each
SIC-year grouping.
 The residual value from this model is the estimate of discretionary accruals Earnings
(DISCACC). management
Measurement of firm characteristics
We cannot examine the differences in earnings management between diversified and
focussed firms regardless of other factors influencing earnings management and
correlated with the type of adopted strategy, diversification or specialization. 183
We identified four factors distinguishing diversified firms from focussed firms.
The first is information asymmetry and agency conflicts. Information asymmetry is
approximated by market-to-book (MB) ratio. This ratio depends on the extent to which the
firms return on existing assets and expected future investments exceeds its required rate
of return on equity. We argue that the larger the MB ratio is, the larger the information
asymmetry between the market and the firm gets. A justification for this measure is
provided by McLaughlin et al. (1998). Agency conflicts are measured by free cash-flows
(FCF), approximated by the ratio [the operating income before depreciation 2 the
interest expense 2 the total taxes 2 dividends]/total asset. Doukas and Pantzalis (2003)
used these two measures to test the impact of agency conflicts on capital structure of
diversified firms.
The second is operating risk (RISK). As Kim and Pantzalis (2003), operating risk is
measured as the standard deviation of the ratio of net income before extra-ordinary
items to sales over the previous seven years. We also integrate the volatility of
operating cash-flows, approximated by the standard deviation of the ratio of operating
cash-flows to total asset over the previous seven years. The operating cash-flows
volatility (OCFV) is often used as a proxy for business risk.
The third is investment. First, we control for capital expenses measured by the ratio
capital expenses deflated by total assets (CAPEXP). Second, we integrate research
and development expenses (RD), approximated by the ratio research and development
expenses deflated by total sales.
The fourth is the firm size and debt ratio. The size is measured by logarithm of
total asset (LNASSET). The debt ratio is measured by total debt to total asset (End).

Hypotheses development and methodology

Hypothesis development
Our study examines whether mean accruals of diversified firms are different from
those of focussed firms. So, we test the following hypothesis:
H1. Differences in earnings management exist between the diversified and
focussed firms.
Under this hypothesis, the mean accruals will not be the same across the two types of
firms. More specifically, we expect to find high (low) discretionary accruals in diversified
firms compared to focussed firms, if the agency conflicts hypothesis is confirmed
(the earnings volatility hypothesis is confirmed).

Econometric approach
Our empirical methodology consists of four stages aimed at checking the above
hypothesis.
RAF In the first stage, we compare discretionary accruals of each diversified firm in our
sample with that of a portfolio of stand-alone firms that approximates the diversified
10,2 firms segments along various dimensions. For each segment-year[2], we try to identify
the focussed firms that trade on the same exchange as the diversified firm, have the same
two-digit SIC code (if such a match is not found at the two-digit level, we choose
matching firms at the one-digit level), and have sales between 0.5 and 1.5 times the sales
184 of the diversified firm. Then, we compare the discretionary accruals and the
characteristics of diversified and focussed firms.
The second stage aims at detecting the role of geographic diversification in the
amplification or the attenuation of earnings management. In order to be considered
internationally diversified, firms must have more than 10 per cent of their total sales
outside their home country (requirement of SFAS No. 14).
We use a combination of business segment and geographic region data to get four
groups of firms. Means comparison tests are also carried out between the four-formed
groups about their degree of earnings management and the variables approximating
their characteristics (Table II).
In the third stage, to study the relation between earnings management and firm
diversification, we run the following cross-sectional regression:
absDISCACCi DIVERSIFICATION VARIABLES : FD; FM; DD; DMi
MBi FCFi OCFVi RISKi CAPEXPi
RDi LNASSETi ENDi 1i
where:
abs (DISCACC) the absolute value of the discretionary accruals.
FD is equal to 1 if the firm is focussed and domestic, 0 otherwise.
FM is equal to 1 if the firm is focussed and multinational, 0 otherwise.
DD is equal to 1 if the firm is diversified and domestic, 0 otherwise.
DM is equal to 1 if the firm is diversified and multinational, 0 otherwise.
In the fourth stage, because the multiple-segment firms in our sample differ from the
single-segment firms not only in terms of the number of reported segments but also
along several other dimensions, we identify the sources of earnings management
differences. We run the following cross-sectional regression:

