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Does High Leverage Impact Earnings Management? Evidence from Non-cash Mergers and
Acquisitions
Malek Alsharairi*
Aly Salama
ABSTRACT
Using a sample of US non-cash acquirers, we find significant evidence of upward earnings
management prior to announcing merger and acquisition deals. In this event study, we adopt an
industry-adjusted leverage proxy. No evidence of premerger earnings management is found in
highly leveraged firms. The results indicate significant evidence of a negative relationship
between earnings management and leverage. The evidence remains robust after replacing the
leverage proxy with a high-low leverage binary variable, as well as after controlling for the
relative size of the deal and profitability of acquirers. No evidence on earnings management by
cash acquirers is reported. These findings are consistent with Jensens Control Hypothesis as well
as advocate the view that creditors play crucial roles in monitoring the firm, which would
increase the credibility of corporate reports and restrict the use of managements discretionary
power to manipulate earnings prior to special business events such as mergers and acquisitions.

JEL classification: G34, M41, M48

Key Words: earnings management, leverage, accruals, mergers and acquisitions

INTRODUCTION AND MOTIVATION

At the root of many of the large-scale corporate scandals in the US and Europe in recent years lies
the growing phenomenon of so-called opportunistic earnings management (Goncharov 2005). In
explaining the issue, Healy and Wahlen (1999: p.368) define earnings management by the use of ...
judgment in financial reporting and in structuring transactions to alter financial reports to either mislead
some stakeholders about the underlying economic performance of the company or to influence
contractual outcomes that depend on reported accounting numbers. That said, the bottom line of an
income statement, i.e. the reported accounting earnings, is commonly used for evaluating a firms
performance, despite the fact it consists of two components; a cash component and an accrual component.
Therefore, it is crucial to recognize that a major portion of accruals could be subject to managements
discretionary power, and this brings to light managements ability to shift earnings between accounting
periods to influence users perceptions.
Earnings management may arise as a consequence of agency problem. Managers could manage
earnings to window-dress financial statements with the aim of improving their position (Iturriaga and
Hoffmann 2005), obscuring facts that stakeholders ought to know (Loomis 1999), or influencing
contractual outcomes that depend on reported accounting numbers (Schipper 1989; Dechow and Skinner
2000). The underlying managerial incentives to manage earnings are various. These include instances
when a firm reported a loss in the previous financial year; influencing short-term stock prices and
fulfilling capital market expectations; carrying out lending agreements, and obtaining bonuses through
management compensation contracts (Healy and Wahlen 1999; Dechow and Skinner 2000).
For many years, earnings management has been of grave concern for practitioners and regulators,
and has received considerable attention in the accounting literature. This literature is immense and still
developing. In their study A Review of the Earnings Management Literature and its Implications for
Standard Setting, Healy and Wahlen (1999: p.380) note that prior research has focused almost
exclusively on understanding whether earnings management exists and why. They conclude that
earnings management remains a fruitful area for academic research, and suggest that future research
contributions are likely to come from investigating the extent and magnitude of accruals, and determining
the potential factors that restrict earnings management. The question of factors opens research
*

Alasharairi (correspondent author) is an Assistant Professor of Accounting at The German Jordanian University, in
Amman, Jordan. Salama is a Lecturer in Accounting at Durham Business School, in Durham, UK. Their emails are
malek.alsharairi@gju.edu.jo and aly.salama@durham.ac.uk respectively.
The authors are indebted to two anonymous reviewers at the Global Conference on Business and Finance, Las
Vegas, USA January 2011, for their valuable feedback and suggestions that contributed greatly to this article.

