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

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.