Focussed firms (6,593) Diversified firms (3,295)

Domestic Multinational Domestic Multinational

Number of firms 2,317 4,276 1,320 1,975

Table II. Notes: Focussed firms are firms having only one reportable business segment whereas, diversified
Matrix of ranking firms are firms having more than one reportable business segment; focussed and diversified firms
diversified and focussed are classified into domestic and multinational firms; multinational firms are firms having more than
firms into domestic vs 10 per cent of their total sales outside their home country (requirement of SFAS No. 14); we use a
multinational firms combination of business segment and geographic region data to get four groups of firms
 DISCACCDIFFi NISDIFFi NGSDIFFi MBDIFFi FCFDIFFi OCFVDIFFi Earnings
RISKDIFFi CAPEXPDIFFi RDDIFFi LNASSETDIFFi management
ENDDIFFi 1i

NISDIFF: number of industrial segments of the diversified firm compared to the average
number of industrial segments of the firms in the matching portfolio, NGSDIFF: is number
of geographic segments of the diversified firm compared to the average number of 185
geographic segments of the focussed firms in the matching portfolios, FCFDIFF: is the
difference between the free cash-flows of the diversified firm and the average free
cash-flows of the focussed firms in the matching portfolio, MBDIFF: is the market-to-book
ratio of the diversified firm compared to the average market to book value of the focussed
firms in the matching portfolio, OCFVDIFF: is the operating cash-flows volatility of the
diversified firm to the average cash-flows volatility of the focussed firms in the matching
portfolios, RISKDIFF: is the risk of the diversified firm compared to the average risk of the
focussed firms in the matching portfolios, CAPEXPDIFF: is the capital expenses of the
diversified firm compared to the average of the focussed firms in the matching portfolios,
RDDIFF: is the research and development expenses of the diversified firm compared to the
average research and development expenses of the focussed firms in the matching
portfolios, LNASSDIFF: is the size of the diversified firm compared to the average size of
the focussed firms in the matching portfolios, ENDDIFF: is the debt ratio of the diversified
firm compared to the average debt ratio of the focussed firms in the matching portfolios.

Empirical results
Four stages results are followed to examine our hypothesis.

Descriptive statistics and mean difference tests

Table III displays the descriptive statistics (mean and SD) of total accruals,
discretionary accruals and firm characteristics by group of firms.
The mean of total accruals for the multi-segment firms is 0.0346 while the mean for
single segment firms is 0.0289. The difference is statistically significant. The results
also show that the discretionary accruals for diversified firms are 0.0194 whereas for
focussed firms they are 0.0167. The difference is also statistically significant.
Therefore, the evidence reveals that discretionary accruals in diversified firms are
higher than the discretionary accruals in focussed firms. This result confirms the
agency conflicts hypothesis. It is also interesting to note that both diversified and
focussed firms tend to adopt income-increasing strategies.
Among our results, we find that the mean of operating cash-flows volatility for the
diversified firms are significantly higher than those for the matching single-segment
firms. Cash-flows volatility is often used as a proxy for business risk and it may result in
more noise, and thus, higher stock price variability. This result is in contrast to the
portfolio theory suggesting that earnings is inversely affected by the degree of a firms
diversification because a diversified firms earnings from its different operational units
is less than perfectly correlated with each other. Most important to the understanding of
the diversification discount puzzle is that, according to the finding by Lamont and
Polk (2001), the diversification discount puzzle is entirely a cash-flow phenomenon.
This finding can be justified by the conclusion of Lamont and Polk (2002). These authors
state that diversified firms may be riskier than their matching-focussed counterparts
RAF
Focussed firms Diversified firms Means differences
10,2 Mean SD Mean SD Z Wilcoxon Asymp sig

