Comparison of the effects of earnings management on the financial cost between companies in developed and emerging European countries

• Published date: 01 July 2023
• Author: Mariano González‐Sánchez,Ana I. Segovia San Juan,Eva M. Ibáñez Jiménez
• Date: 01 July 2023
• DOI: http://doi.org/10.1002/jcaf.22622

Received:  November  Revised:  February  Accepted:  February 

DOI: ./jcaf.

RESEARCH ARTICLE

Comparison of the effects of earnings management on the

financial cost between companies in developed and

emerging European countries

Mariano González-Sánchez Ana I. Segovia San Juan Eva M. Ibáñez Jiménez

Department of Business and Accounting,

UNED (Universidad Nacional de

Educación a Distancia), Madrid, Spain

Correspondence

Mariano González-Sánchez, Department

of Business and Accounting, UNED

(Universidad Nacional de Educación a

Distancia), Paseo Senda del Rey,, ,

Madrid, Spain.

Email: mariano.gonzalez@cee.uned.es

Funding information

MCIN/AEI, Grant/AwardNumber:

./

Abstract

Empirical studies found that earnings management (EM) explains firms’ cost of

capital both in companies in emerging and developed countries, but until now,it

has not been analyzed whether the effect of EM on the financial cost is different

among emerging countries inside or outside an economic area (Eurozone). Our

results show that the cost of debt and the idiosyncratic component of the cost

of equity are related to discretionary accruals and abnormal values of operating

cash-flows, that the emerging country effect is more relevant on the cost of debt,

that there is a Eurozone effect that makes discretionary accruals more relevant

than abnormal values of operating cash-flow and that firms in emerging coun-

tries inside the Eurozone benefit from a lower EM penalty on the cost of debt

than firms in other emerging European countries.

KEYWORDS

cost of debt, cost of equity, earnings management, idiosyncratic risk, systematic risk

JEL CLASSIFICATION

G, G, M

1 INTRODUCTION

The literature shows that cost of capital for companies

in emerging countries is higher than that for companies

in developed countries (González-Sánchez, ; Narayan

et al., ). This means that investments in emerging

countries have to achieve higher returns to compensate

for this extra financial cost. In this context, our aim is to

test whether the earnings management (EM) explains this

extra financial cost of capital and, if the EM effect is differ-

ent for companies in emerging countries if the country is

inside or outside of Eurozone.

EM is the ability of the company’s management to

manipulate the company’s results, with the intention of

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©  The Authors. Journal of CorporateAccounting & Finance published by Wiley Periodicals LLC.

obtaining some private gain, but reducing the quality of

financial reporting. The literature has analyzed whether

EM has a negative impact on the quality of financial report-

ing, which may reduce the value of the company, causing

stakeholders to lose confidence. More specifically, EM has

also been analyzed in relation to issues such as the super-

visory role of the majority owner in mitigating managers’

opportunistic behavior in EM (Mellado & Saona, ),

insider trading (Sawicki & Shrestha, ), mergers and

acquisitions (Zhu & Lu, ), debt issuance (Mellado

et al., ), or bankruptcy risk (Agustia et al., ).

EM can take two nonexclusive forms: accrual-based

earnings management (AEM) and real earnings man-

agement (REM). AEM occurs when managers control

J Corp Account Finance. ;:–. wileyonlinelibrary.com/journal/jcaf 197

198 GONZÁLEZ-SÁNCHEZ  .

reported earnings by exploiting accounting discretion

(Dechow et al., , ; Fields et al., ;Healy

&Wahlen,; Kothari et al., ; Schipper, ).

Managers use REM to manipulate results and deliberately

mislead external investors (Al-Shattarat et al., ; Ayers

et al., ; Gunny,; Roychowdhury, ;Zhaoetal.,

)

Managers can also use both practices simultaneously.

Zang () analyzes the trade-offs between AEM and

REM and concludes that high (low) real activities manip-

ulation realized is directly offset by a lower (higher)

amount of AEM. In addition, executive surveys conducted

by Graham et al. () suggest that managers empha-

size real economic actions rather than exercise accounting

discretion to hit earnings benchmarks.

