Earnings management, capital structure, and the role of institutional environments

This paper examines the effect of earnings management on financial leverage and how this relation is influenced by institutional environments by employing a large panel of 25,777 firms across 37 countries spanning the years 1989-2009. We find that firms with high earnings management activities are associated with high financial leverage. More importantly, this positive relation is attenuated by strong institutional environments. Our results lend strong support to the notions that (1) both corporate debt and institutional environments can be served as external control mechanisms to alleviate the agency cost of free cash flow; and (2) it is less costly to rely on institutional environments than debt. After meticulously addressing the possible endogeneity issues and conducting various robustness tests, our main conclusions remain confirmed.