Telling a Tale for a Tariff
Firms involved in anti-dumping trade cases may be massaging the books
Anti-dumping duties are now the prime way by which governments grant domestic firms temporary relief from imports. Between 1995 and 2010, 4,010 anti-dumping cases were initiated internationally, two-thirds of which concluded that domestic producers were being materially injured. To win their cases, domestic firms have a strong incentive to engage in earnings management — to lower their reported profitability in the period leading up to a trade investigation. Michael Welker, professor and KPMG Faculty Fellow in Accounting at Queen’s School of Business, working with David Godsell and Ning Zhang (both of Queen’s School of Business), recently conducted a study of earnings management by firms in the European Union involved in anti-dumping trade investigations. Welker shared their preliminary findings in this conversation with QSB Insight.
When Domestic Industries Cry Foul
One of the things that got us interested in this setting was the fact that domestic industries are very successful when they seek trade relief. We read through all these case documents and were struck, from an earnings management point of view, by the consistency with which they seem to be finding that European Union industries were injured and by how accounting data were used to make that determination.
Usually, a major player in an industry, most often in manufacturing, asks for an investigation. As an example, European industry claims Chinese manufacturers are dumping aluminium wheels into the European Union and that they suffer injury as a result. The authorities typically look at four years of accounting data: they’ll compare accounting data for that industry in those years with a couple of years prior to when the dumping took place. If they see decreases in the profitability of the industry, they’ll use that to determine injury.
The process is based on World Trade Organization (WTO) guidelines and is transparent, so firms and their lawyers know that they’ll be looking at accounting data to see if profitability has gone down.
There was one study in the mid-1980s that looked at a small number of U.S firms and found some evidence of earnings management. It has never been looked at since and never in jurisdictions outside the U.S. But in that time, there have been many changes in how trade is conducted, in regulations and international accounting standards, so we didn’t think we could take that evidence and draw conclusions about other jurisdictions.
If It Looks and Smells Like Earnings Management. . .
Our model controls for the economic circumstances of the firm. We include cash flows and sales figures, and then the model identifies the unexplained portion of the accounting earnings. The model shows exactly the pattern that would maximize apparent injury. We found that earnings are managed up in the baseline period and managed down in the injury period to maximize the appearance of injury. The unexplained part of earnings in the baseline period is positive; it increases return on assets by about one percent. The unexplained portion of earnings in the injury period is negative, again by about one percent of assets. It’s big. The combined effect is that you have about two percent of apparent injury that is unexplained by the underlying economics of these firms.
There was another interesting finding. The European Union imposes tariffs based on one of two margins: either the dumping margin — how much price undercutting is there by this foreign firm — or the injury margin — how much will we have to impose tariffs to take away the injury to that industry. They take the smaller of the two. There’s good reason to believe firms can predict which margin would be the ultimate tariff. So if they know that injury will determine the tariffs, that heightens the incentives to show greater apparent injury. So we focused on those cases where the injury would determine the margins. We found that earnings management was concentrated in those cases.
Earnings management that shows greater injury gives the firm better tariffs and more help competing in that market
We’re also now looking at data from the U.S. The focus here is, Is earnings management affecting what’s happening in terms of tariffs? And the answer is yes. If you manage your earnings down in the injury period, you’re more likely to get an injury decision. Earnings management that shows greater injury gives the firm better tariffs and more help competing in that market.
There is also what’s called a sunset review. Governments will put tariffs in place for five years and at the end of that period decide whether or not to maintain the tariffs. It’s an interesting setting because what they study at that point is whether or not the tariffs are helping the firm. Suddenly, the incentives are flipped on their head, and you can guess the punch line. Whenever you want to show injury, earning are managed down, and whenever you want to show that the tariffs are helping you, earnings are managed up.
The Challenge of Playing to Two Audiences
We found variations in how private versus public firms handle earnings management around trade relief cases. Public firms have stock price pressures and analysts following them, so if they’re doing earnings management, they’ll be managing earnings up because they want to inflate their stock price. They might want to get import relief but they don’t want their stock price to take a beating if they show that they’re being injured. And that’s what we found. Earnings management was more pronounced in private firms that don’t have these other pressures.
At the same time, private companies may be going to capital markets to raise money during the period when they’re claiming injury, so it might help them on one end but hurt them on the other. We looked at the data and found, again, that if you’re raising capital, it applies a countervailing pressure on earnings management for trade relief.
How Do Governments Fit Into This Story?
When an industry makes a complaint, the government agency in that country follows a process based on WTO guidelines. The agency gathers data from other members of the industry and foreign exporters who are accused of dumping and decides whether or not there’s a case and the level of injury to the domestic industry. It only goes to the WTO if there is a complaint from other parties. But if you join the WTO, you’re saying that you will follow their guidelines.
There is quite a bit written in the trade literature about a bias in the process in favour of having tariffs because the domestic industry is organized and governments don’t want local companies going belly up and putting people out of work. If they put a tariff on wheels coming into the European Union, the consumer will pay a little more for their BMWs or Volkswagens but consumers are not organized.
The historical pattern is for developed countries to lodge complaints against developing countries. China has been the target of a lot of anti-dumping claims, but they’re starting to fight back. China and India are becoming much more active in this area; they’re saying, If you imposed tariffs on our industry, we’re going to impose tariffs on what you’re bringing into our country.
Are New Indicators Needed?
It would be useful for trade regulators to consider looking at indicators that are not provided by the allegedly injured parties. Having an awareness that firms have both the incentives and the capability to engage in earnings management would be a good start.
Regulating accounting standards to address the problem is a tough nut to crack because accounting will always have estimation. We’ll always have management input into that estimation because they know the business. So writing accounting standards that would eliminate earnings management is an impossibility. The best thing we can do is to make sure people know that accounting earnings are not fact, that they do involve estimation, and that there are moral hazard problems associated with that estimation.
— Interview by Alan Morantz