{'fraction_non_alphanumeric': 0.027657492190746872, 'fraction_numerical': 0.013245565818932579, 'mean_word_length': 4.880331099724083, 'pattern_counts': {'":': 0, '<': 0, '<?xml version=': 0, '>': 0, 'https://': 0, 'lorem ipsum': 0, 'www.': 0, 'xml': 0}, 'pii_count': 0, 'substrings_counts': 0, 'word_list_counts': {'cursed_substrings.json': 1, 'profanity_word_list.json': 0, 'sexual_word_list.json': 0, 'zh_pornsignals.json': 0}}
Where do firms manage earnings?

Despite decades of research on how, why, and when companies manage earnings, there is a paucity of evidence about the geographic location of earnings management within multinational firms. In this study, we examine where companies manage earnings using a sample of 2,067 U.S. multinational firms from 1994 to 2009. We predict and find that firms with extensive foreign operations in weak rule of law countries have more foreign earnings management than companies with subsidiaries in locations where the rule of law is strong. We also find some evidence that profitable firms with extensive tax haven subsidiaries manage earnings more than other firms and that the earnings management is concentrated in foreign income. Apart from these results, we find that most earnings management takes place in domestic income, not foreign income.


Introduction
The study of earnings management dates back to at least Healy (1985). 1 In subsequent decades, researchers have conducted hundreds of studies of earnings management. Among other things, these studies have provided insights into when firms manage earnings, what types of accounts they manage, why they manage earnings, and how they manage earnings. 2 Surprisingly, however, there is a paucity of evidence about where firms manage earnings. Does earnings management generally take place in a firm's foreign operations, far from headquarters and perhaps the scrutiny of auditors, or does it happen closer to home? This study provides initial evidence on the location of earnings management.
Prior research has examined whether the location of a firm's headquarters or location of incorporation is associated with measures of earnings management (for example, Leuz et al. 2003). In these studies, the broad research question is whether the institutions, customs, laws, and accounting standards in the firm's parent location affect financial reporting. In our study, we take the next step to investigate this broad question, but we go inside the firm to examine whether the institutions and laws, including tax laws, in the locations of the firm's subsidiaries (proxied by the World Bank 'rule of law' and tax haven status), are associated with differences in earnings management in reported financial statements of the entire consolidated company. Thus, the question is whether the institutional features of the subsidiaries affect financial reporting, despite the firm as a whole being subject to U.S. Generally Accepted Accounting Principles (GAAP) and Securities and Exchange Commission (SEC) regulations.
We examine a sample of U.S.-based multinational firms from the years 1994 to 2009, constituting 11,077 firm-years. Our study focuses on multinational firms; we exclude purely domestic firms to avoid the trivial result that domestic firms by definition manage only domestic earnings. An important aspect of our sample is that GAAP and the regulatory environment is presumptively held constant at the firm level, in the sense that a U.S. listed firm is subject to U.S. GAAP and U.S. securities laws across its entire operations, whether domestic or foreign. Our first set of tests examines whether companies with a higher concentration of material subsidiaries (disclosed in Exhibit 21 of the 10-K) in low rule of law locations or tax havens have more discretionary accruals. Our second set of tests investigates whether earnings management occurs in foreign earnings or in domestic earnings by examining the mapping of foreign and domestic earnings into discretionary accruals. We also test the frequency of earnings restatements across the partitions of firms as an alternative measure of earnings management.
We report three main findings. First, the data show that overall earnings are managed less when the firm has a high concentration of subsidiaries in foreign countries with a strong rule of law. This differential in earnings management for firms with subsidiaries in high rule of law countries is more pronounced in foreign income, consistent with the earnings management occurring in the foreign jurisdiction. Again, we are not comparing earnings management of foreign firms to U.S. firms-all the firms in the sample are U.S. domiciled and subject to U.S. laws and accounting standards. Thus, despite the firm being subject to U.S. GAAP and SEC rules, the data are consistent with the geographic location of a U.S. firm's foreign subsidiaries being associated with significant differences in earnings management.
Second, we find that profitable firms with extensive tax haven subsidiaries engage in more earnings management, which is also concentrated in foreign earnings. This is not simply a manifestation of tax havens reducing the tax expense; we measure earnings management before taxes. Rather, we posit that tax havens are more desirable locations for earnings management because there is little or no local tax cost as a result of managing pre-tax income (and likely no U.S. tax cost because cash repatriations are not affected). For example, Erickson et al. (2004) find that firms engaging in fraudulent accounting incur actual tax costs when inflating their accounting earnings. They conjecture that firms can minimize the tax cost of such activities by locating them in a tax haven. In addition, Desai and Dharmapala (2006) observe that the same types of activities and structures that facilitate tax avoidance via tax havens can be used to facilitate managerial misappropriation. Our predictions are based on implications from these prior papers-earnings management can generate tax costs that can be avoided in tax havens, and the structures employed in tax haven subsidiaries provide obfuscation that aids earnings management activities.
Finally, apart from the above results, earnings management appears to be more prevalent in domestic income than in foreign income. This is not a simple result of domestic operations being larger in scale than foreign operations; on average, foreign and domestic operations are of the same order of magnitude for the firms in our sample.
We conduct a number of additional tests to examine the robustness of the results, including examining the absolute value of discretionary accruals, controlling for performance differences across firms, using different measures of rule of law and tax haven status, and using restatements as the indication of earnings management instead of discretionary accruals. Across these tests, the results are generally consistent and in line with our main findings. One exception is that when examining restatements we do not find evidence that firms operating in tax havens are more likely to restate their financial statements. The evidence on rule of law continues to hold in the restatement sample as it did in the discretionary accruals tests, that is, firms with proportionately more subsidiaries in low rule of law countries restate earnings more often.
We contribute to the literature by examining a new aspect of earnings management-the role of the geographic footprint of a U.S. multinational's subsidiaries. Specifically, we show that the previously documented effect that rule of law has on earnings management is actually much more pervasive. Not only does the rule of law in the parent company's jurisdiction matter, but so does the rule of law in the jurisdictions of the firm's subsidiaries. In addition, we show that subsidiary structures involving tax havens are associated with higher discretionary accruals for profitable firms. Finally, policymakers will find the results of this study interesting, particularly to the extent they have expressed concern about auditing and accounting in the foreign operations of U.S. multinationals and as they consider U.S. policies toward tax haven nations.
The paper proceeds as follows. In the next section, we review the prior literature with particular attention to research that provides a basis for our predictions about the geographical incidence of earnings management. In Sect. 3, we develop our hypotheses. In Sect. 4, we discuss our sample, variable measurement, and empirical tests. In Sect. 5, we present our results, and in Sect. 6, we conclude.
2 Background and prior literature

