Abstract
This study examines how leverage affects real earnings management (REM) in non-financial firms listed on the Korea Composite Stock Price Index from 2010 to 2018 by employing total, short-term, and long-term debt ratios (i.e., leverage) as independent variables and four REM metrics as dependent variables. We find a significant positive relationship between leverage and REM in suspicious firms, whereas the effect of leverage is insignificant in non-suspicious firms. We also find that the positive relationship between both variables is stronger in the second half of the fiscal year, which shows the prevalence of the seasonality of REM, as managers collect high-frequency financial information during this period. These findings are consistent with those in the literature that managers increase firm leverage and REM activities to reduce their probability of being discovered, since financial statements in the interim quarters are not often audited. Our study complements the literature by introducing quarterly data to identify clearly REM activities and detect the strongest effect on the relationship between REM and leverage. Moreover, our results from the two-stage least square (2SLS) regression analysis are consistent with our previous findings.
Highlights
Earnings refer to a company’s net income or profit for a certain period, such as a fiscal quarter or year
We report the inverted sign for the variables abnormal CFO (ABN_CFO) and ABN_SG&A, given that both measures will show negative residuals when firms engage in real earnings management (REM) activities
Our findings can be generalized for firms with similar characteristics of our sample disaggregation depending on the national accounting and financial regulations, given that International Financial Reporting Standards (IFRS) adoption has improved the comparability of financial statements among firms in Korea and international firms
Summary
Earnings refer to a company’s net income or profit for a certain period, such as a fiscal quarter or year. Earnings alterations in each quarter, called “real-time” adjustments, are difficult to detect in the annual financial report, because these modifications can be reversed in subsequent quarters or might experience a trade-off between REM activities in each quarter, suggesting that REM would be underestimated or misread in annual reports, giving the leeway to managers to engage in real manipulation initiatives Given that this type of accounting analysis may be expensive to implement practically, auditors and regulators primarily review annual financial statements instead of quarterly reports. We are able to conclude that high-leverage firms are more likely to manage real earnings than low-leverage companies These findings suggest that regulators need to analyze quarterly statements as well as annuals and to be more careful of high-leverage firms in detecting window-dressing of the firm’s performance.
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