This is not the document you are looking for? Use the search form below to find more!

Report home > World & Business

The effect of leverage increases on real earnings management

1.00 (1 votes)
Document Description
Main subject of this paper is to understand whether there could be an incentive for managers to manipulate cash flow from operating activities (CFO) through the use of real earnings management (REM), in situations with increasing leverage. Based upon a study of Jelinek (2007) who researched the correlation between increasing levels of leverage and accrual earnings management, I developed my main hypothesis with respect to the effect of leverage increases on REM to influence CFO. Results indicate that in leverage increasing firms, the leverage results in REM, in order to affect CFO, when using the absolute value of long term debt in calculating leverage.
File Details
  • Added: March, 14th 2010
  • Reads: 6244
  • Downloads: 503
  • File size: 178.65kb
  • Pages: 18
  • Tags: effect of leverage, real earnings management, manager
  • content preview
Submitter
  • Username: shinta
  • Name: shinta
  • Documents: 4332
Embed Code:

Add New Comment




Related Documents

The Effect of Firm Size on Earnings Management

by: shinta, 32 pages

This study examines the effect of firm size on corporate earnings management. Documented is empirical evidence that both large- and small-sized firms manage earnings to avoid reporting ...

The Effect of Leverage on Financial Markets

by: shinta, 8 pages

When people get excited about their prospects on the stock market, they borrow money from the bank to invest. This leverage effectively couples the bank to the stock market. Thus, interest

The Effect of Information Quality on Liquidity Risk

by: shinta, 59 pages

The relation between information quality and cost of capital is of significant academic interest and many explanations (e.g., estimation risk, market risk, liquidity) have been posited ...

The Effect of Excessive Crying on the Development of Emotion ...

by: wick, 20 pages

The goal of this study was to examine the effect of excessive crying in early infancy on the development of emotion self-regulation. Cry diaries were used to categorize excessive criers and typical ...

A Meta-Analysis of the Effect of Common Currencies on International Trade

by: shinta, 25 pages

Thirty-four recent studies have investigated the effect of currency union on trade, resulting in 754 point estimates of this effect. This paper uses meta-analysis to combine, explain, and ...

The Effect of Air Pockets on the Efficiency of Disinfection of Respiratory Equipment by Pasteurization

by: shinta, 5 pages

Many potential users of pasteurization equipment have questions about the effect of air pockets on the efficiency of disinfection of respiratory equipment by pasteurization. In this ...

The Effect of Brewing Temperature on Coffee Concentration

by: shinta, 6 pages

This report describes an investigation of the effect of grinding time on the concentration of Starbuck’s French Roast Coffee produced in an Automatic Drip Coffee Maker. Coffee ...

The Effect of Milling Time on Ni0.5Zn0.5Fe2O4 Compositional Evolution and Particle Size Distribution

by: shinta, 5 pages

This study involved an investigation to ascertain the diffusion of NiO and ZnO into the tetrahedral and octahedral sites using mechanical alloying method. The effect of mechanical ...

The Effect of Common Currencies on International Trade: Where do we Stand?

by: shinta, 20 pages

Twenty-four recent studies have investigated the effect of currency union on trade, resulting in 443 point estimates of the effect. This paper is a quantitative attempt to summarize the ...

On the Effect of Disciplinary Variation on Transitivity: The Case ...

by: egon, 14 pages

The purpose of this study was twofold. First, an attempt was made to systematically characterize Book Reviews (BRs) as an academic written genre in terms of the elements of transitivity system. ...

Content Preview
The effect of leverage increases on real
earnings management


Irina Zagers-Mamedova11


Executive summary

Main subject of this paper is to understand whether there could be an incentive for
managers to manipulate cash flow from operating activities (CFO) through the use of real
earnings management (REM), in situations with increasing leverage. Based upon a study of
Jelinek (2007) who researched the correlation between increasing levels of leverage and
accrual earnings management, I developed my main hypothesis with respect to the effect
of leverage increases on REM to influence CFO. Results indicate that in leverage increasing
firms, the leverage results in REM, in order to affect CFO, when using the absolute value of
long term debt in calculating leverage.