There is a vast literature on the relationship between

EM and the potential effects of EM on the capital mar-

ket. Chung et al. () found that firms receiving warnings

preferred to use REM than accounting EM to avoid poten-

tial litigation and penalties. Cohen et al. ()pointed

out that the market considers managers’ earnings fore-

casts with bad news to be more credible than forecasts

with good news, not because forecasts with good news are

biased. Beckmann et al. () showed that firms actively

manage earnings around cross-listing events. Chen et al.

() conclude that firms in countries with a strong legal

system, strengthened outside investor rights, more insti-

tutional shareholders, and more monitoring by financial

analysts are less likely to engage in EM, while firms with

low stock market liquidity tend to manipulate earnings

compared to those with high liquidity. Huang and Ho

() find that, in a sample of Chinese listed firms, an

increase in stock liquidity is associated with a decrease in

the degree of EM. Bansal et al. () test for an asymmetri-

cal perception of EM by investors, since, stocks returns are

negatively related to the EM sign. Le and Trinh ()find

that limited analyst’s attention may negatively affect cor-

porate financial reporting quality as these firms covered

by distracted analysts manage their earnings more inten-

sively. Espahbodi et al. () show that firms that appear

to manage their earnings more intensively are more likely

to increase their dividends, but standard EM metrics do

not explain changes in firm value around dividend change

announcements.

More relevant for our purpose, however, are the empir-

ical papers that study whether EM cannot be effectively

identified by investors and, as a consequence, the company

could easily obtain capital market financing and reduce its

cost of equity and debts due to its excellent performance

masked by EM manipulation.

So, Francis et al. (, ) found that, based on a

sample of US firms, accruals quality influences the cost of

equity. Gray et al. () found the same results in a sam-

ple of Australian firms. For the US sample, Kim and Sohn

() showed that REM has a positive relationship with

the cost of equity. Strobl () found that the relationship

between EM and the cost of capital is conditioned by the

timing of the economic cycle. Hsu and Yu()usingTai-

wanese listed companies, found that AEM increases the

cost of equity, but REM decreases it.

On the other hand, in terms of the cost of debt, Kim

et al. () is the first empirical study on the relationship

between REM and the cost debt capital and found that the

relation varies depending on the institutional environment

of the country in which a firm is headquartered. Similarly,

the literature also shows a causal relationship between EM

and corporate financing characteristics. Fields et al. ()

find that firms have higher discretionary accruals during

periods of increasing short-term debt and this relationship

is stronger for firms that ultimately obtain new loan financ-

ing. Pappas et al. () show that greater EM is related to

higher bond yield spreads and more intensive covenants,

but this does not affect maturity or collateral requirements.

Thanh et al. () find nonlinear effects of debt ratio on

EM: positive effect with low debt and negative effect with

high debt. Mughal et al. () note post-merger acquir-

ers’ underperformance, as a consequence of the acquiring

firm’s EM. Shoaib and Siddiqui ()findaneffectofEM

on the relationship between firm performance and capital

structure.

Additionally, the literature has found that EM occurs

in companies in both developed and emerging countries

(Chen et al., ;Leuzetal.,;Lietal.,;Viana

et al., ), but the perception of EM among countries is

different (Kliestik et al., ).

In this context, however, despite the vast literature on

the relationship between EM and company financing, to

the best of our knowledge, there is no empirical study

that analyzes whether the higher financing cost (both

debt and equity) suffered by companies in emerging coun-

tries compared to companies in developed countries is

explained by a different investor interpretation of EM and

a different regulatory framework (according to inside vs.

outside a developed economic zone). To do so, first, we

construct a sample composed of companies from  devel-

oped countries and  emerging countries, all belonging

to the same geographical area (Europe) with a sample

period from  to ; also, thereare  developed coun-

tries and seven emerging countries among the countries in

the sample, that use the euro as their currency. Next, we

test whether the EM effect on financing cost is different

between companies in emerging and developed countries

and, furthermore, whether the effect is different when the

country is inside or outside the Eurozone. This last objec-

tive of the study closes the existing gap in the literature

and would allow us to check whether investors penalize