Debt Financing and Earnings Management: An Internal Capital Market Perspective

Authors

  • Hong-Da Wang,

  • Chan-Jane Lin

    Corresponding author
    • Address for correspondence: Chan-Jane Lin, Department of Accounting, College of Management, National Taiwan University, No. 1, Sec. 4, Roosevelt Road, Taipei 106, Taiwan.

      e-mail: cjlin@ntu.edu.tw

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    • The first author is from National Kaohsiung First University of Science and Technology, Kaohsiung City, Taiwan. The second author is from National Taiwan University, Taipei, Taiwan. The authors appreciate the constructive comments of Martin Walker (Editor), an anonymous referee, Chia-Ching Cho, T. K. Chou, Tony Kang and participants at the 2010 Annual Meeting of the American Accounting Association. Any errors or omissions are the responsibility of the authors. (Paper received August, 2011, revised version accepted February, 2013).


Abstract

This paper investigates the role internal capital markets play in mitigating earnings management of group firms. We predict that the funding advantages of internal capital markets from business affiliates obscure solvency problems resulting from higher leverage for individual firms within a group, which in turn mitigates their incentives for earnings management. Using Taiwanese firms as a sample, we provide evidence that is consistent with such a prediction. In particular, we show that higher group profitability reduces its member firms’ sensitivity of earnings management to debt levels. Among business groups, earnings management in pyramidal groups is less sensitive to debt levels. We also find that the debt-abnormal accrual curve becomes smoother as group profitability increases when considering the non-monotonic relationship between firm leverage and earnings management.

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