1.

Introduction

1.1 Historical perspective and actuality
The focus of external users on reported earnings as a central variable for making decisions
and recent corporate scandals have caused earnings management (EM) to find itself in the
center of public attention. Much quoted in this respect is Arthur Levitt, former Chairman
of the Securities and Exchange Commission (“SEC”). In his speech of 1998, Levitt (1998)
talked about the “the numbers game” with which he attacked practices where
management abuses “big bath” restructuring charges, premature revenue recognition,
“cookie jar” reserves, and write-offs of purchased in-process research and development
(R&D) (Healy and Wahlen 1999). These practices are threatening the credibility of financial
reporting, according to Levitt. Others followed Levitt when they expressed their views
about EM. Frits Bolkestein, the former Dutch European Commissioner in charge of Internal
Market and Taxation for example, raised his concerns regarding EM in his speech of July
2002. Bolkestein (2002) said: “We must have factual, not fictional, accounting.” He also
emphasized the importance of company accounts that are true and fair and stated that
companies: “… must not distort, hide, fabricate and present, in whole or in part, a
misleading web of lies and deceit.”
Managers who want to influence accounting income can choose from a large set of
methods. Some of the methods require real transactions and some are pure accounting
decisions. In general, EM is classified into the two categories: EM achieved by fraudulent
activities and EM achieved by non-fraudulent activities. EM while staying within the

11 Irina Zagers-Mamedova completed her master at the Erasmus University in September 2008, and now resides
in Geneva, Switzerland for a period of two years. Thesis supervisor: Prof. dr. M.A. van Hoepen RA.

47

boundaries of generally accepted accounting principles (GAAP), may be accomplished
through accruals, manipulations with no cash flow effects and through real earnings
management (REM), manipulations which do have cash flow effects. In this paper EM
achieved by fraudulent activities and EM achieved by non-fraudulent activities are seen as
two different categories. So with EM I will only refer to non-fraudulent activities that stay
within the boundaries of GAAP.
A significant portion of studies on EM have focused on EM through manipulation of
accruals. However, Graham et al. (2005) find evidence that managers take real economic
actions to maintain accounting appearances, and sometimes are more likely to use real
actions than to use accruals to apply EM. It appears that managers are willing to burn
“real” cash flows for the sake of reporting desired accounting numbers. There appears to
be a constant tension between the short-term and long-term objectives of the firm.
In the current global economy, it seems that a company can only survive by joining forces
through mergers and acquisitions. Acquisition prices are often structured through capital
increases and external debt financing which often results in increasing interest charges.
Next to the focus on reported income statement earnings, analysts and investors focusing
more on cash flows rather than the income statement of a company as a result of
corporate scandals analysts have lost faith in earnings-based metrics. This is also caused by
high interest charges more and more companies seem to face, as a result increasing
financial loans and increasing interest rates. Sufficient cash flows from operating activities
are essential for these companies to remain profitable and viable in the future. Lack of
cash flows could result in bankruptcy or a Company to turn into a takeover prey. Knowing
that investors use the cash flow statement to make investment decisions, highly
motivated and intelligent management teams could be involved in REM to create ways to
influence the true picture of a company’s cash flow from operations (CFO) and receive or
maintain external debt financing.
Highly leveraged companies could favor cash flow from operations in favor of other
financial support sources primarily because many analysts believe that cash flow from
operations is a more transparent indicator of a company’s performance. The results of the
research performed by Nwaeze et al. (2005), suggest that leverage has positive and
significant effect on the role of cash flow from operations.
The importance of reliable information on CFO for investors and the (adverse) economic
consequences that manipulations of real activities might have, makes REM an interesting
subject. In this paper for leverage increasing firms, the relationship between REM and
leverage increases is researched to understand whether there could be an incentive for
managers to manipulate CFO through the use of real REM.
The remainder of this paper is organized as follows. Section 2 gives the definition of REM
and provides evidence from prior studies on the existence of REM. The third section
consists of three parts. In the first part, I develop the main hypothesis, based on this
extensive literature overview. The second part presents the design of a conceptual model
to identify REM that affects CFO, the model to analyze solvability. The sample period and
sample selection presented in the third part. The interpretations of results are presented
in section 4. Section 5, provides the analysis of results and gives the suggestions for further
research. Finally, the summary and conclusion are presented in section 6.