TA 0.0289 0.2276 0.0346 0.2187 7.179 0.000

DISCACC 0.0167 0.2859 0.0194 0.2923 10.964 0.000
MB 2.046 4.2561 3.2312 5.2941 20.847 0.000
186 FCF 0.0092 0.0587 0.0103 0.0654 2 1.849 0.061
OCFV 0.0105 0.0784 0.0127 0.0694 2 3.387 0.001
RISK 0.0214 0.1045 0.0301 0.1245 1.156 0.260
CAPEXP 0.0961 0.1326 0.1131 0.1258 2 12.032 0.000
RD 0.0526 0.0954 0.0751 0.1031 2 3.101 0.002
NSG 1.6476 1.2791 1.1304 1.3630 2.066 0.042
LNASSET 0.0703 0.2617 0.0881 0.2722 11.897 0.000
END 0.2312 0.3251 0.2106 0.2951 2 2.843 0.004
Notes: This table provides descriptive statistics (mean and SD) by group of firms (focussed firms and
diversified firms) and the results of the means differences tests (Z-Wilcoxon tests); TA, total accruals
are defined as net income before extraordinary items less operating cash flows; DISCACC,
Table III. discretionary accruals are the residual value from Dechow et al. (2003) model; MB: market-to-book
Descriptive statistics of ratio; FCF, free cash-flows; OCFV, operating cash-flows volatility; cash from operations deflated by
variables and means total assets; RISK, operating risk is measured as the standard deviation of the ratio of net income
comparisons tests before extra-ordinary items to sales over the previous seven years; CAPEXP, capital expenses
between diversified and measured by capital expenses deflated by total assets; RD, research and development expenses,
focussed firms (matching approximated by research and development expenses deflated by total sales; NSG, number of
portfolios) geographic segments; LNASSET, logarithm of total asset; END, ratio of debt to total asset

in that when they engage in cross-subsidization, diversified firms tend to take on

excessively risky projects with high discount rates. High discount rates, like the wastage
of cash flows, lead to value destruction. If diversified firms overly subsidize bad
segments and underinvest in good segments (Shin and Stulz, 1998), they would be riskier
than their counterparts. However, for our measure of operating risk, we do not find
statistically significant differences between diversified and focussed firms. This result is
confirmed by the findings of Comment and Jarrell (1995) and others arguing that
diversified and focussed firms have equal risk exposures.
We also find that information asymmetry problems and free cash-flows are higher in
diversified firms than in focussed firms. Indeed, diversified firms are generally larger,
have more complex organizational structures and have fewer transparent operations.
In addition, they are likely to exhibit agency conflicts and information asymmetry
problems, which also facilitate the numbers game. This information asymmetry seems
to facilitate aggressive accounting practices and can justify the reporting of
aggressively positive discretionary accruals.
Our results show statistically significant differences between diversified and
focussed firms in their investments. This finding is not surprising because diversified
firms are real asset-portfolio managers and thereby they often undertake many
investments.
Our results also reveal that focussed firms are more geographically diversified than
multiple segments firms. The difference is statistically significant. This finding implies
that cultural diversity problems can be greater in focussed firms.
Finally, it is evident to find that diversified firms are bigger than focussed firms
because they operate in many industries. Moreover, we note that they have smaller
debt ratio than focussed firms. We can interpret this finding by the excessive cost of Earnings
debt of these diversified firms.
To summarize the findings reported in this section, we find that diversified firms have
management
higher discretionary accruals than focussed firms. We also note statistically significant
dissimilarities in their characteristics (operating cash-flows volatility, investments,
information asymmetry). So, we can think that differences in earnings management are
largely due to the differences in these characteristics between the two types of firms. 187
The impact of geographic diversification
It is worth interesting to control the impact of geographic diversification on earnings
management because some studies identified a complementarity between industrial and
geographic diversification (Davies et al., 2001). Table IV provides the means of total
accruals, discretionary accruals and firm characteristics for four groups: focussed and
domestic firms, focussed and multinational firms, diversified and domestic firms and
diversified and multinational firms as well as means differences between the four groups.
Our results show an income-decreasing earnings management in domestic firms
regardless of whether they operate only in one or more business segments. This
aggressive earnings management, approximated by discretionary accruals, is more
intense in diversified firms. Moreover, some dissimilarity have been detected between
domestic and focussed versus domestic and diversified firms. First, the domestic and
focussed firms seem to perform better, based on operating cash-flows volatility. Second,
these firms have high information asymmetry and an important operating risk.
However, domestic and diversified firms are characterized by significant investments.
For multinational firms, regardless of whether they operate only in one or more
business segments, we find income-increasing accruals. This earnings management is
more intense in diversified firms than in focussed firms. It seems that this aggressive
manipulation is motivated by high operating cash-flows volatility, high information
asymmetry, an amplified operating risk and important investments.
Means comparisons tests indicate statistically significant differences between the
four groups in their degree of earnings management. We also find statistically
significant differences in firm characteristics which, in turn, explain the differences in
earnings management between the four groups.
The results of Table VI reveal that a group of diversified firms or focussed firms
cannot be considered as homogeneous because it is necessary to take geographic
diversification into account.

