Earnings Management by Controlling Shareholders of Private Firms Preceding Ownership Transfers: The Case of Chaebols

Under Korean tax laws, the value of an unlisted stock is measured by ‘the Alternative Valuation Method’, which is an explicit function of earnings reported over the prior three fiscal years. Few studies examine how a valuation rule for unlisted stocks would provide controlling shareholders with tax-motivated incentives to influence the managerial decisions of firms, such as the reporting of earnings. I study hand-collected data of ownership transfers conducted by the controlling shareholders of private companies associated with Chaebols to find that firms decrease their discretionary earnings during the valuation years, which is the three fiscal years preceding the year in which controlling shareholders transferred ownership to their related parties. The evidence suggests that controlling shareholders tend to use income-decreasing earnings management to reduce the personal gift tax levied on their related parties.