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opportunities for investigating internal and external factors including corporate governance mechanisms.
Previous studies provide evidence that firms with good corporate governance in general have a tendency
to conduct less earnings management. Nonetheless, results are not consistent for the leverage effect on
earnings management (Shen and Chih 2007).
While the conflict of interests between managers and stockholders due to separation of control
and ownership is well known, an important aspect of managing these differing interests is the need to
control the managers behavior through monitoring mechanisms (Jensen and Meckling 1976; Watts and
Zimmerman 1986). Among those calling for improving corporate governance, the lead economist in the
World Bank, Cheryl Gray (1997: p.29), emphasizes the creditors crucial role in corporate governance
stating that effective debt monitoring and collection play a crucial role in corporate governance in
market economies and require adequate information, creditor incentives, and an appropriate legal
framework. Grays view is in line with the interactive system of corporate governance introduced by
Triantis and Daniels (1995), in which they try to describe a stylized theory of the role of stakeholders,
including lenders, in an effective governance system that is more able to control managerial slack.
Since managerial motives play a decisive role when exercising the discretionary power over
accruals, we learn more about other factors affecting earnings management if the motive effect is
neutralized. In other words, the empirical test needs to maintain the experimental setting where all firms
under study have the same motive that drives their decision toward earnings management. Several studies,
such as those by Erickson and Wang (1999), Baik et al. (2007) and Lee et al. (2008) noted that acquiring
firms in mergers and acquisitions have the motive to manage their earnings upward prior to offering their
stocks to target firms in stock swap deals. Hence, the higher the acquirers stock price, the lower the
exchange ratio, and thus, the lower the cost represented in the number of stocks given up to the target
firm. Holding the motive setting of premerger earnings management, of a sample of non-cash acquiring
firms, in this article, we examine the leverage effect as a governance mechanism on earnings
management. In particular, we seek to provide empirical evidence on how debt creation does impact
managements discretionary power to inflate the pre-merger reported earnings by acquirers, if they pay by
stocks instead of cash.
The following sections include a review of previous research related to earnings management in
mergers and leverage, the methodology used, the results of empirical testing and finally a summary of
findings and a conclusion.

LITERATURE REVIEW
Earnings Management In Non-Cash Acquirers.
The literature on earnings management in mergers and acquisitions is found to be limited. The
difficulty of collecting proper samples, the complexity of deals and a dearth of timely data could explain
why. Erickson and wang (1999) provide a good foundation in this area. They find it necessary to
categorize mergers and acquisitions based on the payment method used to complete them. They posit that
acquirers management has greater incentives in stock for stock deals to manage earnings prior to merger,
in order to reduce the cost of acquisition, because the exchange ratio is negatively associated with the
acquirer's stock price. They provide evidence that stock swap acquirers do manage earnings and this is
positively associated with the deal size. Botsari and meeks (2008) support these findings, explaining that
stock swap acquirers wish to increase the market value of their stocks prior to the merger by driving their
premerger earnings upwards, they assume that profit boosting will be reflected in their stock price so they
can issue fewer stocks to the stockholders of the target firm. Conversely, erickson and wang (1999)
address a disincentive to these acquirers, reminding us to consider that targets, unlike other users, are
likely to detect earnings manipulation as their decision is usually assisted by financial advisors. Therefore,
stock swap acquirers should manage earnings only if believe that the cost of undoing earnings
management outweighs the cost of doing it.
Given that the merger and acquisition transacting process is taking place under imperfect
information (hansen 1987), the information asymmetry problem is addressed in most research on mergers
and acquisitions valuation. Yet, baik et al. (2007) argue that acquirers are exposed to greater estimation
risk in the valuation of privately held targets relative to the valuation of public targets, and that acquirers
have to attempt to guard against the additional risk of buying out privately held targets, which receive less

