The effect of financial leverage on real and accrual-based earnings management

Past research has documented a substitution effect between real earnings management (RM) and accrual-based earnings management (AM), depending on relative costs. This study contributes to this research by examining whether levels of (and changes in) financial leverage have an impact on this empirica...

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Bibliographic Details
Published in:Accounting and business research 2017-02, Vol.47 (2), p.191-236
Main Authors: Anagnostopoulou, Seraina C., Tsekrekos, Andrianos E.
Format: Article
Language:English
Subjects:
accrual-based earnings management
Companies
Complementarity
debt
Deviation
Earnings
Earnings management
Financial leverage
Leverage
Manipulation
market performance
real earnings management
Scrutiny
Tactics
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Summary:Past research has documented a substitution effect between real earnings management (RM) and accrual-based earnings management (AM), depending on relative costs. This study contributes to this research by examining whether levels of (and changes in) financial leverage have an impact on this empirically documented trade-off. We hypothesise that in the presence of high leverage, firms that engage in earnings manipulation tactics will exhibit a preference for RM due to a lower possibility - and subsequent costs - of getting caught. We show that leverage levels and increases positively and significantly affect upward RM, with no significant effect on income-increasing AM, while our findings point towards a complementarity effect between unexpected levels of RM and AM for firms with very high leverage levels and changes. This is interpreted as an indication that high leverage could attract heavy outsider scrutiny, making it necessary for firms to use both forms of earnings management in order to achieve earnings targets. Furthermore, we document that equity investors exhibit a significantly stronger penalising reaction to AM vs. RM, indicating that leverage-induced RM is not as easily detectable by market participants as debt-induced AM, despite the fact that the former could imply deviation from optimal business practices.
ISSN:0001-4788
2159-4260
DOI:10.1080/00014788.2016.1204217