48

2.
Real earnings management and prior literature

Introduction
Based on recent literature a definition for REM is given. Next, an overview of relevant
literature in the field of REM is presented. Recent studies are categorized in groups and
provide strong evidence on the existing of REM and show methods on how REM can be
measured.

2.1 Real earnings management
For the purpose of the paper I define REM as a purposeful action by management of a
company to alter reported earnings in a particular direction, which is achieved by changing
the timing and/or structuring of an operation, investment and/or financial transaction
with cash flow effects and has sub-optimal business consequences.
This definition is based on definitions given by Healy and Wahlen (1999) and Zang (2007).
From the definition we learn that there should be managerial intent in order to influence
earnings by structuring transactions. This is the key to the definition of REM. The way a
firm accounts for a transaction depends on the form of the transaction. Consequently, if a
firm can design a transaction to give it a specific form, it will be able to record this
transaction in a desired way; this is what Healy and Wahlen (1999) call “structuring
transaction” (Stolowy and Breton 2004). Also there is a difficulty in parsing out which
effect is due to normal business activities and which is due to real management activities.
In this paper the focus will be on manipulation through real activities. The reason for this
is twofold. First the negative value implications of manipulating real activities are thought
to be the one of the most serious forms of earnings management (Ewert and Wagenhofer
2005; Chen et al. 2008). The second reason, is that by definition, accruals management
does not directly affect cash flows, but merely changes the timing of revenue and expense
recognition. However, REM can adversely affect cash flows both in the short in the long
term by, for example by cutting discretionary expenditures.

2.2 Prior studies
The possibility that managers manipulate real activities is discussed in the academic
literature. In general, most of the existing work focuses on R&D expenditures (Baber et al.
1991; Dechow and Sloan 1991; Bushee 1998; Cheng 2004).
Baber et al. (1991) found that relative R&D spending is significantly less when spending
jeopardizes the ability to report positive or increasing income in the current period. In
most instances, choices among accounting practices have no direct cash flow
consequences, but changes in R&D spending to satisfy current-period income objectives do
alter cash flow.
Dechow and Sloan (1991) investigate the hypothesis that chief executive officers (CEOs) in
their final years of office manage discretionary investment expenditures to improve short-
term earnings performance. The authors examine the behaviour of R&D expenditures for a
sample of firms in industries that have significant ongoing R&D activities. The results
suggest that CEOs spend less on R&D during their final years in office.
Next to Dechow and Sloan, Bushee (1998) examines firms trying to meet previous year’s
earnings and finds that they reduce R&D more if they have lower institutional ownership.

49

He found evidence that R&D reductions by firms trying to meet earnings thresholds are
potentially value-destroying and are prevented by the presence of sophisticated investors.
Also evidence exists on firms engaging in a whole range of activities in addition to just R&D
expense reduction.
Cheng (2004) provides evidence that compensation committees establish a greater positive
association between changes in R&D spending and changes in CEOs options in order to
prevent opportunistic reductions in R&D spending. He defines the horizon problem as the
CEOs that are 63 or older, and myopia as a firm facing a small earnings decline or a small
loss.
There are few studies about how managers use specific transactions, other than cutting
R&D expenditures, to influence earnings. Some of the studies focus on stock repurchases
(Hribar et al. 2006; Bens et al. 2003), examine the sales of fixed assets (Herrmann et al.
2003; Bartov 1993), sale price reductions (Jackson and Wilcox 2000), overproduction,
managing of sales, advertising, SG&A expenses and effect of REM (Roychowdhury 2006;
Gunny 2005) and trade off between accrual and REM (Zang 2007).

I briefly review the remaining studies.