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attention from stakeholders and regulatory agencies, unlike the public targets. For this reason, stock swap
acquirers motives to manage earnings in the pre merger announcement period vary depending on the
level of informational asymmetry between the engaging parties. They provide evidence that acquirers
inflate their earnings using accruals, and those acquirers whose targets are privately held firms show
greater positive abnormal accruals relative to acquirers of public targets. Baik et al. (2007) use a leverage
proxy in their regression analysis, but results do not show significant evidence on the leverage impact on
earnings management. We find this result unsurprising because their leverage proxy falls short to contain
industries leverage discrepancy. We illustrate this below in the research design section. Interestingly,
baik et al. Do not find evidence on the effect of method of payment on earnings management by the
acquirers if their targets were publicly held firms.
While koumanakos et al. (2005) find weak evidence on earnings management in a sample of
mixed acquirers, studies by louis (2004), lee et al. (2008) and gong et al. (2008) did find evidence on
positive earnings management, once they segregated their sample by the method of payment to find that
abnormal accruals are significant for acquirers using stocks in financing the merger and acquisition deal.
Another recent study by guo et al. (2008), based on the same view about the incentives for stock swap
acquirers, adds that those acquirers intending to split their stock prior to merger have greater motivation
to manage their earnings upwards. They argue that stock swap acquirers with highly inflated stocks would
go for stock-split to, at least, delay market correction of their overvalued stocks.
Leverage and earnings management
The impact of debt financing on earnings management is an empirical controversy. There are two
different streams are found describing the relationship between leverage and earnings management.
On one hand, evidence suggests that firms with high leverage are more likely to aggressively
manage their earnings. Press and Weintrop (1990) provide evidence that high leverage is positively
associated with the likelihood of violating debt covenants. Sweeney (1994) and DeFond and Jiambalvo
(1994) also explain that firms near default employ income-increasing accounting changes in order to
delay their technical default. Watts and Zimmerman (1990) and Mohrman (1996) support this view by
arguing that firms with higher leverages are expected to adopt accounting procedures that increase current
income. Likewise, Becker et al. (1998) noted that managers of highly leveraged firms have incentives to
strategically report discretionary accruals in order to increase reported earnings in their efforts to avoid
debt covenant violation. Moreover, Gu et al. (2005) reported that variability of accruals is positively
related with leverage.
On the other hand, a completely opposite view is found in literature that adopts the control
hypothesis by Jensen (1986), which suggests that debt creation reduces managers opportunistic behavior.
This implies that high leverage may restrict managers ability to manipulate income-increasing accruals,
since management opportunism and earnings management are found to be associated (Christie and
Zimmerman 1994). In a study that compares firms of high-accruals with firms of low-accruals, Dechow et
al. (2000) document that firms with high accruals are characterized by low leverage. In line with this
finding, Ke (2001) shows evidence that firms are less likely to show increases in earnings through
accruals if the firms are highly leveraged. Iturriaga and Hoffmann (2005) emphasize the monitoring and
governance role of leverage as they argue that there is a negative relationship between debt financing and
the use of discretionary power in managers' accounting decisions, since the higher the leverage the more
thoroughly is the control applied by lenders. They also suggest that managers of highly leveraged firms
have fewer motives to manage earnings because their creditors are interested in debt service rather than
accounting information, which means that financial statements have less relevant informational content in
this case. The empirical findings of Iturriaga and Hoffmann (2005) support the alternative hypothesis and
reveal a significant negative influence of leverage on earnings management. Jelinek (2007) examines the
impact of leverage increases on earnings management, across a five-year sample period for firms that
undergo leverage increases and a control group of consistently highly leveraged firms. The results suggest
that increased leverage is associated with a reduction in earnings management.
Both sides of the arguments are supported by theory and evidence in their favor, but neither has
delivered a compelling, definitive answer. Furthermore, many studies either failed to find statistically
significant evidence on the relation between leverage and abnormal accruals, e.g. such as Chung and
Kallapur (2003), or they provide mixed evidence, such as Shen and Chih (2007). Therefore, the question

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of the association between leverage and earnings management is still open. This study contributes to the
ongoing debate over the implications of leverage on managements accounting discretionary power by
examining the leverage effect in a sample of firms that have the motivation for earnings management.