The regulation of multinational companies
Our inquiry focuses on U.S. multinationals and the management of earnings within the firm, that is, where do multinationals manage earnings. Because our sample consists entirely of U.S. SEC registrants, all the companies are required to apply U.S. GAAP to their financial statements regardless of where the underlying operations are located. 3 In our sample, the top-level regulatory environment is held constant across our firms. What varies, however, are the local legal and regulatory environments of the countries in which foreign subsidiaries are located.
The ability of the U.S. to effectively exert regulatory control over the accounting in the foreign operations of U.S. multinationals has been a longstanding issue. For example, the Foreign Corrupt Practices Act (FCPA) of 1977 aims to prevent U.S. companies and their agents from bribing foreign officials. The FCPA also contains important accounting provisions that require U.S. registrants to maintain a system of internal controls that provide reasonable assurance that, among other things, the transactions are properly recorded to permit preparation of financial statements in conformity with GAAP (Golden et al. 2006). In addition, the SEC enforcement manual states that it may be more difficult to obtain evidence to bring a case forward with respect to activities in certain foreign jurisdictions (SEC 2011).
Two examples in which the SEC did become aware of and bring action against firms for earnings management in their foreign subsidiaries are as follows. The SEC, in Accounting and Auditing Enforcement Release (AAER) No. 2727, accuses Bristow Group Inc., a Delaware corporation with headquarters in Houston, Texas, of improprieties at a foreign subsidiary. Specifically, Bristow's wholly owned U.S. subsidiary, AirLog International, Ltd., through its Nigerian affiliate, Pan African Airlines Nigeria Ltd. (PAAN) made improper payments totaling approximately $423,000 to employees of the governments of two Nigerian states. These improper payments, however, were not properly recorded in AirLog's books and were never included in Bristow's consolidated statements. Bristow's internal controls failed to detect and prevent the improper payments. In another example, the SEC concluded that a Japanese subsidiary of Boston Scientific recorded false sales and materially overstated its earnings for several years in the 1990s, which then caused material misstatements in Boston Scientifics' consolidated financial statements (AAER 1295).
The Public Company Accounting Oversight Board (PCAOB) has also expressed concern with quality control in audits across borders. The then-acting chairman, Daniel L. Goelzer, in a recent speech stated the following concerns: (1) U.S. engagement partners sometimes do not have a sufficient basis on which to assess whether the non-U.S. audit personnel are qualified and familiar with U.S. GAAP, PCAOB standards, and SEC requirements; (2) internal inspection information about foreign-affiliate firms and personnel are sometimes not made available to the audit engagement partners and, at times, engagement partners fail to even ask for it; (3) audit firms may not have minimum levels of training for U.S. GAAP, PCAOB standards, or SEC requirements for foreign-affiliate personnel; and (4) U.S. engagement teams sometimes fail to appropriately evaluate the results of a foreign affiliate's work or fail to adequately supervise and control the affiliate's work. 4 Thus, while subsidiaries need to report their earnings following U.S. GAAP, the local institutions will vary across subsidiaries and the knowledge of U.S. GAAP and securities laws may vary across personnel at the companies and at the audit firms.
In sum, there is concern by accounting regulators about foreign operations of U.S. multinationals and there exist examples of earnings management in both domestic and foreign operations. What is lacking is large sample evidence about the geographic location of earnings management within firms and the factors that drive the location. There is, however, prior research that informs our thinking of how the geographic incidence of earnings management within the firm might play out, and we turn to this research in the next section.

Prior literature
There is little prior research on where, within a multinational company, earnings are managed. Leuz et al. (2003), in an influential paper, examine earnings management around the world in a sample of over 8,000 firms from 31 countries and provide evidence of the importance of institutional features on accounting. For example, they provide evidence that earnings management is more likely to occur at companies that are located in countries where investor protection is weaker, reasoning that such protection prevents the extraction of private benefits by insiders and thus reduces the incentives to obfuscate information. However, they do not examine earnings management within the firm. In other words, they compare a U.S. domiciled company with a firm domiciled in Singapore, for example, but they do not compare the domestic earnings of a U.S. multinational with the foreign earnings of that same multinational company. Like Leuz et al. (2003), we are interested in the effect of rule of law on earnings management, but our focus is on whether the rule of law at the subsidiary level matters, holding constant the parent rule of law. Thus, our entire sample is U.S.-based multinationals, and all of the earnings are subject to U.S. securities laws and regulations and are reported under U.S. GAAP. We examine whether variation in the local rule of law applying to the foreign subsidiaries affects earnings management. Kedia and Rajgopal (2011) examine the geography of financial misreporting, but their study is focused on the location of corporate headquarters relative to an SEC office. If corporate headquarters is in a county far from an SEC office and the local auditor office in the county is lax, companies in that county report a higher incidence of earnings decreasing restatements. Dyreng et al. (2010), Grullon et al. (2010), andMcGuire et al. (2012) examine the effect of social norms on earnings management. These studies generally find that firms located in counties with high levels of religious adherence are less likely to engage in earnings management. While related and interesting, these papers examine differences in earnings management across firms and do not look at the location of the earnings management within the firm.
Other papers do examine foreign earnings relative to U.S. earnings of U.S. multinational corporations, but these papers do not examine the extent of manipulation of those earnings. More importantly, the studies do not investigate the effect of institutional features in the location of the earnings on earnings properties. These papers are primarily concerned with the relative market valuation of the earnings. For example, Bodnar and Weintrop (1997) examine the relation between returns and domestic and foreign incomes and report that foreign earnings have a greater association with returns, consistent with the foreign earnings being related to growth opportunities reflected in returns. Another example is Thomas (1999), who, in a Mishkin (1983) framework, examines whether foreign earnings have different persistence than domestic earnings and whether trading profits can be earned via trading on the knowledge of such a difference. Thomas reports that foreign earnings have greater persistence than domestic earnings but that the market underestimates the persistence of foreign earnings, leading to predictable future returns. Hope et al. (2008) extend Thomas (1999) and report evidence consistent with investor mispricing of foreign earnings decreasing after the adoption of SFAS 131 Disclosures about Segments on Enterprise and Related Information. While these papers consider foreign versus domestic earnings, their focus is on mispricing, not where multinationals undertake earnings management.
Perhaps most closely related to our paper are three working papers : Durnev, et al. (2011), Beuselinck et al. (2010), and Fan (2008. Durnev et al. (2011) examine governance at offshore financial centers and the effects on earnings management. The authors classify companies incorporated in an offshore financial center and U.S. domiciled firms that have affiliates in offshore financial centers both as ''offshore firms,'' to which they compare other U.S. firms without offshore affiliates. The authors report evidence consistent with offshore firms engaging in more earnings management than non-offshore firms. They further document that companies with a higher Offshore Attitude Index, intended to measure the firm's institutional and legal environment, manage earnings more with accruals than with real earnings management. Beuselinck et al. (2010) examine earnings management in European subsidiaries of EU-based multinational corporations. The authors find that earnings management is higher at the subsidiary level when the subsidiary-country institutional quality is weak. They also document evidence consistent with the governance characteristics of the multinational company parent affecting the magnitude of subsidiary earnings management over and above subsidiary-specific characteristics. The authors conclude that the parent-level characteristics have contagion effects for their subsidiary-level financial reporting quality.
Finally, Fan (2008) examines whether earnings management is evident in foreign earnings of U.S. multinationals and whether the earnings management pattern changed after the adoption of SFAS 131. Fan uses the Burgstahler and Dichev (1997) discontinuity in the distribution of earnings levels and earnings changes as the measure of earnings management. Fan reports evidence consistent with foreign earnings being managed to avoid a loss but not to avoid an earnings decrease. She also reports that domestic earnings are not managed to avoid a loss. She does not find a significant difference, on average, between the pre-and post-SFAS 131 periods in loss avoidance behavior.
In sum, a few studies have addressed aspects of our research question. However, the evidence, even when pieced together, is inconclusive. For example, Thomas (1999) documents that foreign earnings are more persistent than domestic earnings, while Fan (2008) documents that foreign earnings are used more often than domestic earnings to avoid a loss for U.S. multinationals. Neither of these studies examines the institutional forces at work in the various locations (for example, in a tax haven or not, or in a location with a strong rule of law or not). In contrast, Leuz et al. (2003) focus on the institutional forces but do not study earnings management within a multinational firm. Rather, they study the earnings quality of firms located in different countries operating under different standards, legal environments, and governance/shareholder protection regimes. Durnev et al. (2011) focus exclusively on offshore financial centers, combining multinational firms with affiliates in these centers with firms domiciled in these centers. Despite the advances made in understanding earnings management, it is not known whether U.S. multinational firms have more earnings management in domestic earnings, foreign earnings, or both, and whether such earnings management is affected by the local institutional regimes in which its foreign subsidiaries operate. 5 5 There are other important papers that are somewhat related to our research but less directly. For example, Duru and Reeb (2002) report evidence that analysts have lower forecast accuracy when firms have greater international diversification. Looking across firms-thus, more similar in spirit to Leuz et al. (2003), Pincus et al. (2007) document the occurrence of the accrual anomaly in foreign countries, and DeFond et al. (2007) provide evidence that earnings announcements are more informative in countries with strong investor protections. In addition, there are other papers beyond Erickson et al. (2004) that study the relation between taxes and earnings management. For example, Badertscher et al. (2009) (discussed below), Frank et al. (2009), andRego (2003). Frank et al. (2009) find a positive relation between aggressive tax reporting and aggressive financial reporting, and Rego (2003) finds economies of scale in tax planning, such that multinational firms are better able to avoid tax. We do not study tax planning in our paper.
Where do firms manage earnings? 655