Stock repurchases
Hribar et al. (2006) extend Bens et al. (2003) in several ways. They identify the conditions
under which a stock repurchase increase earnings per share (EPS) and document the
frequency of accretive (i.e., EPS increasing) repurchases. Second, they examine whether
accretive stock repurchases are disproportionately more frequent among firms whose
reported quarterly EPS would have otherwise fallen short of analysts’ forecasts. The study
provides evidence on whether stock repurchases are used to manage reported EPS. Third,
they investigate how investors price the repurchase-induced accretive component of
reported EPS when the extent of repurchase in first disclosed.
Bens, Nagar and Wong (2003) investigate the use of stock repurchases to offset earnings
per share (EPS) dilution caused by employee stock options. They report that managers of
firms increase the level of their firms’ stock repurchases in years when options-related EPS
dilution increases and when annual earnings are below the level required to sustain past
EPS growth rates. Managers partially finance these repurchasing by reducing R&D.

Sales of fixed assets
Herrmann et al. (2003) examine the usage of income from the sale of fixed assets and
marketable securities to manage earnings. They found a negative relation between income
from asset sales and management forecast error. When current reported operating income
is below (above) management's forecast of operating income, firms increase (decrease)
earnings through the sale of fixed assets and marketable securities.
Bartov (1993) examines sales of fixed assets and shows that the profit from sales of assets
is negatively correlated with earnings changes. He uses this to argue that firms facing
earnings declines boost profits through increased asset sales.



50

Sale price reductions
Jackson and Wilcox (2000) in their study, made an investigation whether managers grant
sales price reductions in the fourth quarter to accelerate customer purchases and, as a
result, avoid losses and declines in earnings and sales. Consistent with expectations, the
results of univariate and multivariate tests indicate that firm managers grant sales price
reductions in the fourth quarter to meet annual financial reporting targets.

Overproduction, managing of sales, advertising, SG&A expenses and effect of real
manipulation
Management of sales, reduction of discretionary expenses, overproduction are examined
by Roychowdhury (2006). In his study he develops the empirical methods to detect real
activities manipulation other that reduction of R&D expenses. The results suggest that
drawing inferences on earnings management by analyzing only accruals may be
inappropriate, because suspect firm-years manipulate real activities to avoid reporting
losses. Additionally, firms appear to be managing real activities to a greater extent if they
have a higher proportion of current liabilities.
Next to Roychowdhury, Gunny (2005) examines the extent to which REM affects
subsequent operating performance (as measured by both earnings and cash flow) and
whether investors anticipate the performance consequences of real management. The
results provide evidence that REM has an economically significant impact on future
performance.

Trade off between accrual and real earnings management
Zang (2007) studies whether managers use real manipulation and accrual manipulation as
substitutes in managing earnings and studies the order in which managers make these
decisions. The author follows the prior literature on REM (Roychowdhury 2006; Gunny
2005). She found that managers determine real manipulation before accrual manipulation.
Based on this result, she used an empirical model that captures the sequentially of real
and accrual manipulations to test the tradeoffs between the two.
Cohen et al. (2007) document that following the passage of SOX accrual-based earnings
management declined significantly, while REM increased significantly. Consistent with the
results of a recent survey by Graham et al. (2005), this suggests that firms switched to
managing earnings using real methods, possibly because these techniques, while more
costly, are likely to be harder to detect.
Ewert and Wagenhofer (2004) found factors that determine the intensity of the
substitution of accounting by REM and the welfare effects, such as substitution rates
between accounting and REM by manager, the real cost of earnings management, and the
precision of the market knowledge about the manager’s incentives.
The most important evidence on REM is provided by Graham et al. (2005). The authors
found strong evidence that managers take real economic actions to maintain accounting
appearances. In particular, 80% of survey participants report that they would decrease
discretionary spending on R&D, advertising, and maintenance to meet an earnings target.
More than the half (55.3%) state that they would delay starting a new project to meet an
earnings target, even if such a delay entailed a small sacrifice in value.