METHODOLOGY
Sampling
Unlike previous studies that took samples of firms with varied motives for earnings management,
we use a sample of firms with a similar motive to manage earnings. Therefore, we consider non-cash
acquirers in premerger period to measure their discretionary accruals, and then examine the impact of
leverage on earnings management.
A sample of US acquirers is taken from Thomson One Banker. We include all acquirers in deals
completed between 01/01/1999 and 12/31/2008. Acquiring firms included in the sample meet the
following criteria as well: 1. the M&A deal is completed, 2. the acquirer and its target are publicly listed
companies to avoid variation in information asymmetry and motives in managing earnings, 3. acquirers
from the financial sector, which have SIC code between 6000 and 6999, are excluded from the sample
since this sector is subject to special regulations, 4. the deal value is at least $1 million so acquirers do not
lose the economic incentive to manage earnings due to small deal size, 5. the acquirer obtains a
controlling ownership interest in the deal, which means the acquirer has never owned 50 percent or more
before the transaction and would have greater than 50 percent by completing the transaction. A total of
661 acquirers meet the criteria. In Panel A of Table 1, the sample distribution by year shows that year
2000 has the highest contribution in the sample by providing 111 acquirers, whereas year 2008 reveals the
lowest number of acquirers in the study sample with 32 observations. Of the total sample, 244 acquirers
(36.9 percent) pay their targets using only cash, while 417 acquirers (63.1 percent) use equity or a hybrid
method to pay off the merger and acquisition deal. As explained later, we use the non-cash acquirers for
further analysis. In Panel B of Table 1, we show that the total sample of acquirers is distributed across a
range of five main industry divisions representing 31 major groups. The overwhelming majority (80.48
percent) of the total sample is represented by two industry divisions; manufacturing and services. While
the manufacturing industry division (SIC 2000-3999) represents 50.68 percent of the total sample, the
services industry division (SIC 7000-8999) represents 29.80 percent. At the level of major groups, four
groups cover 59.76 of the total sample. Namely, they include chemicals (SIC 2800-2899) with 75
acquirers (11.35 percent), electronics (SIC 3600-3699) with 85 acquirers (12.86 percent), instruments
(SIC 3800-3899) with 71 acquirers (10.74 percent) and business services (SIC 7300-7399) with 164
acquirers (24.81 percent).
The descriptive statistics are provided in Table 2, which also presents a comparison of the
acquirers characteristics by method of payment for the total sample, and by low-high leverage for the
non-cash acquirers sample. Panel A in Table 2 shows that cash acquirers in general are larger in both size
and sales when compared to non-cash acquirers. It shows that the mean book value of total assets (total
sales) of the cash acquirers is $11.891 billion ($8.799 billion) compared to $7.333 billion ($4.053 billion)
for the non-cash acquirers with an average of $9.014 billion ($5.806 billion) for the overall sample.
Unsurprisingly, the mean value of cash deals ($689.7 million) is not as sizeable as those financed using
equity or mixed method ($2.042 billion). Non-cash acquirers are less profitable with a negative mean
ROE (-11.59 percent) compared cash acquirers (6.08 percent) while both samples have nearly the same
mean debt to equity ratio of 43.9 percent.
Panel B Table 2 describes only non-cash acquirers after splitting them into low-high leveraged with
respect to their industries. We find that high-leverage non-cash acquirers have larger size with mean total
assets (total sales) of $12.453 billion ($6.538 billion) compared to low-leverage ones with mean total
assets (total sales) of $2.700 billion ($1.799 billion).
Measurement of earnings management
Most studies in the literature refer to the discretionary portion of the accrual component of
earnings when defining earnings management. In a study that examines the managerial incentives to
affect earnings reporting in case the executives are rewarded by earnings based bonuses, Healy (1985)
argues that total accruals can serve as an estimate of discretionary accruals by simply taking the
difference between the net accounting income and the net cash flow generated from operating activities.

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Building on Healys method, DeAngelo (1986) takes an event study approach analogously by considering
the total accruals in the previous period as a benchmark of normal accruals, then calculating the change in
total accruals from period to period, assuming that change in accruals is due to the nondiscretionary
accruals. Instead of assuming that nondiscretionary accruals are generally constant over time, Dechow
and Sloan (1991) use a model assuming that the determinants of the nondiscretionary accruals are only
common for firms in the same industry. Nevertheless, a better treatment in relaxing DeAngelos
assumption of the constant nondiscretionary accruals is introduced by Jones (1991). In her model, Jones
controls for the effect of changing economic circumstances on the nondiscretionary accruals by
developing an expectations model. She uses the non-cash working capital to calculate total accruals and
the residuals proxy for the discretionary accruals. Still, these approaches fall short, as they do not take
into account the managements ability to manipulate credit revenues. Dechow et al. (1995), in an
evaluation to the previous models, introduce a modification to Jones model to include the possible
managements discretion over accrual revenues.
Although the existing models in earnings management literature are still unable to provide
accurate estimation of discretionary accruals (Fields, Lys et al. 2001), the modified Jones model is still
widely used in this area of research, especially with the control for performance suggested by Kothari et
al. (2005) in their performance-matched firms discretionary accrual approach.
Similar to Louis (2004), in this study we employ the modified Jones model in cross-sectionally
estimating the discretionary accruals using the industry-performance-matched abnormal accruals over the
last three quarters prior to deal announcement.
First, we calculate the actual current accrual for each acquiring firm in the required quarter as
follow:
(1)
Where ACCi is the actual current accruals, CASSi is the change in current assets (COMPUSTAT XPF
mnemonic code ACTQ), CLIABi is the change in current liabilities (mnemonic code LCTQ), CSHi is
the change in cash (mnemonic code CHEQ), STDEBTi is the change in current maturities of long term
debt and other short term liabilities included in current liabilities (mnemonic code DLCQ) and i denotes
acquiring firm.
Second, we use COMPUSTAT universe to construct portfolios that control for quarter, industry
and performance. Per quarter in every year we construct portfolios, each of which consists of firms in
similar industries based on the industry major groups classification (2-digit SIC) and similar in quintile of
performance based on firms ROA last year same quarter1. For each portfolio, we estimate the parameters
of the following accruals model:
(2)
Where Qq is a binary variable to control for seasonality that takes 1 when data is taken from calendar
quarter q and 0 otherwise; REVi is the change in sales (mnemonic code REVTQ); ARi is the change in
accounts receivables (RECTQ); PPEi is the gross property, plant and equipment (PPENTQ); LACCi is the
current accruals in the same quarter last year; LTASSi is the total assets same quarter last year (ATQ) and
is the regression residual, which also represents the difference between the actual current accrual and the
estimated current accruals all scaled by lagged total assets.
The cumulative abnormal accruals of acquirers over the three quarters prior to announcement data
are used to proxy for earnings management, which can take positive and negative values.
Leverage proxy
The need for developing a leverage proxy is for capturing the impact of debt contracting and
creditors monitoring earnings management. Yet, corporate finance literature has not agreed on the optimal
leverage proxy since D'Mello and Farhat (2008) warned that different leverage proxies lead to different
1