Hypothesis development
Earnings management can occur at the direction of central management or via the conduct of a division or subsidiary manager. 6 In our setting, the predictions are the same in either case. For example, if central managers decide to engage in earnings management, they must decide whether to manage domestic income, foreign income, or both. Managers are expected to consider the expected costs of earnings management, including the likelihood of being challenged or discovered. In addition, managers will consider the potential benefits of earnings management such as higher compensation (Healy 1985) or avoiding the violation of a debt covenant (DeFond and Jiambalvo 1994;Sweeney 1994;Dichev and Skinner 2002), for example. The expected likelihood of being caught may be lower for domestic earnings management, if directing earnings management in the foreign jurisdiction would involve more people or would involve people who do not work closely with top management. In other words, to the extent that top management wants to limit the number of people involved and keep the misreporting close to the parent company, earnings management will occur in domestic income. However, it is possible that foreign income will be managed more in order to avoid getting caught. For example, if the Kedia and Rajgopal (2011) result-that firms farther from SEC offices manage earnings more than firms close to SEC offices-can be generalized to U.S. subsidiaries relative to foreign subsidiaries, then more earnings management will take place in foreign jurisdictions. Because there are reasons for earnings management to be located either more or less in foreign earnings than domestic earnings, we make no directional prediction with regard to the overall geographic location of earnings management. Our first directional prediction (Hypothesis 1) focuses on the rule of law in the foreign countries where the firm's subsidiaries are located. We predict that the local legal systems of the firm's subsidiaries affect the firm's propensity to engage in earnings management, such that having subsidiaries in weak rule of law countries will be associated with more earnings management. The effect of local institutions on accounting quality has been shown in prior literature, as discussed above (for example, Leuz et al. 2003). Earnings management in foreign operations may be less likely to be challenged, and, if so, the consequences are likely to be less stringent when there is a weak rule of law. Audits of foreign operations are typically performed by foreign affiliates of the auditor or, in some cases, by an unrelated foreign audit firm. If those audits are lacking the rigor of the audit of the U.S. operations, as suggested is often the case by the PCAOB chair as discussed above, then the managers might face less chance of being challenged if they manage 6 In an analysis of fraudulent financial reporting over the period 1998-2007, the Committee of Sponsoring Organizations of the Treadway Commission (COSO) states: ''The SEC named the CEO and/ or CFO for some level of involvement in 89 % of the fraud cases, up from 83 % of cases in 1987-1997. Within 2 years of the completion of the SEC's investigation, about 20 % of CEOs/CFOs had been indicted and over 60 % of those indicted were convicted'' (Beasley et al. 2010). Thus, many cases of financial manipulation name central managers as the guilty party. However, some cases are done by ''rogue'' managers, as the two SEC AAER cases in Sect. 2 indicate. Top management at Boston Scientific and Bristow did not appear to be, and were not accused of being, involved in the fraud. foreign income, particularly if the rigor of the local audit is affected by the local rule of law. The effect of local rule of law on earnings management, if any, is interesting when examining the earnings of subsidiaries of U.S. multinationals because the earnings of subsidiaries are required to be reported under U.S. GAAP and U.S. securities laws. The U.S. is considered to have a strong rule of law, which ideally should act as a constraint on earnings management in both domestic and foreign operations, in which case weaker constraints based on local law would not matter.
Our second directional prediction (Hypothesis 2) focuses on the role of tax havens in earnings management. We predict that having subsidiaries in tax havens is associated with more earnings management. This prediction comes in part from Erickson et al. (2004), which examines whether firms engaging in accounting fraud pay taxes on the fraudulent earnings. Erickson et al. (2004: p. 391) do not study where firms manage the earnings, or whether the taxes are foreign or domestic, but the authors conjecture that ''the firm might overstate the income of a foreign subsidiary located in a low-tax country.'' Managing earnings in a tax haven avoids cash tax payments as well as the accounting income tax expense in most cases. 7 In a follow-up study to Erickson et al. (2004), Badertscher et al. (2009) examine restatement firms and characteristics of restatement firms that manage earnings using methods where book income conforms to taxable income or using methods that are unconfirmed. One of the premises in that study is that nonconforming earnings management is less costly than conforming earnings management because there is no tax cost if the item managed is not conformed between book and taxable incomes. In our study, we look within a firm and hypothesize another way managers can avoid paying tax on the income managed-by managing the earnings in a lowtax jurisdiction (that is, a tax haven). 8 Thus, our study complements Badertscher et al. (2009) because we both hypothesize that earnings management is more likely when tax costs are lowest.
Another reason we expect to see more earnings management for firms with tax haven subsidiaries comes from Desai et al. (2007) and Desai and Dharmapala (2006). Those studies posit that the same structures and activities conducive to tax avoidance (that is, complex structures and secrecy) are also conducive to private diversion of the firm's resources by managers. Indeed, the authors argue that the primary intent of many tax shelters is to increase accounting earnings. Furthermore, in a report by the Joint Committee of Taxation (JCT) prepared for the Senate Finance Committee, the JCT noted that Enron created many entities in jurisdictions that did not impose taxes on such entities (for example, tax havens). In particular, as of December 31, 2001, the Enron ownership structure included 441 entities formed in the Cayman Islands, a country that has never imposed a corporate income tax. These entities were used for transactions that increased reported earnings (for example, LJM Cayman) but did not generate additional taxes.
Of note is that our hypothesized prediction for tax havens is most applicable to profitable, tax-paying firms. Our prediction is that tax havens allow earnings management in a tax free manner, which implies that taxes are costly for the firm. As a result, in the tests that follow, we estimate our regressions over the full sample and separately over a subsample of profitable firms (that is, positive pre-tax domestic and foreign earnings).
In addition, we recognize that haven locations could be used by the corporations in our study for tax planning purposes. The income and accruals measures that we examine in our tests are pre-tax and thus are not affected by reductions in tax expense as a result of any tax planning via tax havens (or otherwise). For example, the earnings management that we observe in our measures is not simply a manifestation of transfer pricing for tax purposes. Such tax-motivated income management involving tax havens typically involves shifting income across jurisdictions (for example, U.S. to foreign) within the current year. While this can increase pre-tax foreign income and decrease pre-tax domestic income, it will not affect total consolidated pre-tax earnings. In contrast, accounting-motivated earnings management involves shifting income over time (for example, accruals that increase current year income and decrease next year's income or real transactions accelerated into the current period). 9 4 Variables, sample, and descriptive statistics