51

3.
Hypothesis development, research design and sample

Introduction
In this section, I present my hypotheses with respect to the effect of leverage increases on
REM and more specific on REM to influence CFO. I also discuss REM in relation to CFO. Next
the focus is on external financing and more specific on solvability or leverage. Then the
definition of solvability and relevance for REM is given. Based upon these discussions, the
hypotheses for this study are presented.

3.1 Hypothesis development

CFO
The majority of investors are now keenly aware of the concept of quality of earnings. As a
result, certain investors ignore reported earnings and use the operating activities section
of cash flow statement as a “reality check” on reliability of the revenues and expenses
reported in the income statement. The cash flow statement (CFS) is one of three
statements required for financial statements to be in accordance with US GAAP.
The definition of CFO is specified in Statement of Financial Accounting Standards (SFAS)
No. 95, Cash Flows and is defined as follows: “Operating cash flows are those that are
related to the corporation’s operating activities (i.e., those activities reflected in the
corporation’s income statement).
From the definition we learn that the CFO section reports the corporation’s ongoing cash-
generating activities that provide cash for dividend and other payments.
Prior studies provide evidence the existence of REM (Section 2). The effects on CFO had
significantly less focus of researchers. Because REM is thought to be the one of the most
serious forms of EM and is an issue that concerns the investment community, it is
important to better understand the factors that could be behind this phenomenon.
There are some studies that assume that cash flows are free from manipulation (Givoly and
Hayn 2000; Barth, Cram and Nielson 2001). However, recent academic studies indicate that
managers may engage in and benefit from managing cash flow (Melendrez et al. 2005;
Graham et al.2005).
There are indications that managers take real actions to report positive or to improve CFO
(Zhang 2006). Taking into account the importance of reliable information about CFO for
investors and the (adverse) economic consequences that manipulations of real activities
might have (Gunny 2006) the question arises whether companies are, in a certain situation,
for example, companies with relatively high or increasing debt, more likely to take real
actions with positive cash flow consequences.

Leverage
In the current global economy, as already noted in section 1, it seems that a company can
only survive by joining forces through mergers and acquisitions. Companies that have high
leverage may be at risk of bankruptcy if they are unable to make payments on their
external debt financing; they could also be unable to find new lenders in the future. So, if
a company wishes to take out a new loan, lenders will scrutinize several measures of
52

whether the company is borrowing too much and will demand that it keeps its debt within
reasonable boundaries.
Previous literature suggests that leveraged firms engage in EM to avoid debt covenant
default (Beatty and Weber 2003; Dichev and Skinner 2002; DeFond and Jiambalvo 1994).
However, these studies measure EM using accrual based measures.
Jelinek (2007) studies the effect of leverage increase on accrual EM. Jelinek suggests that
leverage changes and leverage levels have a different impact on EM and concludes that
increased leverage is associated with reduced accrual EM. Moreover results suggest that
there is a beneficial consequence of debt because the increased debt reduces manager’s
discretionary spending, and in turn, reduces accrual EM.
The conclusion has been drawn by Jelinek could be incorrect. As there could be another
explanation of why increased leverage is associated with reduced accrual EM. For example
companies with increasing debt could be involved in the REM. However, increased leverage
could give an incentive for managers to switch from accrual earnings management to REM.
Moreover, reducing of discretionary expenses is one of the REM activities that could
provide evidence that the company engage in REM.
One relevant research on management of CFO is performed by Zhang (2006) and comes
close to consider the effect of the level of leverage on REM; he investigates the possibility
that debt covenants, amongst others, could be a one of the incentives for management to
manipulate cash flow through real activities. The result of his research suggests that
coefficients on debt covenants are positive but not significant, because the proxy to
capture incentives is too crude. Unlike this paper, Zhang considers the incentives to avoid
default of debt covenants, amongst which debt-to-equity-ratio, rather than researching
whether changes in the level of leverage are positively correlated to REM.
The purpose of this thesis is to develop a model to investigate whether increases of
leverage of a company are an incentive for management to manipulate earnings through
real activities in order to affect CFO. Based on the study of Jelinek (2007) that
distinguishes between leverage increasing firms and highly leveraged firms the main
hypothesis is as follows:

H1: Leverage results in real earnings manipulation by management.