Before ranking firms in each industry into performance quintiles, we reduce measurement error by discarding
observations with top and bottom 0.1 percent ROA of the universe and those with obsolete value of current accruals
exceed their total (Gong, Louis et al. 2008). Portfolios with less than 20 observations are excluded also.

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empirical results. Given our event-based sample, we believe that the industry-adjusted leverage proxy is
superior to other approaches in capturing the impact of debt contracting on firms. CFOs were surveyed by
Graham and Harvey (2001) to find that industry-wide leverage ratios do significantly influence firms
financing decisions.
The proxy we are constructing in this study is similar to Martins (1996). It is motivated by
Bradley et al.s (1984) evidence that debt ratios differ remarkably among industry sectors, and by Fama
and Frenchs (1997) implication that optimal leverage ratio varies over time and industry. Using the
COMPUSTAT universe of firms, we first calculate the average debt to equity ratio per industry in each
year over the ten-year sampling range. Then we compare the acquirers debt to equity ratio to the industry
average calculated for each year in order to get the industry-adjusted ratio. From Panel A Table 2 the
mean industry-adjusted leverage ratio is around 29 percent for both cash and non-cash acquirers. For
splitting the non-cash acquirers into high-low leverage as shown in Panel B Table 2, we partition the
observations into below and above the sample median value of the firms industry-adjusted leverage ratio
(17.9 percent).

EMPIRICAL RESULTS
Univariate analysis
Acquirers would not be motivated to manage their earnings prior to merger if their targets were
offered purely cash (Erickson and Wang 1999; Asano, Ishii et al. 2007; Baik, Kang et al. 2007; Botsari
and Meeks 2008). On the grounds of this argument, cash acquirers are withdrawn from the experiment
sample and used as a control group in our univariate analysis. We test the earnings management
hypothesis for the total sample as well as for cash and non-cash acquirers separately before proceeding to
the next level in our analysis.
By using t-test for testing the mean and Wilcoxon-z for testing the median in Table 3, we find
that the overall sample shows a significantly positive mean (0.8589 percent significant at 5 percent) for
the cumulative abnormal accruals for the last three quarters prior to the deal announcement. Expectedly,
evidence holds only for the non-cash acquirers sample, which has a positive mean of 1.1378 percent
significance at 5 percent confidence interval, after splitting the overall sample by the method of payment.
These findings are consistent with the previous studies.
To investigate the extent to which abnormal accruals are affected by leverage, we partition the
overall sample into above-below the median of industry-adjusted leverage ratio. Interestingly, we find
very significant evidence on earnings management only in the low-leveraged acquirers. Table 4 the mean
abnormal accruals over the three quarters t-1, t-2 and t-3 (0.667, 09128 and 0.4936 percent) are significant
at 10, 1 and 10 percent confidence interval respectively. The mean cumulative abnormal accrual (1.9848
percent) of the low-leverage group is significant at the 1 percent confidence interval, and the positive
median is significant at 5 percent. However, the mean abnormal accruals over the three quarters prior to
announcement are insignificant in the high-leveraged acquirers group.
Similar evidence is reported in Table 5, which reveals more detailed results by interacting the
method of payment with high-low leverage of acquirers. We find that only non-cash acquirers with low
leverage ratio show significantly positive mean abnormal accruals in quarters t-1, t-2 and t-3 (0.973,
1.2537 and 0.9903 percent, respectively) at confidence interval 5, 1 and 5 percent. The mean cumulative
abnormal accruals over the three quarters are very significant at 1 percent confidence interval, and its
median is also significant at the same level. No evidence found on earnings management at any quarter
prior to announcement for cash acquirers, or for those non-cash acquirers which have industry-adjusted
leverage ratio above the overall sample median.
As a robustness check, the analysis was repeated after redefining high and low industry-adjusted
leverage as above and below the mean instead of the median. The results of the univariate analysis
remained robust and did not change our inferences.
Regression analysis
In this section we analyze the leverage effect on premerger earnings management using ordinary
least squares regression model. More specifically we estimate the following model:
(3)

