Managed earnings, prior cost of capital, and firm location

Purpose - A seemingly certain commonality in the extant literature is that firms that engage in the practice of managing earnings do so to massage their performance. The purpose of this paper is to examine the pecuniary effect of the prior cost of capital and a firm’s location on the propensity for firms to manage earnings. Design/methodology/approach - This study uses longitudinal data for US firms from COMPUSTAT and Center for Research in Security Prices from 1980 to 2010 for an average of 1,627 firms. The authors apply several regression methods – namely: least squares regressions, quantile, interaction-terms, seemingly unrelated and endogeneity test – and come to similar conclusions. Findings - The authors find that managed earnings behavior varies depending on the prior cost of capital. Managers positively exacerbate earnings when the firms’ prior cost of debt is high. Managers inverse its exacerbation of earnings when the firms’ prior cost of equity is high. This effect remains the same in all regression techniques applied in this paper. Originality/value - The authors contribute to the literature primarily in three areas. First, by considering the effect of a firm’s location jointly on a firm’s prior cost of capital, the authors show that a firm’s environment amplifies the managers’ discretionary actions. Second, by showing that the prior cost of capital which a firm pursues can inundate the managers to pursue and exacerbate earnings. Finally, the evidence suggests that adjustment in previous years for debt obligated firms and that location affects managed earnings behavior.