Based on study Jelinek (2007) and based on the primary purpose of this paper, I distinguish
between high leverage and leverage-increasing firms. To investigate whether leverage
changes
and leverage levels have different impact on REM, I present the following
hypothesis:

H2: Real earnings management in order to positively affect cash flow from operating
activities, in leverage-increasing firms, is positively correlated with the level of leverage.

Based upon my study of recent literature, I was unable to identify other previous research
that focuses on researching these hypotheses. This is most likely caused by the focus of
earnings management on accruals management, and less on REM. Researchers that focus
on REM most commonly research the effects on earnings rather than effects on CFO. As
such, and to my best knowledge, this is the first time a hypotheses is developed to identify

53

the positive correlation of the level of leverage and the changes in leverage with REM used
to positively effect operating cash flows. In the next section I develop a model to test
these hypotheses and identify data samples.

3.2 Research design
Models to measure real activities manipulation
In general, in literature two models are indentified to measure real activities
manipulation.
Investigating firm’s total level of REM. As a proxy for REM researchers (Chen et al.
2007) use abnormal level of cash flows from operations. To determine normal level of
CFO they use the model developed by Dechow et al. (1998) which was implemented in
research by Roychowdhury (2006).
Examine abnormal level of cash flows from operations and also abnormal discretionary
expenses and abnormal production costs, and the sum of standardized three REM
proxies, to capture the effects of real actions presumably better (Roychowdhury
2006).12
Roychowdhury focuses on the following three manipulation methods: manipulation of
sales, overproduction, decrease of discretionary expenses . In general, some of three
activities would increase operating cash flows, but some would decrease them.
The primary purpose of this thesis is to develop a model, that will more precisely measure
whether the increasing level of solvability (leverage) of a company is an incentive for
management to manipulate earnings through real activities and not the existence of a
higher or lower level of REM. Therefore, I use abnormal CFO based on Roychowdhury
[2006], as a proxy for REM. The reason is twofold. First, I am primarily interested in
investigating a firm’s total level of REM in order to identify increasing effects of REM on
cash flow from operating activities rather than a mixture of positive and negative effects
of REM on cash flow from operating activities, and abnormal cash flow from operation is
one such aggregate measure. Second, not one model is deemed to have prevalence above
the other model. The explanation could be that studies concerning REM are only in
development.

Normal level of CFO
To determine normal level of cash flow from operating activities for every firm and year, I
use the model developed by Dechow et al. (1998) and implemented in research by
Roychowdhury (2006).
Roychowdhury (2006) explains normal CFO as linear function of sales (Sit) and change in
sales in the current period (?Sit). All variables in the model are scaled by lagged total
assets (Ai,t-1).

(CFOit /TAi, t-1 = ?0t + ?1t [1/TAit-1] + ?2t [Sit/TAi, t-1] + ?3t [?Sit/TAi, t-1] + ?it
(1)



12 This proxy for REM has been used and verified to be valid in subsequent studies by Gunny (2006), Cohen
(2007), Zhang (2006), Zang (2007).
54

Abnormal CFO
Next, for every firm and year, I calculate abnormal level of cash flow from operation (RE).
Abnormal CFO is equal to actual cash flow from operation minus the “normal” cash flow
from operation computed using estimated coefficients from the above equation (1).

Model to measure level of leverage
In general, two widely used methods exist to measure the level of leverage. Measurement
based on the use of book value debt and equity (i.e., accounting) or market value of debt
and equity. There is no law or regulation stating how the level of leverage should be
measured. For example, in case of leased assets accountants try to estimate the present
value of the lease commitments. In the case of long term debt they simply show the face
value. This can sometimes be very different from present value. To be consistent with
previously studies (i.e., Nwaeze et al. 2005; Jelinek 2007), first I measure leverage
(LEVERAGE) as the ratio of long term debt to the total of book value of equity and long
term debt. Although more commonly a ratio of long term debt to book value of equity is
used, I use this method as it is preferable in situations where a sample includes companies
with a negative book value of equity. A negative book value of equity would otherwise
result in a low leverage level (negative) despite the absolute value of long term debt.
Therefore the first formula to calculate LEVERAGE can be shown as follows:

(LEVERAGE) = long-term debt / book value of equity + long term debt.

