Abstract

Empirical studies found that earnings management (EM) explains firms’ cost of capital both in companies in emerging and developed countries, but until now, it has not been analyzed whether the effect of EM on the financial cost is different among emerging countries inside or outside an economic area (Eurozone). Our results show that the cost of debt and the idiosyncratic component of the cost of equity are related to discretionary accruals and abnormal values of operating cash-flows, that the emerging country effect is more relevant on the cost of debt, that there is a Eurozone effect that makes discretionary accruals more relevant than abnormal values of operating cash-flow and that firms in emerging countries inside the Eurozone benefit from a lower EM penalty on the cost of debt than firms in other emerging European countries.

INTRODUCTION

The literature shows that cost of capital for companies in emerging countries is higher than that for companies in developed countries (González-Sánchez, 2022; Narayan et al., 2014). This means that investments in emerging countries have to achieve higher returns to compensate for this extra financial cost. In this context, our aim is to test whether the earnings management (EM) explains this extra financial cost of capital and, if the EM effect is different for companies in emerging countries if the country is inside or outside of Eurozone.

EM is the ability of the company’s management to manipulate the company’s results, with the intention of obtaining some private gain, but reducing the quality of financial reporting. The literature has analyzed whether EM has a negative impact on the quality of financial reporting, which may reduce the value of the company, causing stakeholders to lose confidence. More specifically, EM has also been analyzed in relation to issues such as the supervisory role of the majority owner in mitigating managers’ opportunistic behavior in EM (Mellado & Saona, 2005), insider trading (Sawicki & Shrestha, 2008), mergers and acquisitions (Zhu & Lu, 2013), debt issuance (Mellado et al., 2017), or bankruptcy risk (Agustia et al., 2020).

CONCLUSIONS

Empirical evidence shows that the financial cost of companies in emerging countries is higher than that of companies in developed countries. In this context, we test whether this difference is due to the way creditors and investors take into account EM in both types of companies or whether their interpretation of earnings manipulation is independent of the extra financial cost in emerging versus developed countries. Our main objective is to study whether there is a different effect for companies in the Eurozone and whether, as a consequence, companies from emerging countries inside the Eurozone have a different effect than other companies from emerging European countries outside the Eurozone.

To study this differential effect, we built a database composed of 4514 companies from 16 developed countries and 3399 companies from 21 emerging countries. The novelty of our sample is that all countries belong to the same geographical area (Europe), so that implicitly the economic, social, and cultural relations (among others) should not show substantial differences in the way EM explains financial cost. Moreover, by including in the sample developed and emerging countries that share a common regulatory framework and a common currency (euro), this difference should be nonexistent. The sample period is from 2012 to 2020.