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Are Financing Needs a Constraint to Earnings Management? Evidence for Private Portuguese Firms

  • José António Moreira


    (CETE, Faculdade de Economia, Universidade do Porto)

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    In this paper I test two intuitions. First, that small private firms have incentives to undertake earnings management. Second, that firms’ financing needs are one of such incentives, constraining the sense of the income manipulation. The tax incentive is deemed to motivate firms into adopting income decreasing actions aimed at reducing the tax bill, and is especially strong in an environment where they are managed by the owners and with close alignment between the accounting and tax systems. However, the debt incentive, which tends to affect mainly those firms with high financing needs, is expected to act as a constraint to the adoption of income decreasing actions, given that firms want to signal their quality to banks. The empirical evidence obtained from a sample of small private Portuguese firms fully supports my intuitions, showing that firms with low financing needs tend to focus on the minimization of the tax bill. Those with high needs are more pervasive in reporting larger profits. Moreover, firms with audited accounts seem to show a lower likelihood of reporting profits, and tentative explanations are either that they are more constrained in adopting earnings management actions, or that audited accounting may act as a signal of their quality, a kind of substitute for the signal underlying the sign and size of reported earnings.

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    Paper provided by Universidade do Porto, Faculdade de Economia do Porto in its series CEF.UP Working Papers with number 0610.

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    Length: 33 pages
    Date of creation: Oct 2006
    Date of revision:
    Handle: RePEc:por:cetedp:0610
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    1. Burgstahler, David & Dichev, Ilia, 1997. "Earnings management to avoid earnings decreases and losses," Journal of Accounting and Economics, Elsevier, vol. 24(1), pages 99-126, December.
    2. Degeorge, Francois & Patel, Jayendu & Zeckhauser, Richard, 1999. "Earnings Management to Exceed Thresholds," The Journal of Business, University of Chicago Press, vol. 72(1), pages 1-33, January.
    3. José António Moreira, 2006. "Manipulação para Evitar Perdas: o Impacto do Conservantismo," CEF.UP Working Papers 0605, Universidade do Porto, Faculdade de Economia do Porto.
    4. Sweeney, Amy Patricia, 1994. "Debt-covenant violations and managers' accounting responses," Journal of Accounting and Economics, Elsevier, vol. 17(3), pages 281-308, May.
    5. Aasmund Eilifsen & Kjell Henry Knivsfla & Frode Saettem, 1999. "Earnings manipulation: cost of capital versus tax," European Accounting Review, Taylor & Francis Journals, vol. 8(3), pages 481-491.
    6. Allen N. Berger & Gregory F. Udell, 2002. "Small Business Credit Availability and Relationship Lending: The Importance of Bank Organisational Structure," Economic Journal, Royal Economic Society, vol. 112(477), pages F32-F53, February.
    7. McNichols, Maureen F., 2000. "Research design issues in earnings management studies," Journal of Accounting and Public Policy, Elsevier, vol. 19(4-5), pages 313-345.
    8. Cindy Durtschi & Peter Easton, 2005. "Earnings Management? The Shapes of the Frequency Distributions of Earnings Metrics Are Not Evidence Ipso Facto," Journal of Accounting Research, Wiley Blackwell, vol. 43(4), pages 557-592, 09.
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