Earnings management by local firms: A dynamic model

When foreign banks establish lending relationships with local firms, their lending strategies differ from those of domestic banks, influencing local firms’ earnings management behavior. As foreign banks gain experience, information asymmetry with local firms declines, reducing firms’ incentives to manipulate earnings. While prior studies have largely examined this relationship in a static setting, this paper develops a dynamic theoretical model to explain how foreign banks’ lending experience affects local firms’ earnings management and then tests these predictions empirically. The results support the model’s predictions: foreign banks’ initial screening of large firms increases earnings management in the early phase of lending, whereas accumulated relationship and lending experience mitigate it over time. The findings highlight the dynamic interaction between bank learning and firm reporting behavior, providing new insight into how foreign bank experience shapes corporate financial transparency.