Variables
We examine two measures of discretionary accruals in our analyses, and later in the paper we examine restatements as well. The first is signed pre-tax discretionary accruals, PTDACC. The second is the absolute value of pre-tax discretionary accruals |PTDACC|. The absolute value of discretionary accruals is useful as a dependent variable to capture both income-increasing and income-decreasing earnings management when there is reason to expect both types of earnings management in a sample. 10 Note that data on foreign operations is extremely limited from public sources, especially following the implementation of SFAS 131, and thus direct tests of earnings management in specific foreign locations are difficult (Berger and Hann 2003). We employ company-wide measures of discretionary accruals and conduct an array of cross-sectional tests using the rule of law and tax haven location to investigate our research question.
We measure discretionary accruals according to the modified Jones model, before taxes (Jones 1991;Dechow et al. 1995). We expect tax haven usage to facilitate the management of pre-tax accounting income, because the earnings management will be tax free. Thus, we exclude discretionary accruals that may arise from managing tax expense. Specifically, we start with pre-tax accruals, PTACC, defined as pre-tax income (PI), less pre-tax cash flow, which is cash flow from operations (CFO), plus cash tax paid, less cash from extraordinary items and discontinued operations: Then, PTDACC (pre-tax discretionary accruals) is the estimated residual ( it ) from the following model (estimated by 2-digit SIC and year): where DSALES is the change in sales from the prior year to the current year; DAR is the change in accounts receivable from the prior year to the current year; and PPE is gross property, plant, and equipment at the end of the year. The explanatory variables of most interest are RULE OF LAW and HAVEN INTENSITY. RULE OF LAW is measured as the average rule of law of countries in which the firm discloses subsidiaries in Exhibit 21 of Form 10-K. The rule of law scores at the country-year level are from the World Bank Governance Indicators dataset. Thus, in our data RULE OF LAW is a firm-year measure based on the combination of subsidiaries the firm has and the local rule of law applying to those subsidiaries. RULE OF LAW will be high when the firm's material subsidiaries are predominantly located in countries with a strong rule of law. RULE OF LAW captures perceptions of the extent to which agents have confidence in and abide by the rules of society and, in particular, the quality of contract enforcement, property rights, the police, and the courts, as well as the likelihood of crime and violence. 11 We predict that, despite our sample firms being subject to U.S. GAAP and U.S. securities laws on their worldwide earnings, the local legal systems of their subsidiaries will affect their propensity to manage earnings, such that more earnings management happens when the subsidiaries are located in countries with weak rule of law.
HAVEN INTENSITY is measured as the number of subsidiaries located in tax haven countries, divided by the total number of subsidiaries. Data on subsidiaries are from Exhibit 21 of the Form 10-K, where firms are required to list their material subsidiaries. Tax havens are identified as countries that are on at least two of the four commonly used tax haven lists. 12 While there is not an official definition of a tax haven, the Organization for Economic Cooperation and Development (OECD) lists criteria to being labeled a tax haven, including (1) imposing no or only nominal taxes, (2) a lack of transparency, (3) laws or administrative practices that prevent the effective exchange of information for tax purposes with other governments on taxpayers benefiting from the no or nominal taxation, and (4) an absence of a requirement that the business activity be substantial. 13 We expect a positive relation between HAVEN INTENSITY and the magnitude of discretionary accruals.
We include variables to control for the general complexity of the firm, the scope of its foreign operations, and the macroeconomic conditions of the countries in which it has subsidiaries. We measure the extent to which the firm has special purpose entities, SPE INTENSITY, as the number of limited liability companies, limited partnerships, and trusts divided by the total number of subsidiaries on Exhibit 21. Prior research has used this approach to identify special purpose entities and shown that their use is associated with an increased propensity to disclose material weaknesses (Doyle et al. 2007). 14 We include two measures of the scope of foreign operations. The first, FOREIGNNESS, is foreign sales divided by total sales of the entire company. The second is the natural log of the number of countries in which the company has material subsidiaries, NCOUNTRIES. We include a measure of firm size, defined as the natural log of the firm's assets, SIZE. We also include variables that reflect time-varying macroeconomic characteristics of the countries in which the firm operates. The first, CPI CHANGE SUB COUNTRIES, reflects the average of the change in the consumer price index of the countries in which the firm operates. The second, GDP CHANGE SUB COUNTRIES, reflects the average of the change in gross domestic product of the countries in which the firm operates. These two variables are gathered from the World Economic Outlook Database, April 2010 edition, available from the International Monetary Fund.
We also include two variables to reflect the operating volatility of the firm. Hribar and Nichols (2007) suggest including these variables when using the absolute value of discretionary accruals as a dependent variable. We include the variables in our signed accruals tests as well for ease of comparability. SALES VOLATILITY is the rolling 5-year standard deviation of sales, from year t to t -4. CASH FLOW VOLATILITY is the rolling 5-year standard deviation of cash flow from operations (from the statement of cash flows), going from t to t -4.

Sample and descriptive statistics
Our sample selection criteria are described in Table 1. We begin with all U.S. incorporated firm-years listed on Compustat during the period 1994-2009, excluding only the smallest of firms (assets less than $1 million or lagged assets less than $1 million), firms in regulated industries (SIC codes 4900-4999 and 6000-6999), and those with missing values for pre-tax income, operating cash flow, cash taxes, change in sales, change in receivables, and gross property, plant, and equipment. This gives us an initial sample of 78,448 firm-years. From these observations, we exclude firm-years that belong to industry-years with less than 10 observations. We calculate our modified measure of Jones model discretionary accruals using this slightly reduced sample of 69,819 firm-years. To investigate the incidence of earnings management in domestic and foreign income, we need companies to have foreign income. When we require firm-years to have nonmissing values for pre-tax domestic and foreign income, we obtain 32,734 firm-years. Finally, we require nonmissing data to compute the independent variables in the study. Many of the independent variables, described below, are based on data from Exhibit 21 of the 10-K, where firms are required to list their material subsidiaries. As stated above, we use these data to compute measures of tax haven intensity, rule of law, and special purpose entity intensity. After applying these screens, the main sample used in our tests has 11,077 firm-years from 2,067 firms. Table 2 presents the breakdown of the sample across the Fama-French 30 industries. 15 The sample is well spread over industries, with no industry accounting for more than 22 % of the firms. Most industries account for 1-5 % of the firms. The industry representation in our sample is similar to the composition of multinational firms listed in Compustat (where we define multinational firms to be those with nonzero pre-tax foreign income or nonzero foreign tax expense).
Descriptive statistics for the main variables (income based item are scaled by assets) in the study are presented in Table 3. Pre-tax discretionary accruals have a mean (median) of 0.003 (0.011) in the sample. 16 The absolute value of pre-tax discretionary accruals has a mean (median) of 0.064 (0.041). This is smaller than the 0.101 mean absolute value of discretionary accruals in Hribar and Nichols (2007), but this is to be expected since our sample includes only multinational firms, and Hribar and Nichols (2007) show that larger firms have smaller absolute value of discretionary accruals. As the sample consists of multinationals, foreign operations are a substantial part of the firms in the sample. The mean pre-tax domestic income is 0.026 in the sample, which is slightly smaller than the mean pre-tax foreign income of 0.028. The median firm still has more domestic income, however, with median pre-tax domestic income of 0.036 compared to median foreign pre-tax income of 0.019. RULE OF LAW has a mean (median) value of 1.065 (1.087). The raw Rule of Law measure from the World Bank is designed so that it is mean zero, with a standard deviation of one across all countries in a given year. Thus, the firms in the sample tend to have most of their subsidiaries in high rule of law countries. There is a substantial use of tax haven subsidiaries in the sample, consistent with widespread use of tax haven subsidiaries among multinational firms in general. The variable HAVEN INTENSITY has a mean (median) of 0.177 (0.146), indicating that 17.7 % of the average firm's material foreign subsidiaries are located in tax havens. Most  (2007), we find positive correlations between the absolute value of (in our case pre-tax) discretionary accruals and the volatility of cash flows and sales and a negative correlation with firm size. The number of countries in which the firm lists material subsidiaries is also negatively correlated with the absolute value of pre-tax discretionary accruals. We next turn to the multivariate tests.

