Firm Location and Cost of Capital effect on Managed Earnings.

What is it about?

A commonality in the extant literature is that firms that engage in the practice of managing earnings do so to massage their performance. However, there is a dearth of literature examining if the probative costs of capital impact a manager’s choice to manage earnings. This paper examines the pecuniary effect of the prior cost of capital and a firm's location on the propensity for firms to manage earnings. Using longitudinal data for US firms from COMPUSTAT and CRSP from 1980 to 2010 for an average of 1,627 firms. We find that managed earnings behavior varies depending on the prior cost of capital. Managers positively exacerbate earnings when the firms’ prior cost of debt is high. Specifically, managed earnings are increased by about 7%. Managers reverse the upward trending when the firms’ prior cost of equity is high. Manager earnings are decreased by about 4%. The evidence is robust as several regression method, namely: OLS, quantile, interaction-terms, seemingly unrelated, and endogeneity test was applied for validation.

Featured Image

Why is it important?

First, by considering the effect of a firm’s location jointly on a firm’s prior cost of capital, the authors show that a firm’s environment amplifies the managers’ discretionary actions. Second, by showing that the prior cost of capital which a firm pursues can inundate the managers to pursue and exacerbate earnings. Finally, the evidence suggests that adjustment in previous years for debt obligated firms and that location affects managed earnings behavior.

Perspectives