Impact of diversification on earnings management

Table V reports the results of our multivariate regressions using absolute values of the
discretionary accruals as the dependent variable[3].Model 1 includes a dummy variable:
FD (equal to 1 if the firm is focussed and domestic, 0 otherwise) and control variables.
Model 2 includes a dummy variable FM (equal to 1 if the firm is focussed and
multinational, 0 otherwise). Model 3 includes dummy variable DD (equal to 1 if the
firm is diversified and domestic, 0 otherwise). Model 4 includes dummy variable DM (equal
to 1 if the firm is diversified and multinational, 0 otherwise). Finally, in model 5,
three dummy variables are included that distinguish among single-segment multinational
(FM), multi-segment domestic (DD) and multi-segment multinational (DM).
In model 1, our results show that the coefficient for the FD dummy variable is negative
but not statistically significant. This finding does not imply that specialization decreases
 10,2

188
RAF

regions
Table IV.

sorted by business
between groups of firms
Means comparisons tests

segments and geographic

Focussed Focussed Diversified Diversified
and and and and
domestic multinational domestic multinational
(I) (II) (III) (IV) I-II I-III I-IV II-III II-IV III-IV

TA 2 0.04032 0.0351 20.0201 0.0297 5.235 (0.000) 7.258 (0.000) 3.452 (0.001) 10.00 (0.000) 20.182 (0.851) 21.324 (0.163)
DISCACC 2 0.0108 0.0302 20.0206 0.0452 2.461 (0.014) 22.955 (0.003) 2.886 (0.004) 6.032 (0.000) 21.707 (0.088) 22.136 (0.033)
MB 4.2351 2.0143 2.8741 3.5478 3.084 (0.002) 2.436 (0.015) 22.520 (0.012) 0.155 (0.877) 0.789 (0.625) 1.467 (0.142)
FCF 0.0314 0.0167 0.0207 0.0254 20.111 (0.912) 3.984 (0.000) 2.799 (0.005) 1.335 (0.182) 3.886 (0.000) 4.607 (0.000)
OCFV 0.0081 0.0123 0.0236 0.0197 4.987 (0.000) 1.929 (0.054) 3.577 (0.000) 2.269 (0.023) 10.584 (0.000) 20.099 (0.921)
RISK 0.0309 0.0382 0.0210 0.0452 5.448 (0.000) 214.290 (0.000) 2.841 (0.004) 6.025 (0.000) 24.293 (0.000) 8.266 (0.000)
CAPEXP 0.1234 0.0874 0.1675 0.1025 26.459 (0.000) 24.526 (0.000) 24.461 (0.000) 2 7.213 (0.000) 25.776 (0.000) 1.278 (0.201)
RD 0.0432 0.0325 0.0952 0.0873 0.827 (0.408) 1.983 (0.047) 0.053 (0.958) 0.550 (0.583) 1.389 (0.165) 21.834 (0.067)
LNASSET 0.0671 0.0841 0.0721 0.1025 28.959 (0.000) 5.156 (0.000) 54.069 (0.000) 2.893 (0.004) 25.542 (0.000) 0.011 (0.991)
END 0.2514 0.2376 0.2043 0.1984 2.602 (0.009) 2.655 (0.008) 6.936 (0.000) 6.714 (0.000) 0.805 (0.421) 8.2345 (0.000)
Notes: This table provides the means of total accruals, discretionary accruals and firm characteristics for four groups: (I) focussed and domestic firms
(II) focussed and multinational firms (III) diversified and domestic firms and (IV) diversified and multinational firms as well as the results of means
comparisons tests; where: TA, total accruals are defined as net income before extraordinary items less operating cash flows; DISCACCi, discretionary
accruals are the residual value from Dechow et al. (2003) model; MB, market-to-book ratio; FCF, free cash-flows; OCFV, operating cash-flows volatility;
cash from operations deflated by total assets; RISK, operating risk is measured as the standard deviation of the ratio of net income before extra-ordinary
items to sales over the previous seven years; CAPEXP, capital expenses measured by capital expenses deflated by total assets; RD, research and
development expenses, approximated by research and development expenses deflated by total sales; LNASSET, logarithm of total asset; END, ratio of
debt to total asset
 Model 1 Model 2 Model 3 Model 4 Model 5
Coefficient t-statistic Coefficient t-Statistic Coefficient t-Statistic Coefficient t-Statistic Coefficient t-statistic