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Where EMi is the dependent variable which represents earnings management of the acquirer
measured by the cumulative abnormal return over the last three quarters prior to announcement date; LEVi
is the independent variable that represents the leverage proxy measured as the industry-adjusted debt to
equity ratio.
Recalling the findings of Erickson and Wang (1999) and Baik et al. (2007) that suggest earnings
management is positively related with the respective economic benefits that are measured by the size of
the deal, we control for RSIZEi, the relative size of the deal measured by relating the book value of total
assets of the target to the book value of total assets of the acquirer. In addition, we posit that controlling
for Sarbanes-Oxley Act 2002 (SOX) effect is relevant here for at least two reasons. First, the reliability in
financial reports is perceived as higher since SOX was enforced (Rittenberg and Miller 2005), and
second, there is substantial evidence that M&A candidates started to rely heavily on financial and legal
advisors since SOX came into effect (Madura and Ngo 2010), which could impact managements
decisions regarding discretionary accruals. Hence, we add SOXi as a dummy variable that takes 1 if the
deal was announced after SOX act and 0 otherwise.
We noted that McNichols (2000) found that highly profitable firms have higher discretionary
accruals. However, we do not control for the profitability effect at this stage since our previously
described methodology of calculating abnormal accruals is similar to Kothari et al.s (2005), which
already considers profitability by creating portfolios of firms with comparable performance within each
industry division group at the same quarter in which abnormal accruals were cross-sectionally calculated.
Table 6 presents the results of regression analysis in two panels. While Panel A of Table 6 reports
the regression results from running the model using the total sample of acquirers, Panel B of Table 6
reports the results after segregating the sample of acquirers with respect to the method of payment.
Our preliminary findings from univariate analysis in the previous section put forward two main
points; cash acquirers do not engage in earnings management and those low-leveraged acquirers are more
likely to manage earnings upward than highly leveraged ones. Therefore, it is not surprising that our
model fails to predict a relationship (Adjusted R-squared is either too low or negative) if a subsample of
cash acquirers is used to run the model as shown under the four regressions of Cash acquirers in Panel
B of Table 6, where neither F-statistic nor any of the independent variables coefficients is statistically
significant. Likewise, regression (1) in Panel A of Table 6 shows weak results, when the total sample was
tested without segregating out non-cash acquirers or including CASHi, a dummy variable to indicate
payment method.
However, after having the dummy variable CASHi included in the model when we run the
regression for the total sample, we get better results in terms of statistical significance of the model and its
parameters coefficients and in terms of goodness of fit as shown in regressions (2) to (7) in Panel A of
Table 6. The negative sign of the estimated coefficient of leverage proxy (LEVi) in regressions (2) and (3),
-2.555 and -2.554, respectively, and both significant at P-value <10 percent, suggests significant evidence
on the inverse relationship between leverage and pre-merger earnings management, even after controlling
for the relative size of the deal and SOX effects. This inference holds after replacing LEVi with a
top/bottom leverage dummy (DLEVi ) that takes 1 if the acquirers leverage proxy is above sample median
as presented under regression (6) in Panel A of Table 6.
In a more focused analysis, we run the regression model after excluding cash acquirers from the
total sample. The results again reveal very significant evidence on the negative relation between earnings
management and leverage as reported under Non-cash acquirers section in Panel B of Table 6, where
the estimated coefficient of LEVi (-4.265 with P-value < 5percent) in regression (1) remains robust (4.775 with P-value<1 percent and -5.158 with P-value<1 percent) after controlling for the relative size
and SOX effects in regressions (2) and (3), respectively. Moreover, the models goodness of fit improved
since Adjusted R-squared responded positively to these two control factors. The outcome of regression
(4), in which LEVi is replaced with DLEVi, also agrees with our inference on the inverse relation between
pre-merger earnings management and leverage of acquirers, given that the method of payment is not cash.
This brings up a natural question on the potential interaction between the two variables, i.e. the
method of payment and the leverage level, as the effect of (non-cash*low leverage) on mean earnings
management may not be additive but multiplicative too (Gujarati 2004). Therefore, we add the interaction
term CASH
i* DLEV
i, which represents a binary variable, which takes 1 the acquirer was non-cash and
ranked as low-leveraged in the sample and 0 otherwise, to regressions (4), (5) and (7) in Panel A of Table

