The Effect of Financial Leverage on Real and Accrual-Based Earnings Management

Accounting and Business Research, Vol. 47, No. (2), pp. 191-236, 2017

Posted: 3 May 2016 Last revised: 22 Aug 2019

See all articles by Seraina C. Anagnostopoulou

Seraina C. Anagnostopoulou

University of Piraeus, Department of Banking and Financial Management

Andrianos E. Tsekrekos

Athens University of Economics and Business - Department of Accounting and Finance

Date Written: May 1, 2016

Abstract

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.

Keywords: Leverage, Debt, Real Earnings Management, Accrual-Based Earnings Management, Market Performance

JEL Classification: M40, M41

Suggested Citation

Anagnostopoulou, Seraina C. and Tsekrekos, Andrianos E., The Effect of Financial Leverage on Real and Accrual-Based Earnings Management (May 1, 2016). Accounting and Business Research, Vol. 47, No. (2), pp. 191-236, 2017. Available at SSRN: https://ssrn.com/abstract=2773292

Seraina C. Anagnostopoulou (Contact Author)

University of Piraeus, Department of Banking and Financial Management ( email )

80 Karaoli & Dimitriou Str.
Piraeus, 18534
Greece

Andrianos E. Tsekrekos

Athens University of Economics and Business - Department of Accounting and Finance ( email )

76 Patission Street
GR-104 34 Athens
Greece

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