The effect of leverage on earnings management in Brazil

Abstract

The main goal of this paper is to analyze the relation between the leverage ratio and the managers’ decision to manage earnings in Brazil. Using abnormal accruals as a proxy for earnings management we design a linear regression model to capture the relation between these two variables. We use three models of discretionary accruals as proxy for earnings management. First one was the Jones model. Proposed by Jones (1991), the second model was the Modified Jones model, proposed by Dechow, Sloan and Sweeney (1995). The third one was the KS model, proposed by Kang and Sivaramakrishnan (1995), which uses an instrumental variable approach to correct for endogenous variables. Using a linear regression method with observation from 1994 to 2010 firms all BMF&Bovespa listed firms we try to model the relationship between earnings management and the leverage ratio. We also control our model for the cost of capital and the natural logarithm of total assets. We used the assets natural logarithm to control for firm size and the firm cost of debt to try to remove precious known endogeneity in the proposed model. Our final results show no relations between the leverage ratio and earnings management. These results contribute to the literature that examines the effect of opportunistic behavior on earnings management that examines the leverage/earnings management relation. Moreover the main findings suggest that there is a beneficial consequence of debt because the increased debt might reduce manager’s discretionary spending, and in turn, reduces accrual earnings management.