FD 20.0443 21.2450 (0.213) 2 0.0502

FM 0.0816 3.6048 (0.000) 0.0905 3.905 (0.000)
DD 20.0662 219.7257 (0.000) 2 0.0775 2 18.10 (0.000)
DM 0.0871 13.394 (0.000) 0.0905 14.201 (0.000)
MB 0.0004 0.0889 (0.929) 0.0664 8.2847 (0.000) 0.106 1.356 (0.17) 0.0156 7.1635 (0.000) 0.0183 7.223 (0.000)
FCF 0.0126 0.3714 (0.710) 0.0120 23.844 (0.000) 20.054 20.625 (0.53) 0.0314 15.270 (0.000) 0.0209 13.101 (0.000)
OCFV 0.000 0.251 (0.802) 0.004 1.430 (0.150) 0.0539 2.2936 (0.023) 0.075 1.116 (0.26) 0.059 1.560 (0.110)
RISK 0.0678 9.5974 (0.000) 2 0.001 20.031 (0.970) 0.431 1.480 (0.14) 0.046 1.100 (0.270) 0.0501 1.147 (0.251)
CAPEXP 0.0009 1.255 (0.210) 0.0468 13.403 (0.000) 0.0006 0.359 (0.71) 0.0033 2.2419 (0.025) 0.0101 3.501 (0.000)
RD 0.553 1.576 (0.110) 0.6679 22.775 (0.000) 0.084 0.659 (0.51) 0.0154 3.2258 (0.001) 0.0202 3.909 (0.000)
LNASSET 20.196 2 1.146 (0.250) 0.001 1.565 (0.110) 20.124 20.147 (0.880) 0.002 0.029 (0.971) 0.00203 0.370 (0.711)
END 0.0270 4.2639 (0.000) 2 0.0008 21.183 (0.230) 0.036 0.917 (0.36) 0.0005 0.313 (0.750) 0.004 1.24 (0.213)
R2 0.471 0.561 0.482 0.607 0.621
Notes: This table provides results from regressing of the absolute value of the discretionary accruals on the diversification dummies and controls; that is:

absDISCACCi DIVERSIFICATION VARIABLES : FD; FM; DD; DMi MBi FCFi OCFVi RISKi CAPEXPi RDi
LNASSETi ENDi 1i

where:
abs (DISCACC) the absolute value of the discretionary accruals; FD, if the firm is focussed and domestic, 0 otherwise; FM, if the firm is focussed and
multinational, 0 otherwise; DD, if the firm is diversified and domestic, 0 otherwise; DM, if the firm is diversified and multinational, 0 otherwise; MB,
market-to-book ratio; FCF, free cash-flows; OCFV, operating cash-flows volatility (cash from operations deflated by total assets); RISK, operating risk is
measured as the standard deviation of the ratio of net income before extra-ordinary items to sales over the previous seven years; CAPEXP, capital
expenses measured by capital expenses deflated by total assets; RD, research and development expenses, approximated by research and development
expenses deflated by total sales; LNASSET, logarithm of total asset; END, ratio of debt to total asset; the values in parentheses are p-values

on the diversification
management
Earnings

discretionary accruals

dummies and controls

absolute value of the
Regressions of the
Table V.
189
RAF earnings management. However, in model 2, we find that the coefficient for the FM dummy
10,2 variable is positive and significant at the 1 per cent level, suggesting that geographic
diversification increases earnings management. For the domestic and diversified firms, the
coefficient of DD dummy variable is negative and significant indicating that industrial
diversification decreases earnings management. This result is consistent with Jiraporn et al.
(2008) and confirms the earnings volatility hypothesis. Nevertheless, we denote that the
190 coefficient of DM dummy variable is statistically and significantly positive consistent
with higher level of both industrial and geographic diversification being associated with
larger earnings management. This finding confirms the agency conflicts hypothesis.
Finally, in model 5, the single-segment multinational dummy and the multi-segment
domestic dummy remain significant. In addition, the coefficient of DM dummy variable
is also positive and significant suggesting that a combination of industrial and
geographic diversifications increases earnings management by 9.05 per cent.
To sum up, multivariate regressions reveal that industrial diversification can
mitigate earnings management. This finding supports the earnings volatility
hypothesis which shows that diversification is associated with lower firm risk due
to the existence of multiple lines of business with imperfectly correlated returns
(Amihud and Lev, 1981). Nevertheless, geographic diversification can accentuate this
phenomenon. Indeed, geographically diverse operations can reduce firm value if the
managers and shareholders interests are not aligned. As Bodnar et al. (1999) observe,
global firms are more complex than domestic firms. This increases the cost of
coordinating activities of different parts of the firm. In addition, delegating resources
and authority to geographically diverse locations can increase agency costs (managers
making decisions that reduce firm value) making monitoring more difficult and costly.
Moreover, foreign operations can exacerbate information asymmetry because, relative
to managers in the home country, local managers have more specific knowledge about
the future cash flows associated with invested assets. Moreover, geographic and
industrial diversification combined can amplify earnings management.
In models 2, 4 and 5, we find that agency conflict, information asymmetry and
investments problems have a positive impact on earnings management. These findings
are evident because first, agency conflicts and information asymmetry are the
fundamental conditions of earnings management. It is also noteworthy that the agency
conflicts are approximated by the free cash-flows ratio and that low-growth firms with
high free cash flows will use income-increasing discretionary accruals to offset the low or
negative earnings that inevitably accompany investments with negative net present
values (Chung et al., 2005). Second, research development expenses can be exploited by
managers to improve financial reporting (Aboody and Lev, 1998; Oswald, 2008). These
expenses can be used as a proxy for the extent of information asymmetry in the firm which
is considered as a necessary condition of earnings management. Third, corporate
investments are likely to provide further favourable conditions for earnings management
through discretionary accruals.
In model 3, operating cash-flows volatility only have a significant positive impact
on discretionary accruals. Management was motivated to reduce cash flow variability
in an attempt to reduce firms perceived risk because smoothed cash are viewed
favourably by the markets, and firms with smoother cash-flows series are perceived as
being less risky.
 For control variables, we denote that debt ratio and operating risk have a positive and Earnings
significant impact on earnings management in Model 1. Indeed, managers have an management
incentive to present future debt holders with low variance income streams, thus
lowering the required return of the debt holders and thereby the firms long-term cost of
capital (Trueman and Titman, 1988). Also, the managers are motivated to reduce
earnings variability in an attempt to reduce firms perceived risk. This belief is based on
casual observations on the one hand, but also on the method of estimating the risk. The 191
variance of the profit is a measure of the risk associated with this profit. So if, for a given
total amount of profit, the managers diminish the variance, they will modify the
perception of the risk associated with it that the market will have.