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6. Interestingly, the interaction binary variable has a significant positive coefficient for all regressions and
improved the estimated lines goodness of fit as well. This finding suggests that the two dummy variables
CASHi and DLEVi have a multiplicative impact on earnings management.
Finally, we report a positive coefficient for RSIZEi at a statistical significance level of 5 percent
for most regressions. This evidence is consistent with the economic benefit conjecture, which suggests
that managements have less economic incentives to manipulate earnings in case of relatively small noncash deals, provided that inflating the reported earnings is not costless (Erickson and Wang 1999; Botsari
and Meeks 2008). We report that the coefficient of SOXi unexpectedly has a positive sign and shows
statistical significance.

SUMMARY AND CONCLUDING REMARKS

The main aim of this paper is to contribute to the ongoing debate over the implications of
leverage on managements accounting discretionary power. Specifically, we examine how leverage may
impact managements discretionary power over earnings whereas, unlike prior studies in this particular
area, we employ an experimental setting that ensures we examine firms with homogeneous motives to
manage their earnings. Noting that relevant literature is split regarding the direction of the impact of
leverage on earnings management was our motive to do this study. Firms with high leverage may wish to
manipulate accruals to manage earnings in order to keep their financial reports in accordance to debt
contractual agreements and creditors requirements (Mohrman, 1996; Gu et al. 2005). Against this, high
leverage could mean higher governance and better monitoring that may restrict the discretionary power of
managers to manage earnings (Iturriaga and Hoffmann 2005). We measure earnings management using
an industry-performance matched model similar to Louis (2004) and Kothari et al.s (2005) method over
the last three quarters prior to announcement. Our analysis employs a sample of acquiring firms where we
differentiate acquirers with respect to their method of payment by either using a dummy variable or
segregating the total sample. The splitting procedure is common in literature when examining the
acquirers motive to manage earnings prior to M&A activity.
Similar to the results that have been consistently documented by previous studies such as
Erickson and Wang (1999), Botsari and Meek (2008) and Gong et al. (2008), we report upward earnings
management practices by non-cash acquirers prior to deals announcement dates. After splitting the
sample into above and below the median value of the industry-adjusted leverage proxy, only the lowleverage group of non-cash acquirers shows significant evidence of earnings management. This finding is
supported by our regression analysis, which provides evidence that the inverse relation between earnings
management and leverage is very significant. The evidence holds after replacing the leverage proxy with
the high-low leverage dummy, as well as after controlling for other factors like the relative size of the
deal and new legislations represented by SOX. Unlike non-cash acquirers results, no evidence was found
of earnings management by cash acquirers as they lack the economic incentive. Therefore, it was not
surprising that testing the relationship between earnings management and leverage in this particular
sample actually did not reveal any significant results, and the model could not predict any relation.
Although testing the relationship between the method of payment in M&A on pre-merger
earnings management by acquirers is not the main contribution in this study, it is needed to set up the
precondition for examining the relationship between leverage and earnings management by holding the
sample firms motive to manage earnings.
Given this experimental setting, we provide significant evidence on the inverse relationship
between leverage and premerger earnings management. We document that debt creation is more likely to
restrict firms ability to inflate their discretionary accruals, if it is high in relation to their industries; at
times those firms have the economic incentive to manipulate their accruals. Our analysis also indicates
that payment method and leverage have a multiplicative effect as well as an additive effect on upward
earnings management. The importance of our findings does not only stem from being consistent with
Jensens (1986) control hypothesis, but also because they suggest that testing the control hypothesis under
the economic incentive conditions would provide more relevant results. From the perspective of
regulators like the Securities and Exchange Commission (SEC), such evidence on earnings management
and its influencing factors helps in directing accounting standards enforcement that improves the
credibility of corporate reports.

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Since the main concern of this study is the impact of debt creation governance, further research
might consider other corporate governance indicators in a similar research design. Future studies also
might replicate the study using different event-based samples consisting of firms with motives to manage
their earning.