Foreign subsidiaries and discretionary accruals
Our first set of analyses examine whether foreign subsidiary characteristics are associated with discretionary accruals. Three models with different combinations of explanatory variables are estimated, with the full model as follows: The results are presented in Table 5, Panel A. 17 In the first column, we present the results from estimating the regression including RULE OF LAW and control variables. In the second column, we present results from estimating the regression including HAVEN INTENSITY and control variables. The full model with all of the 17 We use robust regression to control for outliers. In the regressions, all continuous variables are mean centered at zero for ease of interpretation of the interaction effects (Aiken and West 1991). We multiply the dependent variable by 100 to facilitate interpretation of the coefficients as percentages. The standard errors in all regressions are computed after clustering observations by firm and year to mitigate the effects of cross-sectional and intra-firm correlation in the residuals (Petersen 2009). For all regressions we present one-tailed p values for t statistics where we have a prediction and two-tailed p values otherwise.     . This is consistent with the prediction that firms with subsidiaries located in strong rule of law countries manage their earnings less than firms with subsidiaries located in weak rule of law countries. Economically, a one standard deviation increase in RULE OF LAW lowers the level of discretionary accruals by about 0.33 % of beginning total assets. HAVEN INTENSITY is not significantly different from zero in Model 2 or in Model 3. A positive coefficient would be consistent with the prediction that firms with more subsidiaries located in tax havens have more earnings management, as proxied by discretionary accruals. The analysis in Panel A includes all observations regardless of whether they are profitable firms or loss firms. However, there is evidence that discretionary accruals can be asymmetric with respect to losses (Ball and Shivakumar 2006). Moreover, as stated above, our hypothesis about earnings management being concentrated in tax havens presumes that firms are profitable, tax-paying firms. Loss firms are unlikely

RULE OF LAW
Each of the variables shown in the table is defined in Table 3. The dependent variable, PTDACC it , has been multiplied by 100 to ease interpretation of the coefficients. T statistics, shown in parentheses below the coefficient estimates, are based on standard errors that are clustered by firm and year. One tailed tests of significance are used where a signed prediction has been made. ***, **, and * represent statistical significance at the 1, 5, and 10 % levels, respectively b This table presents estimates from Eq. (3): Only observations with positive domestic and foreign pre-tax incomes are included. Each of the variables shown in the table is defined in Table 3. The dependent variable, PTDACC it , has been multiplied by 100 to ease interpretation of the coefficients. T statistics, shown in parentheses below the coefficient estimates, are based on standard errors that are clustered by firm and year. One tailed tests of significance are used where a signed prediction has been made. ***, **, and * represent statistical significance at the 1, 5, and 10 % levels, respectively Where do firms manage earnings? 667 to face significant tax costs from earnings management in the first place and thus are less likely to focus their earnings management in tax havens. Accordingly, in Panel B of Table 5, we re-estimate Eq. (3) over the set of firm-years that have positive pre-tax foreign and positive pre-tax domestic income. The results in Panel B indicate that, among profitable firms, earnings management is increasing in the extent to which the firms have tax haven subsidiaries. The coefficient on HAVEN INTENSITY is positive and significant in both specifications where it is included, ranging from 0.828 in column (2) to 0.836 in column (3). Economically, a one standard deviation increase in HAVEN INTENSITY increases the average level of discretionary accruals by about 0.15 % of beginning assets. As in the broad sample of firms, RULE OF LAW is negative and significant, as predicted, in each specification where it is included, with a one standard deviation increase in RULE OF LAW translating to a decrease in discretionary accruals of about 0.5 % of beginning assets. In terms of the control variables, the results in Table 5, Panel A, and Table 5, Panel B, show a consistently positive coefficient on FOREIGNNESS, though insignificant in Panel A, and a consistently negative coefficient on SIZE. Coefficients on CASH FLOW VOLATILITY are significantly negative across all specifications. These findings are consistent with the modified Jones model better explaining accruals, and thus leaving less to be labeled discretionary, for large firms and firms with low operating volatility (Hribar and Nichols 2007). We also find consistently negative coefficients on CPI CHANGE SUB COUNTRIES, though   Fig. 1. As the figure shows, the effect of RULE OF LAW on PTDACC is greatest when moving from the first to second quintile and then continues to strengthen through the fifth quintile. The effect of HAVEN INTENSITY on PTDACC appears to be greatest when moving from the second to third quintile of HAVEN INTENSITY, and again from the fourth to fifth quintiles, with the largest effect concentrated in the quintile containing the most haven-intense firms.

