Earnings Management Behavior of Firms with Financial Constraints: Focusing on Firms that Issue Redeemable Convertible Preferred Stocks

Abstract

Purpose: This study aims to explore the effect of financial constraints on earnings management by focusing on firms that issue redeemable convertible preferred stocks (RCPS). RCPS are considered a financing option primarily used by firms that have investment opportunities but face difficulties in raising funds with a low cost of capital. Therefore, the issuance of RCPS can be an effective indicator to identify firms with financial constraints. Design/methodology/approach: This study employs a sample of 12,406 firm-year observations of listed companies in the Korean stock market from 2011 to 2018. The study conducts multiple regression analyses to investigate the level of earnings management of RCPS-issuing firms with respect to that of non-issuing firms. In this analysis, the earnings management is proxied by discretionary accruals and real operational activities. Findings: This study shows that RCPS-issuing firms have a higher level of discretionary accruals than non-issuing firms. Meanwhile, there is no significant difference in the level of real activities management between RCPS-issuing and non-issuing firms. These findings imply that firms with financial constraints engage in aggressive earnings management through discretionary accruals rather than real operational activities. Research limitations/implications: This study provides compelling evidence that financially constrained firms strategically use discretionary accruals to signal positive prospects for external capital suppliers, allowing them to raise the capital necessary for investment. It is also confirmed that financially constrained firms do not depend on real activities management, which sacrifices cash flows and firm value in the long run. Originality/value: T his is t he f irst s tudy t o test t he l ink between f inancial c onstraints a nd e arnings m anagement by analyzing RCPS-issuing firms that conform to the definition of financial constraints. This approach can alleviate the risk of errors in the classification of firms and the endogeneity problems accompanied by estimating financially constrained firms with firm characteristics, such as dividend payout ratio, cash flows, size, age, or a combined index of these variables.