Does earnings management matter for firm leverage? An international analysis

ABSTRACT

This paper examines the relation between corporate information environment and capital structure decisions, and whether this association changes with cross-country institutional environments. Using earnings management as a measure of the corporate information environment, we find that firms with higher earnings management activities have greater firm leverage ratios. We further document that the effect of earnings management on leverage is more pronounced in countries with weaker institutional environments. Overall, our study adds to the strand of research on imperfect factor markets and verifies the influence of information asymmetry on debt financing choices in a cross-country setting.

KEYWORDS:

• Earnings management
• capital structure
• information asymmetry
• institutional environments

Acknowledgments

We would like to thank Fariborz Moshirian and Bohui Zhang for sharing their data. We also thank the participants at the 30^th Australasian Finance and Banking Conference (2017), and the 2017 Vietnam International Conference in Finance, for very fruitful comments and suggestions.

Disclosure statement

No potential conflict of interest was reported by the authors.

Notes

1. Given the pecking order theory, firms’ managers are assumed to know more about the firms’ value than external investors. Firms would use internal financing first in order to increase firm value and maximize the shareholder value. However, firms with high information asymmetry expand their level of debt financing, which can lead to the potential for financial default risk (Graham and Leary 2011). Chang, Dasgupta, and Hilary (2006) and Bharath, Pasquariello, and Wu (2009) find that firms with a better information environment issue more equity, while information problematic firms employ more debt to seek external financing.

2. Leuz, Nanda, and Wysocki (2003) find evidence that firm managers and insiders do not disclose true information regarding firm performance, suggesting that earnings management is negatively related with outside investor rights.

3. Kothari, Lewellen, and Warner (2006) investigate the stock market’s reaction to earnings news and observe that prices neither underreact nor overreact to aggregate earnings news. He and Hu (2014) find that stock returns following earnings announcements are less positive in countries with more transparent financial disclosure that helps investors accurately forecast earnings.

4. For instance, see Rajan and Zingales (1995), La Porta et al. (1997), (1998)), Demirguc-Kunt and Maksimovic (1998, 1999), Booth et al. (2001), Giannetti (2003), Djankov et al. (2008), Bae and Goyal (2009), Fan, Titman, and Twite (2012), Gao and Zhu (2015), An, Li., and Yu (2016), and Dang et al. (2017).

5. In a similar vein, Healy and Palepu (2001) find that weak institutional environments increase firm-level information asymmetry and conflicts between firms and investors, which can lead to higher leverage and, therefore, disturb the functioning and importance of capital markets.

6. The construction of the related variables is detailed in the Appendix.

7. Bharath, Pasquariello, and Wu (2009) find that liquidity has a negative relation with firm leverage, while Lang, Lins, and Maffett (2012) document higher liquidity for firms with a better information environment. Consequently, to ensure that our results are not driven by this omitted variable, we include an additional control variable for liquidity in our models.

8. We also re-estimate the regression models substituting the Tobin’s Q ratio for the book-to-market (BM) control variable, and we find that the negative relationship between the earnings management proxies and firm leverage ratios remain, although the coefficients on the ESmooth and ECorrelation variables lose their statistical significance in the book leverage regression models. This is likely explained by different information asymmetry and financing implications for growth opportunities relative to assets-in-place, as suggested by Wu and Wang (2005). Addressing these differing results is beyond the scope of the current paper, however, it should be noted that Tobin’s Q (M/B) ratios have commonly been used as a determinant of leverage in the literature (for instance, Fama and French 2002; Wu and Yeung 2012). We thank the anonymous reviewer for suggesting this estimation change.

Additional information

Funding

This research is funded by Vietnam National Foundation for Science and Technology Development (NAFOSTED) under grant number 502.02-2018.10 NAFOSTED [502.02-2018.10].