A Cross-Country Study of Legal Environment and Real Earnings Management

Abstract:     
We study how the strength of country-level legal system affects firms’ use of real activities to manage earnings. Using absolute values of abnormal discretional expense and production cost, we find that the level of real earnings management is higher in countries with stronger legal system, which is opposite to the relation prior studies have found between accrual-based earnings management and country-level legal protection. Our suspect-firm analysis, using signed proxies of real earnings management, consistently shows that strong legal environment is associated with more upward earnings management in firm-year observations that just meet two earnings benchmarks: zero and last year’s earnings. Additional tests based on discretional accruals show that strong legal environment curbs the use of accrual-based earnings management. These findings are in line with the substitution effects between the two types of earnings manipulation suggested in prior literature. Further analysis based on legal origins indicates that all of the three types of civil law origins: German, French, and Scandinavian, are associated with less real earnings management compared with common law countries. This is consistent with the finding by La Porta et al. (1998) that common law countries have stronger legal system than civil law countries.

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