C ONCLUSIONES Y RECOMENDACIONES

The main aim of this research is to contribute to the on-going empirical debate regarding the implications of leverage on management’s accounting discretionary power. This study distinguishes itself from prior studies and offers two main contributions to the existing literature. First, it employs a structured sample of non-cash acquiring firms, which already have the motivation to manage their earnings upwards, in examining the impact of debt-

173

financing on earnings management. This study claims that the adopted design provides more reliable results when comparing the magnitude of earnings management among firms with different levels of leverage, since the motivation to manage earnings is arguably consistent and intentional for all firms in the testing sample, rather than being random or undetermined as in prior studies. Second, unlike previous studies, which usually use a common debt ratio to proxy for leverage, this study constructs a leverage proxy more consistent with earnings management research methodology (Martin 1996).

It is argued in this chapter that pre-merger earnings management conducted by non-cash acquirers should be negatively associated with the firm’s level of leverage. This argument is built on two theoretical foundations. First, acquiring firms have the incentive to adopt income- increasing methods before offering their shares to pay for M&A deals (Erickson and Wang 1999; Botsari and Meeks 2008; Gong et al. 2008). Moreover, leverage can be a determinant of the payment method in a M&A (Faccio and Masulis 2005), a control of managerial opportunism (Jensen 1986), an effective external monitoring device (DeAngelo et al. 1994) and a source of conflicting incentives of earnings management (Jones 1991; Beneish 2001; Chung et al. 2002).

Earnings management is measured using an industry-performance matched model similar to Louis (2004) and Kothari et al.’s (2005) method over the last three quarters prior to M&A announcement. Similar to the results that have been consistently documented by previous studies, such as those found in the works of Erickson and Wang (1999), Botsari and Meek (2008) and Gong et al. (2008), this study reports evidences of upward earnings management practices displayed by non-cash acquirers prior to deals’ announcement dates. After splitting

174

the sample into low versus high leverage subsamples based on an industry-adjusted leverage proxy, only the low-leverage subsample of acquirers provides evidence of earnings management.

As expected, the evidence of pre-merger earnings management is more robust for non-cash acquirers. This finding is supported by a multiple regression analysis, which provides evidence that the inverse relation between earnings management and leverage is very significant. The evidence holds after replacing the leverage proxy with the high-low leverage dummy, as well as after controlling for other factors such as the relative size of the deal and new legislations as represented by SOX.

Unlike the non-cash acquirers’ results, no evidence is found to support the notion of earnings management by cash acquirers, which is unsurprising as they lack the economic incentive. Therefore, as expected, testing of the relationship between earnings management and leverage in this particular sample did not reveal any significant results, while the cross-sectional model could not predict any relation.

This chapter has documented how debt creation is more likely to restrict a firm’s ability to manipulate discretionary accruals as well as addressing whether it is high in relation to the firm’s respective industry, at times when those firms have the economic incentive to manipulate their accruals. Given the link between earnings management and managerial opportunism (Christie and Zimmerman 1994; Easterwood 1997; Jelinek 2007), this can be explained by Jensen’s (1986) control hypothesis, which predicts that a higher level of leverage

175

has a mitigating effect over managerial opportunism since management’s control over free cash flow is reduced.

Similarly, the findings can be explained in light of agency theory using the close lenders’ monitoring hypothesis by DeAngelo et al. (1994), which predicts both that the relationship between lenders and the borrowing firms is governed by the firm’s accounting numbers and that lenders seek to protect their interests by closely monitoring their borrowers.

An alternative interpretation of the results of this study can be found by assuming the conflicting incentives of earnings management (Jones 1991), given that both debt contracts and equity issues are considered as potential sources of incentives for income-increasing earnings management (Beneish 2001). Moreover, this school of thought argues that the impact of earnings management is transient since the effect of discretionary accruals on earnings in a given accounting period has a reversal effect on earnings in a future period (Chung et al. 2002).

Finally, the importance of the findings of this study not only stems from their consistency with previous theories that advocate the mitigating effect of leverage on earnings management, such as Jensen’s (1986) control hypothesis, but also because these findings emphasise the relevance of examining the “leverage – earnings management” relationship while the economic incentive to manage earnings exists. From the perspective of regulators such as the SEC, such evidence on earnings management and understanding its mitigating factors has implications on direct accounting standards enforcement that improves the credibility of corporate reports.

176