Discretionary accruals on foreign and domestic pre-tax income
In Table 6 we examine the mapping of foreign and domestic pre-tax income into discretionary accruals. The idea is to examine how earnings management can be Each of the variables shown in the table is defined in Table 3. The dependent variable, PTDACC it , has been multiplied by 100 to ease interpretation of the coefficients. Each of the variables has been meancentered to facilitate interpretation of the interaction terms. T statistics, shown in parentheses below the coefficient estimates, are based on standard errors that are clustered by firm and year. One tailed tests of significance are used where a signed prediction has been made. ***, **, and * represent statistical significance at the 1, 5, and 10 % levels, respectively b This table presents estimates from Eq. (11): Only observations with positive foreign and domestic pre-tax incomes are included in the tests. Each of the variables shown in the table is defined in Table 3. The dependent variable, PTDACC it , has been multiplied by 100 to ease interpretation of the coefficients. Each of the variables has been mean-centered to facilitate interpretation of the interaction terms. T statistics, shown in parentheses below the coefficient estimates, are based on standard errors that are clustered by firm and year. One tailed tests of significance are used where a signed prediction has been made. ***, **, and * represent statistical significance at the 1, 5, and 10 % levels, respectively attributed to domestic versus foreign activity by directly including measures of such activity. Since U.S. firms are required to disclose the breakdown of their pre-tax income (PI) into pre-tax income from domestic sources (pre-tax income-domestic; PIDOM) and pre-tax income from foreign sources (pre-tax income-foreign; PIFO), those data are available for a broad sample. 18 First, we define the rate of company-wide discretionary accruals as: This ratio captures the fraction of total pre-tax income that is estimated to be discretionary accrual income. Re-arranging the terms, and letting d it represent the rate of pre-tax discretionary accruals, we obtain: In this study, we ask where earnings are managed. One way to provide evidence on this question is to test whether the discretionary accrual rate on domestic income is different from the discretionary accrual rate on foreign income. That is, we would like to know if d it is the same when pre-tax income is derived from domestic sources (PIDOM) as when it is derived from foreign sources (PIFO). To test this, we can modify Eq. (5) as follows: where a it represents the rate at which domestic pre-tax income maps into discretionary accruals, and b it represents the rate at which foreign pre-tax income maps into discretionary accruals. Empirical implementation requires dropping the subscripts i and t on the coefficients a and b and the inclusion of an error term. We also include an intercept for completeness. Thus, we estimate an OLS regression of the following form: Our first test, for which we have no directional prediction, is whether a = b, or in words, whether there is a difference between the rate at which PIDOM and PIFO map into PTDACC. We are also interested in the cross sectional determinants of a and b. In particular, we hypothesize that b is a function of the rule of law of the foreign countries in which the firm operates material subsidiaries and that b may also be a function of whether the firm operates in tax havens. We can extend Eq. (6) to facilitate these hypotheses as follows: Substituting Eqs. (8) and (9) into Eq. (6) gives the following: 18 The breakdown of pre-tax income into pre-tax domestic income and pre-tax foreign income is required by the SEC to be included in the tax footnote of firm's financial statements to correspond with the breakdown of tax expense into domestic and foreign components.
To empirically estimate Eq. (10), we also add an intercept, the variables from Eq. (3), and an error term: 19 Hypothesis 1 predicts that firms with subsidiaries in countries with a high rule of law will have less earnings management in foreign earnings. That is, Hypothesis 1 predicts that x 1 \ 0. Hypothesis 2 predicts that firms with subsidiaries in tax haven countries will have more earnings management in foreign earnings. That is, Hypothesis 2 predicts that x 2 [ 0. Table 6 presents the results of the estimations of the above equations with Panel A estimated over all firm-years and Panel B estimated over firm-years with positive pre-tax foreign and positive pre-tax domestic income. In Panel A of Table 6, Model 1 examines how discretionary accruals are explained by pre-tax domestic income and pre-tax foreign income without control variables (that is, Eq. (7) above). The coefficients on both PIDOM and PIFO are positive and significant, with values of 22.031 and 14.817, respectively. The coefficient on PIDOM is significantly greater than the coefficient on PIFO, as indicated by the test in the bottom row of the table. The interpretation is that, at the mean, a dollar of pre-tax domestic income results in approximately 22 cents of pre-tax discretionary accruals, whereas a dollar of pre-tax foreign income results in approximately 15 cents of pre-tax discretionary accruals. Dollar-for-dollar, this is consistent with domestic income being subject to more earnings management than foreign income.
We expand this in Model 2 by first adding HAVEN INTENSITY and RULE OF LAW and the control variables from Table 5 Table 6, and their presence is instead noted by a ''YES'' in the rows labeled ''CONTROLS.'' Notice that the control variables result in a large increase in explanatory power from an R 2 of approximately 21 % in Model 1 to approximately 33 % in Model 2. With the controls included, both PIDOM and PIFO remain positive and significant (29.050 and 18.428, respectively), and PIDOM continues to be significantly greater than PIFO.
In Models 3 and 4, we interact PIDOM and PIFO with RULE OF LAW and HAVEN INTENSITY. We expect the effects of rule of law to be concentrated in pretax foreign income. Accordingly, we predict a negative coefficient on the interaction of PIFO and RULE OF LAW. We also allow RULE OF LAW and HAVEN INTENSITY to interact with PIDOM for the sake of completeness, but we make no prediction on the sign for these interactions. Including these interactions allows for the possibility that firms that go to low rule of law countries or tax havens are also those that manage earnings generally, both in domestic and foreign income. Model 3 reveals that the coefficient on PIFO Ã RULE OF LAW is negative and significant, as predicted (-18.633). This is consistent with pre-tax foreign income being subject to more (less) earnings management when the firm's foreign operations are in countries with relatively weak (strong) rule of law.
To facilitate interpretation of the interaction terms, all variables have been meancentered. Thus, for the mean firm in Model 3, 18.8 cents of each foreign pre-tax dollar maps into a dollar of pre-tax discretionary accruals. A one standard deviation increase in RULE OF LAW is associated with a 9.1 cent per dollar lower rate at which pre-tax foreign income maps into discretionary accruals. 20 The coefficient on the interaction of RULE OF LAW and PIDOM is also significant, but the effect is much smaller economically. A one standard deviation increase in RULE OF LAW is associated with a three cent per dollar lower rate at which pre-tax domestic income maps into discretionary accruals.
Model 4 includes the interaction of PIDOM and PIFO with HAVEN INTENSITY. As with RULE OF LAW, we expect that the effects of HAVEN INTENSITY will be concentrated in foreign income. We make no prediction for the interaction of HAVEN INTENSITY and domestic income. In this specification, the coefficient on PIFO Ã HAVEN INTENSITY is negative but insignificant.
In Model 5 we include both RULE OF LAW and HAVEN INTENSITY. Consistent with the results in Models 1-4, the coefficient on PIFO Ã RULE OF LAW is negative and significant (-19.480) in Model 5. The coefficient on PIFO Ã HAVEN INTENSITY becomes positive and significant in Model 5 when we include all of the interactions at the same time. The main effects of both PIDOM and PIFO remain positive and significant, with values 28.950 and 18.560, respectively.
In Table 6, Panel B, we re-estimate the regressions in Panel A, except we use only the subsample of firms that have positive pre-tax domestic income and positive pre-tax foreign income. As in the Table 5 analysis, we include this test because of evidence that discretionary accruals can be asymmetric with respect to losses (Ball and Shivakumar 2006) and because our prediction for HAVEN INTENSITY is most applicable for profitable (tax-paying) firms. Model 1 examines how discretionary accruals are explained by pre-tax domestic income and pre-tax foreign income without control variables. The coefficients on both PIDOM and PIFO are positive and significant, with values of 5.517 and 4.984, respectively. In Model 2 we again include each of the control variables SPE INTENSITY, FOREIGNNESS, NCOUN-TRIES, SIZE, CPI CHANGE SUB COUNTRIES, GDP CHANGE SUB COUN-TRIES, SALES VOLATILITY, and CASH FLOW VOLATILITY interacted separately for PIDOM and PIFO. Model 2 also includes the main effect of each of these variables and the main effects of RULE OF LAW and HAVEN INTENSITY. The controls increase the explanatory power of the model and cause the coefficients on both PIDOM and PIFO to increase to 14.731 and 8.720.
Models 3 and 4 consider the effects of interacting PIDOM and PIFO with RULE OF LAW and HAVEN INTENSITY, respectively. We continue to find a negative coefficient on the interaction of PIFO with RULE OF LAW. Consistent with Model 5 in Table 6, Panel A, the coefficient on PIFO Ã HAVEN INTENSITY is positive and weakly significant as predicted in both Models 4 and 5. This indicates that, among profitable firms, earnings management of foreign income is increasing in the extent of subsidiaries in tax havens.
To graphically illustrate the effect of RULE OF LAW and HAVEN INTENSITY on the mapping of PIFO into PTDACC, we re-estimate the model but replace the continuous variables RULE OF LAW and HAVEN INTENSITY with indicator variables that capture quintiles of RULE OF LAW and HAVEN INTENSITY. The coefficient value for each of the quintiles is then plotted in Fig. 2. As the figure shows, the effect of RULE OF LAW is greatest when moving from the first to second quintile. Similarly, the effect of HAVEN INTENSITY is greatest when moving from the first to second quintile of HAVEN INTENSITY, and increasing thereafter, with the largest effect concentrated in the quintile containing the most haven-intense firms.