(2)

Furthermore, I also measure the level of leverage using market values as valuation models
in the finance literature that use leverage ratios as inputs are generally based on the
market value of debt and equity (White et al. 2003). Market values of both debt and equity
are available or can readily be estimated, and their use can make the ratio a more useful
analytical tool. The use of market values, however, may produce contradictory results.
The debt of a firm whose credit rating declines may have a market value well below face
amount. A debt ratio based on market values may show an “acceptable” level of leverage.
A ratio that would control for this phenomenon and can be used in conjunction with book-
or market-based debt ratios is one that compares debt measured at book value to equity
measured at market:
The formula for calculation this leverage ratio is as follows:

(LEVERAGE) = long-term debt at book value / market value of equity.


(3)

In addition, I also use the actual book value of long term debt as a measure for solvability.
The main reason for this is the assumption that a company with a high absolute amount of
long term debt could be closely monitored by the issuers of debt irrespective of the
relative value of long term debt in comparison to equity. Therefore, I want to measure
whether the total amount of long-term debt is correlated to the level of REM. To
determine the LEVERAGE based upon this measure, leverage is calculated as shown below:

(LEVERAGE)
=
long-term
debt.

(4)


55

Model to measure hypotheses
Since I have chosen to calculate leverage in three separate ways in order to determine
whether one or more of these models individually affect the level of REM, the hypothesis
H2 is subdivided into three sub-hypotheses. I estimate three distinct models by using
ordinary least squares regression to separately test the three hypotheses.
In order to reflect the first book value approach to calculating the leverage ratio, I have
developed the following hypothesis:

H2.A: Real earning management in order to positively affect cash flow from operating
activities, in leverage-increasing firms, is positively correlated with based on the equation
(2) measured level of leverage.

To test hypothesis I estimate the following regression:

(RE) = ?0 + ?1 (LEV_INC) + ?2 (SIZE) + ?3 (CAPIN) + ?it




(5)

In order to reflect the market value approach to calculating the leverage ratio, I have
developed the following hypothesis:

H2.B: Real earning management in order to positively affect cash flow from operating
activities, in leverage-increasing firms, is positively correlated with based on the equation
(3) measured level of leverage.

To test hypothesis I estimate the following regression:

(RE) = ?0 + ?1 (LEV_INC) + ?2 (SIZE) + ?3 (CAPIN) + ?it




(6)

In order to reflect the absolute value of long term debt as the leverage ratio, I have
developed the following hypothesis:

H2.C : Real earning management in order to positively affect cash flow from operating
activities, in leverage-increasing firms, is positively correlated with based on the equation
(4) measured level of long term debt .

The hypothesis H2.C represents that REM is positively correlated to leverage for leverage-
increasing firms, when using the absolute value of long term debt in calculating leverage.
To test hypothesis I estimate the following regression:

(RE) = ?0 + ?1 (LTD_INC) + ?2 (SIZE) + ?3 (CAPIN) + ?it




(7)

Control variables
This study controls for size. Large firms are more widely followed by the analyst’s
community and have a different information environment than smaller firms. To control
for this I include variable (SIZE) in the regression. Also, I include variable (CAPIN) to
56

Download
The effect of leverage increases on real earnings management

 

 

Your download will begin in a moment.
If it doesn't, click here to try again.

Share The effect of leverage increases on real earnings management to:

Insert your wordpress URL:

example:

http://myblog.wordpress.com/
or
http://myblog.com/

Share The effect of leverage increases on real earnings management as:

From:

To:

Share The effect of leverage increases on real earnings management.

Enter two words as shown below. If you cannot read the words, click the refresh icon.

loading

Share The effect of leverage increases on real earnings management as:

Copy html code above and paste to your web page.

loading