Abstract
This study examines the impact of external financing activities on earnings management decisions and further explores the role of enterprise risk management (ERM) as a potential moderating factor in this association. We find that managers use both real-activities and accrual-based earnings management when engaging in equity financing activities. Moreover, when firms have weaker ERM systems, we find that managers are less likely to use real-activities earnings management in their equity financing efforts. Therefore, our policy-relevant findings suggest that weaker ERM systems can signal poor control mechanisms and attract additional investor scrutiny, thus constraining managers' use of real-activities earnings manipulation to harm long-term firm value.
1. Introduction
This paper examines the relationship between external financing activities and earnings management within the setting of a firm's internal control environment as measured by Enterprise Risk Management (hereafter, ERM).2 Firms can obtain external financing through equity or debt offerings, and capital structure theory emphasizes the importance of distinguishing between equity and debt financing.3 From a capital cost perspective, debt financing necessitates the payment of interest and matured principal, but there is no such payment pressure in equity financing. However, firms employing equity financing face performance pressures because poor operational performance will result in a reduced stock price. From an agency theory perspective incorporating control rights, debt financing maintains the current proportion of control rights whereas equity financing reduces the monitoring ability of creditors.4
Prior studies find that the use of external financing can drive firm managers to engage in earnings management (DuCharme, Malatesta, & Sefcik, 2004; Shivakumar, 2000; Shu and Chiang, 2014; Teoh et al., 1998; Yang et al., 2016). These studies focus on accrual-based earnings management and its consequences for post-financing firm performance. For example, Yang et al. (2016) show that firms with higher levels of earnings management and distress risk perform poorly after SEOs. Recent research also documents external financing anomalies, which manifest as negative effects on future stock returns and profitability from a firm's external financing activities (Bradshaw, Richardson, & Sloan, 2006; Papanastasopoulos et al., 2011). Most studies that attempt to detect such external anomalies are based on direct inferences of possible phenomena or hypotheses from the perspective of the impact of outside investors on the change in expected returns. The earnings management hypothesis contributes significantly to the explanation of external anomalies. It argues that managers will manipulate earnings upward before implementing financing policies, and external investors will mistakenly believe that the firm has better operating performance as a consequence. Once the financing policies are in place, the firm's performance may deteriorate due to the reversal of earnings management accruals, thus forcing investors to reevaluate the true value of the firm. This effect ultimately yields negative investment returns (Papanastasopoulos et al., 2011).
5. Conclusion
According to the earnings management hypothesis, managers manipulate earnings upwards to mislead investors into believing that the firm has better operational performance and a higher value than it actually does by engaging in earnings management prior to implementing financing policies. Once the earnings management is reversed, the firm's deteriorating operational performance forces investors to reconsider the value of the firm, thus imposing negative investment returns on investors. This study explores whether such external financing anomalies are associated with the managers' use of earnings management strategies and whether the choice of an earnings management strategy is affected by the presence and effectiveness of an ERM structure.