Absolute value of discretionary accruals
To examine the robustness of the results, we perform a number of additional tests. In this subsection, we change the dependent variable to the absolute value of discretionary accruals (|PTDACC|), to capture both income-increasing and incomedecreasing earnings management. 21 By reflecting both positive and negative accruals, the absolute value of discretionary accruals can capture activities such as the building up and drawing down of cookie jar reserves, without needing a specification of the exact periods of management. Table 7 is the analog to Panel A of Table 5 but with the absolute value of discretionary accruals as the dependent variable. As in the earlier analysis, RULE OF LAW is negatively associated with earnings management, with coefficients of -0.306 in both Model 1 and Model 3. This indicates that firms with subsidiaries in high rule of law countries engage in less earnings management than firms with subsidiaries in low rule of law countries. Unlike Table 5, Panel A, the coefficient on HAVEN INTENSITY is positive and significant, as predicted, with a value of 0.649 in Model 2 and 0.649 in Model 3. We cannot fully explain the economic drivers of a positive relation with the absolute value of discretionary accruals but no relation with signed discretionary accruals. The coefficients on the control variables are generally consistent between Tables 5, Panel A, and 7 in terms of sign and significance. The exceptions are the volatility controls. SALES VOLATILITY was insignificant in Table 5 but is positive and significant in Table 7. CASH FLOW VOLATILITY was negative in Table 5 but is positive in the Table 7 analysis of absolute value of discretionary accruals. Based on Hribar and Nichols (2007), we expect a positive coefficient on both volatility controls in Table 7, where we are explaining the absolute value of discretionary accruals. Table 8 is the analog to Panel A of Table 6 but with the absolute value of discretionary accruals as the dependent variable. The analysis examines how RULE OF LAW and HAVEN INTENSITY affect the mapping of the absolute value of foreign pre-tax income into the absolute value of discretionary accruals. Model 1 of Table 8 reveals that the coefficients on both |PIDOM| and |PIFO| are positive and significant, with values of 8.913 and 4.215, respectively. The coefficient on |PIDOM| is significantly greater than the coefficient on |PIFO|, as indicated by the bottom row of the table. Model 2 includes the control variables from Table 6. As in Table 6, the R 2 of the models increase substantially with the addition of the control variables. With the controls included, both PIDOM and PIFO remain positive and significant. In Models 3 and 4, we interact |PIDOM| and |PIFO| with RULE OF LAW, HAVEN INTENSITY, and all control variables. As indicated earlier, we expect the effects of foreign rule of law to be concentrated in pre-tax foreign income. Accordingly, we predict a negative coefficient on the interaction of |PIFO| and RULE OF LAW. Model 3 reveals that the coefficient on jPIFOj Ã RULE OF LAW is negative and significant, as predicted, at -5.872. This is consistent with pre-tax foreign income being subject to more (less) earnings management when the firm's foreign operations are in countries with relatively weak (strong) rule of law. A one standard deviation increase in RULE OF LAW is associated with a 2.9 cent per dollar lower rate at which pre-tax foreign income maps into discretionary accruals.  This table presents estimates from the following model: PTDACC it j j¼ a 0 þ a 1 RULE OF LAW it þ a 2 HAVEN INTENSITY it þ P a k CONTROL k it þ it . Each of the variables shown in the table is defined in Table 3. The dependent variable, PTDACC it j j , has been multiplied by 100 to ease interpretation of the coefficients. T statistics, shown in parentheses below the coefficient estimates, are based on standard errors that are clustered by firm and year. One tailed tests of significance are used where a signed prediction has been made. ***, **, and * represent statistical significance at the 1, 5, and 10 % levels, respectively In contrast to the effect of RULE OF LAW on management of foreign income, the coefficient on the interaction of RULE OF LAW and |PIDOM| is insignificant, consistent with the rule of law of the firm's foreign operations having little or no effect on the firm's management of domestic income.

Quintile of RULE OF LAW or HAVEN INTENSITY
Model 4 includes the interaction of |PIDOM| and |PIFO| with HAVEN INTENSITY. As predicted, the coefficient on PIFO j jÃ HAVEN INTENSITY is positive and significant (6.113), consistent with firms with extensive tax haven subsidiaries engaging in more earnings management of their foreign pre-tax income. A one standard deviation increase in HAVEN INTENSITY is associated with additional discretionary accruals of 1.1 cents per dollar of pre-tax foreign income.
In Model 5 we include all of the interactions at the same time. Consistent with the results in Models 1-4, the coefficient on jPIFOj Ã RULE OF LAW is negative and Each of the variables shown in the table is defined in Table 3. The dependent variable, PTDACC it j j , has been multiplied by 100 to ease interpretation of the coefficients. Each of the variables has been mean-centered to facilitate interpretation of the interaction terms. T statistics, shown in parentheses below the coefficient estimates, are based on standard errors that are clustered by firm and year. One tailed tests of significance are used where a signed prediction has been made. ***, **, and * represent statistical significance at the 1, 5, and 10 % levels, respectively significant (-6.715) and the coefficient on PIFO j jÃ HAVENINTENSITY is positive and significant (7.776). The main effects of both |PIDOM| and |PIFO| remain positive and significant with values 7.374 and 3.979, respectively. Thus, across the tests with the absolute value of discretionary accruals as the dependent variable, the results suggest that earnings management of foreign income is decreasing in the rule of law of the firm's foreign subsidiaries and increasing in the tax haven intensity of its foreign subsidiaries. Apart from those results, domestic income appears to be managed more than foreign income.

Additional control variables
In this subsection, we include additional control variables in the regressions specified in Eqs. (3) and (11). Specifically, in untabulated results, we include the following control variables: firm age, leverage, the market to book ratio, the market value of equity, a proxy for capital intensity, a proxy for intangible intensity, and a variable that captures the fraction of loss years over the firm's past 10 fiscal years. These variables are drawn from prior research that uses similar dependent variables (for example, Hribar and Nichols 2007;Francis et al. 2005). Results remain statistically and economically similar with the inclusion of these variables.
We also re-estimate all our tests including a control for firm-level governance, as captured by the G-Score from Gompers et al. (2003). Because the inclusion of this variable reduces our sample size by over 20 %, we do not include the variable in our main analyses. However, in untabulated results, we find the inclusion of the variable on the subsample with available data does not lead to material changes in our conclusions, with all coefficients of interest in Tables 5, 6, 7, and 8 remaining statistically significant with similar magnitudes.
In addition, in untabulated tests, we include pretax income as a control variable in Table 5, Panels A and B, and in Table 7. Inclusion of pre-tax income in these regressions slightly increases the coefficient and t statistic on RULE OF LAW and slightly decreases the coefficient and t statistics on HAVEN INTENSITY. However, the conclusions remain unchanged.
Finally, we include two variables to control for determinants of book-tax conforming earnings management. For example, per Badertscher et al. (2009) firms with high quality auditors are more likely to manage earnings in a book-tax conforming manner-the same type one would expect in a tax haven. Thus, we include an indicator variable set equal to one when the company has a non-Big N auditor. Also based on Badertscher et al. (2009), we control for net operating loss (NOL) carryforwards. The main findings stay the same with these additional controls. 22 Finally, we find that the inclusion of two-digit SIC code fixed effects does not alter our findings, which is not surprising because the dependent variable was constructed in regressions estimated by two-digit SIC code. Kothari et al. (2005) describe how performance matching can improve modified discretionary accruals models by controlling for extreme performance that makes estimation of discretionary accruals difficult. Dechow et al. (2011) present a new method of improving the modified Jones model based on researcher-predicted timing of accrual reversals. Both of these adjustments are only improvements to the model under certain conditions. For performance matching, if performance is correlated with earnings management, the power of the model is actually reduced as it throws the proverbial baby out with the bathwater. For the Dechow et al. (2011) model, the modified Jones model's ability to detect discretionary accruals is only improved if the researcher has a prediction of when the managed accruals will reverse.

