Real Earnings Management and Cost of Equity Capital －Evidence from Korean Firms－
Asian Tax Journal Vol. 13 No. 1 (2012), pp. 99-130
Abstract
This paper examines the potential effect of real earnings management on cost of equity capital for Korean firms. Real earnings management(Hereafter Real EM) defined as the deviation from normal business practices with the primary objective of manipulating current period earnings. This study use abnormal cash flow from operations, abnormal production costs and abnormal discretionary expenses as proxies for the managers’opportunistic Real EM behavior (e.g.,Roychowdhury 2006；Cohen and Zarowin 2010). Prior research has documented that accrual EM has positive (＋) relationship with cost of equity capital (e.g., Francis, Lafond, Olsson, and Shipper 2005；Lambert, Luez, and Verrecchia 2007). However according to Cohen, Dey, and Lys (2008), after the SOX (Sarbanes Oxley) act, managers began to substitute earnings management methods from accrual to Real EM because of potential legal costs. Also accrual and real EM have big differences in that regulator or auditor cannot scrutinize Real EM because Real EM is manager’s autonomous behavior to upward reported earnings to meet or beat certain financial reporting benchmarks. In addition, accrual EM has no direct cash flow consequences, Real EM affect cash flows. Prior research document that Real EM has greater negative consequences than accrual EM (Gunny 2005；Zang 2007). Most of Korean Real EM papers just focus on long term operating performance or its stock market reaction (Kim,Bae, and Goh 2009). Despite the increasing interest in and importance of Real EM, little study to date has examined whether and how investors perceived Real EM through implied cost of equity capital in Korean setting. By using Korean firm/year 1,564 observations between 2001 and 2007, we find that Real EM (especially abnormal cash flow operations and abnormal production costs) is positively (＋)associated with cost of equity capital even after well－known risk proxies are controlled for. Thus,we conclude that the more managers use Real EM to increase reported earnings, the higher risk premiums the investor require. This paper’s contribution is as follows. This is the comprehensive study to examine the effect of manager’s Real EM behavior on cost of equity capital for Korean firms. More specifically, this study empirically shows that investor’s perceived risk is higher when manager use upward Real EM to higher reported earnings. We believe that our empirical evidence may shed some lights on our understanding of managers’ opportunistic Real EM on cost of equity capital based on Korean firms.
Keywords
- Real Earnings Management
- Cost of Equity Capital
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