Earnings management and firm characteristics

As pointed out earlier, multiple-segment firms in our sample differ from single-segment
firms not only in terms of the number of reported segments but also along several other
dimensions. Thus, to better identify the sources of earnings management differences, we
run cross-section regressions of difference in earnings management against differences
in firm characteristics of diversified firms and the matching firms used for comparisons.
The regression results provide an indication of the influence of firm diversification on
earnings management after controlling the differences between diversified and focussed
firms. We regress firm level averages of earnings management against averages of firm
characteristics. The independent variables in these regressions include differences in
operating performance, operating risk, culture, investments, information asymmetry,
foreign assets and foreign sales. We choose this specification rather than simple pooled
cross-section, time series regressions because the firm-level observations are clearly not
independent across time. The results of this regression are provided in Table VI.
We note that most of the independent variables are statistically significant. This
implies that they explain the dissimilarities between firms in their degree of earnings
management. Therefore, the more there are differences between firms in operating cash
flows volatility, number of industrial and geographic segments, information asymmetry,
free cash-flows, and investments, the more there will be dissimilarity between them in
earnings management. Yet, we do not find that operating risk, size and debt ratio explain
differences in earnings management between diversified and focussed firms.
These findings confirm largely the results outlined previously by the descriptive
statistics. They indicate that the origins of the differences in earnings management
between diversified and focussed firms are to be found essentially in the dissimilarities
in their respective characteristics. Thus, the results of the regression confirm the
results of the non-parametric means comparison tests.

Conclusion
Our objective in this paper is three-fold. The first is to verify whether there is a
difference in earnings management between diversified firm and a portfolio of
matching single-segment firms. The second is to test whether corporate diversification
influences earnings management by making an explicit distinction between industrial
and geographic diversification. The third is to determine whether the earnings
management difference, approximated by discretionary accruals, between diversified
and focussed firms can be explained by differences in agency conflicts, risk,
investments, size and debt.
RAF
Variables Coefficient t-statistic Prob. (t-statistic)
10,2
Intercept 20.1533 26.2816 0.000
NISDIFF 0.0048 19.9471 0.000
NGSDIFF 0.0165 15.2996 0.000
MBDIFF 0.1658 3.5359 0.000
192 FCFDIFF 0.1438 9.3142 0.000
OCFVDIFF 0.3699 18.7253 0.000
RISKDIFF 0.0008 0.7504 0.454
CAPEXPDIFF 0.4378 4.2825 0.000
RDDIFF 0.4033 4.3379 0.000
LNASSETDIFF 0.0051 0.1053 0.916
ENDDIFF 20.0048 20.9308 0.353
R2 0.507 Adjusted R 2 0.471
Notes: This table provides results from regressing of difference in discretionary accruals against
differences in firms characteristics between diversified firms and the matching firms used for
comparisons; that is:

DISCACCDIFFi NISDIFFi NGSDIFFi MBDIFFi FCFDIFFi OCFVDIFFi RISKDIFFi

CAPEXPDIFFi RDDIFFi LNASSETDIFFi ENDDIFFi 1i

where:
DISCACCDIFF, the difference between discretionary accruals of the diversified firm and the average
discretionary accruals of the focussed firms in the matching portfolio; NISDIFF, number of industrial
segments of the diversified firm compared to the average number of industrial segments of the firms in
the matching portfolio; NGSDIFF, is number of geographic segments of the diversified firm compared
to the average number of geographic segments of the focussed firms in the matching portfolios;
FCFDIFF, is the difference between the free cash-flows of the diversified firm and the average free
cash-flows of the focussed firms in the matching portfolio; MBDIFF, is the market-to-book ratio of the
diversified firm compared to the average market to book value of the focussed firms in the matching
portfolio; OCFVDIFF, is the operating cash-flows volatility of the diversified firm to the average cash-
Table VI. flows volatility of the focussed firms in the matching portfolios; RISKDIFF, is the risk of the
Regression of diversified firm compared to the average risk of the focussed firms in the matching portfolios;
discretionary accruals CAPEXPDIFF, is the capital expenses of the diversified firm compared to the average of the focussed
difference on differences firms in the matching portfolios; RDDIFF, is the research and development expenses of the diversified
of characteristics of firm compared to the average research and development expenses of the focussed firms in the
diversified firms and matching portfolios; LNASSDIFF, is the size of the diversified firm compared to the average size of the
matching portfolios focussed firms in the matching portfolios; ENDDIFF, is the debt ratio of the diversified firm compared
of focussed firms to the average debt ratio of the focussed firms in the matching portfolios

First, we find an income-increasing earnings management both for diversified and

focussed firms with a statistically significant difference. This earnings management is
more intense in diversified firms than in focussed firms. Second, when we integrate the
geographic diversification dimension in our study, we find other trends of earnings
management. Thus, when firms are domestic, independently of diversification, there is
evidence of an income-decreasing earnings management. However, when firms are
multinational, regardless of their industry belongingness, an income-increasing
earnings management is detected. Third, we find that industrial diversification can
mitigate earnings management consistent with earnings volatility hypothesis. However,
geographic diversification can accentuate this phenomenon, and geographic and
industrial diversification combined can amplify earnings management consistent with
agency conflicts hypothesis. Finally, to further identify the sources of the earnings Earnings
management differences, we run cross-section regressions of differences in earnings management
management against differences in firm characteristics between diversified firms
and their matching firms. The regression results provide ample support for the output
of the non-parametric means comparison tests. Earnings management differences
between diversified and focussed firms are largely due to their dissimilarities in agency
problems, risk and investments. 193
The implications of our results for the literature dealing with the diversification
discount, corporate strategy, and earnings management are both interesting and quite
straightforward. First, with regard to the diversification discount and the market
pricing of diversified firms, we found that in general, reported performance decreases
with diversification. This phenomenon may be explained by investment misallocation,
increased cultural diversity and its related coordination difficulties. Indeed, various
factors born in diversification seem to have a negative impact on corporate profitability
and need to be measured and taken into account in pricing diversified firms and in
evaluating a diversification strategy.
Second, with regard to the earnings management literature, the assessment of the
extent of earnings management in diversified firms cannot be correctly achieved without
taking into consideration the impact of diversification on earnings management. Such an
assessment is likely to be further complicated by discretionary segment reporting.

Notes
1. Others studies have used those databases such as Luo (2009).
2. For some segments, sales represent less than 1 per cent of total sales and so we have not
identified a portfolio of comparable single-segment firms.
3. We do not find outliers to be particularly problematic in our dataset.

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About the authors

Imen Khanchel El Mehdi is Assistant Professor of Finance in the Higher Institute of
Technological Studies in Communications of Tunis, Tunisia. She received her PhD degree from
Higher Institute of Management of Tunis, University of Tunis. Her primary research interests
include corporate governance, social responsibility, financial reporting, corporate diversification,
and earnings management. She has published papers in academic journals including Corporate
Governance: An International Review, Managerial Auditing Journal and Journal of International
Financial Management and Accounting. Imen Khanchel El Mehdi is the corresponding author
and can be contacted at: im_khanchel@yahoo.fr
Souad Seboui is Assistant Professor of Finance in the Higher School of Economic and
Commercial Sciences of Tunis, Tunisia. She received her PhD degree from the Higher Institute of
Management of Tunis, University of Tunis. Her primary research interests include earnings
management, corporate diversification, financial reporting, and corporate governance.
She published articles on accounting and finance in such journals as Corporate Governance:
The International Journal of Business in Society and Journal of Asset Management.

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