Controlling for performance
We control for performance by adding return-on-assets to our discretionary accrual regression models in untabulated tests. The results are qualitatively the same for our test variables except for the coefficient on HAVEN INTENSITY in Table 5, Panel B, which becomes insignificant. We do not have predictions about when managed accruals will reverse in our setting and thus do not test for reversals in our analyses.

Alternative measures of rule of law and haven intensity
We test the robustness of our results to different definitions of our main variables. First, we replace HAVEN INTENSITY throughout the study with the natural log of the number of tax haven countries in which the firm operates and find similar results. Second, we replace RULE OF LAW throughout the study with a variable that counts the number of ''corrupt'' countries in which the firm operates and we find that firms in more corrupt countries engage in more foreign earnings management. 23 In sum, our results do not appear to be highly dependent on specific definitions of tax haven intensity or rule of law.

Clustering standard errors by industry and year
To mitigate concerns that there could be industry clustering in our data, in untabulated tests we re-estimate all results but cluster the standard errors by industry and year rather than by firm and year. We use the Fama-French 30 industry classification used in Table 2, when implementing this procedure. While this limits the sample to just 27 clusters on the industry dimension, and some standard errors become larger as might be expected, our conclusions are unchanged both qualitatively and quantitatively.

Restatements
In further robustness tests, we replace pre-tax discretionary accruals from Eq. (3) with a binary variable that equals one if the firm restated its financial statements for that year. Compared with discretionary accruals, restatements have the advantage that they are independent of the researcher, as they are not based on a researcher-generated model of accruals. However, restatements have two main disadvantages. First, restatements will not capture within-GAAP earnings management. Second, and most importantly, for a restatement to occur the GAAP violation must be discovered. Thus, the most successful earnings management may never result in a restatement, either because it was within GAAP to begin with or because it was well hidden and never discovered. Since variation in the risk of detection across foreign operations is at the heart of this paper's hypotheses (that is, firms manage earnings where they expect the likelihood of detection to be the lowest), restatements are less than ideal for this paper (Hennes et al. 2008). (The same would hold true for SEC AAERs.) Indeed, a recent study by Srinivasan et al. (2011) reports that foreign firms from countries with weak rule of law are less likely to restate earnings than those companies from strong rule of law locations, even though the companies from the weak rule of law countries have more earnings management. The authors conclude that home country enforcement affects the likelihood of firms reporting an irregularity, and thus less frequent restatements do not indicate high quality earnings, at least for their sample.
Because the dependent variable is an indicator variable, we estimate the model with logistic regression. We include a number of additional controls that have been used in prior research examining accounting restatements and fraud. 24 Restatements are gathered from the Government Accountability Office (GAO) and cover the years 1995-2005. The new data requirements (the restatement variable plus the additional controls) reduce the sample size to 6,699 firm-years, of which 269 are restatement firm-years.
In Table 9, we report results from the logistic regression. Consistent with our predictions, we find that increases in RULE OF LAW significantly reduce the likelihood of a restatement. The unconditional probability of restatement in our sample given the explanatory variables is about 4 %. A one standard deviation improvement in RULE OF LAW decreases the probability of a restatement by 0.9-3.1 %. On the other hand, we find no evidence that HAVEN INTENSITY is associated with restatements.

Propensity score matching
Current research suggests that propensity score matching can improve the reliability of results in observational studies (Armstrong et al. 2010). Accordingly, we reestimate the results in Tables 5, Panel A, 7, and 9 using a propensity score matching approach, as follows. First, we keep only those observations in the lowest quintile of RULE OF LAW or the highest two quintiles of RULE OF LAW. Firm-years that are in the lowest quintile of RULE OF LAW are assigned to the ''treatment'' group, and firm-years that are in the highest two quintiles of RULE OF LAW are assigned to the potential ''control'' group. We then fit a logistic regression predicting the treatment as a function of the control variables from Table 5. We use the predicted probability of receiving the treatment to match treatment firm-years to control firm-years, requiring matches to have predicted probabilities within 10 % of each other and come from the same industry. Once treatment and control firm-years are matched, we compare mean values for PTDACC and |PTDACC| across the two groups, and we compare the frequency of observed restatements across the two groups. 25 Results  Tables 5 and 7. Panel B shows the frequency of restatements across the two groups. In this panel, the number of observations drops because matching firms were not required to have restatement data. The panel shows that of 799 firm-years with weak RULE OF LAW, 41 were restated, while only 25 of 870 were restated in the strong RULE OF LAW group. The difference is statistically significant with a p value of 0.009. This finding is consistent with the results presented in Table 9 that firms with subsidiaries in countries with a weak rule of law are more likely to restate earnings.
In Table 11, we repeat the exercise of Table 10 but for HAVEN INTENSITY. We find no evidence that firms with greater tax haven intensity have higher mean values of PTDACC and |PTDACC|, although the differences are in the direction that we would predict when examining |PTDACC|. Likewise, we find no evidence that firms with greater tax haven intensity are more likely to restate financial statements. Again, this is consistent with the logistic regression results in Table 9. Overall, the tests suggest that having subsidiaries in weak rule of law countries is associated with more earnings management and a higher likelihood of restatement, whereas having subsidiaries in tax havens does not appear to be associated with statistically higher mean values of PTDACC and |PTDACC|, nor does it appear to be associated with the likelihood of restatement.

Conclusions
We examine the location of earnings management across domestic and foreign income for a sample of 2,067 U.S. multinational firms (11,077 firm-years) over the  years 1994-2009. We report three main findings. First, we find that, on average, domestic income tends to be managed more than foreign income. Second, we predict and find that firms with extensive foreign subsidiaries in countries with a low rule of law engage in more earnings management than other firms and that the earnings management is concentrated in foreign income. Third, we find that profitable firms with a relatively high proportion of subsidiaries in tax havens manage earnings more than other firms, as measured by discretionary accruals, and that the incremental effect is also concentrated in foreign income. Together, these results provide initial evidence about where firms manage earnings. All studies are subject to caveats, and ours is no exception. First, there is disagreement in the literature about how best to measure earnings management. We employ three measures of earnings management and obtain generally similar results. Second, some of the tests assume a linear relation between earnings and discretionary accruals, which is a simplification. Third, in an ideal experiment, we could assign firms randomly to do business in different locals, with varying levels of rule of law and taxation, and then observe how their earnings management changed with the footprint of their operations around the world. Like most researchers using archival data, we do not have the luxury of random assignment, and thus we have the limitations that come with observing data as they naturally occur, including endogeneity and self-selection concerns. We attempt to control for these issues, introducing a number of controls for both firm-specific and macro-factors, as well as conducting a propensity matching analysis. However, to the extent these controls are not sufficient, readers should interpret the results with reasonable caution.
This paper contributes to the long line of research on earnings management by providing initial evidence on where firms manage earnings, a question that is for the most part unexplored. In addition, our study is an early step in the literature focused on looking within multinational firms rather than only across firms. We look forward to further inquiries in this spirit in the future.