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Table 1- Sample Characteristics

The following table presents, in Panel A, the distribution of the overall sample by year in which the deal was
announced. The final sample of overall acquirers comprises 661 firms between 1999 and 2008 inclusive. The sample
was initially selected from Thomson One Banker then we require that sample firms have accounting data on
COMPUSTAT. The following table also shows, in Panel B, how the sample is distributed on industry sector divisions
and major groups, according to acquirers SIC. Moreover, the following table presents the distribution of the sample
by the method of payment used in the respective deal.
Panel A: Distribution of acquirers by year and payment method
Total
Non-cash acquirers
Cash acquirers
Freq Percent
Freq Percent
Freq Percent
1999
68
10.3
52
12.5
16
6.6
2000
111
16.8
80
19.2
31
12.7
2001
97
14.7
68
16.3
29
11.9
2002
62
9.4
36
8.6
26
10.7
2003
62
9.4
39
9.4
23
9.4
2004
57
8.6
36
8.6
21
8.6
2005
62
9.4
34
8.2
28
11.5
2006
55
8.3
25
6.0
30
12.3
2007
55
8.3
30
7.2
25
10.2
2008
32
4.8
17
4.1
15
6.1
Total
661
100
417
100
244
100

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Table 2 - Sample Characteristics (Continued)

Panel B: Distribution of acquirers by industry

SIC
10-14
10
13
20-39
20
21
25
26
27
28
32
33
34
35
36
37
38
39
40-49
42
48
49
50-59
50
51
54
58
59
70-89
70
73
78
79
80
87

Industry Division and Major Group

Mining
Metal mining
Oil & gas extraction
Manufacturing
Food & kindred products
Tobacco products
Furniture & fixtures
Paper & allied products
Printing & publishing
Chemicals & allied products
Stone, clay & glass products
Primary metal industries
Fabricated metal products
Industrial machinery & equipment
Electronic & other electric equipment
Transportation equipment
Instruments & related products
Misc. manufacturing industries
Transportation, Communications,
Electric, Gas and Sanitary Services
Trucking and warehousing
Communications
Electric, gas & sanitary services
Retail Trade
Wholesale trade-durable goods
Wholesale trade-nondurable goods
Food stores
Eating & drinking places
Miscellaneous retail
Services
Hotels & other lodging places
Business services
Motion pictures
Amusement & recreation services
Health services
Engineering & management services

Total

Journal of Financial and Economic Practice

Total
Freq Percent
47
7.11
5
0.76
42
6.35
533
50.68
15
2.27
1
0.15
1
0.15
1
0.15
1
0.15
75
11.35
1
0.15
7
1.06
6
0.91
59
8.93
85
12.86
11
1.66
71
10.74
1
0.15
59
3
45
11
22
6
1
1
1
13
197
1
164
3
3
11
16
661

8.93
0.45
6.81
1.66
3.33
0.91
0.15
0.15
0.15
1.97
29.80
0.15
24.81
0.45
0.45
1.66
2.42
100

Non-cash
acquirers
Cash acquirers
Freq Percent
Freq Percent
38
9.11
9
3.69
5
1.2
0
0
33
7.91
9
3.69
191
45.80
144
59.01
5
1.2
10
4.1
1
0.24
0
0
0
0
1
0.41
1
0.24
0
0
0
0
1
0.41
50
11.99
25
10.25
1
0.24
0
0
3
0.72
4
1.64
3
0.72
3
1.23
28
6.71
31
12.7
56
13.43
29
11.89
3
0.72
8
3.28
40
9.59
31
12.7
0
0
1
0.41
40
1
33
6
13
5
1
1
0
6
134
1
113
1
2
6
16
417

9.60
0.24
7.91
1.44
3.12
1.2
0.24
0.24
0
1.44
37.84
0.24
27.1
0.24
0.48
1.44
3.84
100

19
2
12
5
9
1
0
0
1
7
63
0
51
2
1
5
4
244

7.79
0.82
4.92
2.05
3.69
0.41
0
0
0.41
2.87
25.82
0
20.9
0.82
0.41
2.05
1.64
100

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Table 3- Descriptive Statistics

The following table presents the descriptive statistics for the overall sample (661 acquirers) and sub-samples (cash
acquirers of 244 and non-cash acquirers of 417). Panel A of the following table reports the results for all acquirers
aggregated, and the results of acquirers by method of payment used in the respective deal. Panel B reports the
descriptive statistics for the 417 non-cash acquirers in a more detailed analysis, where non-cash acquirers are
segregated into Low and High Leverage based on their industry-adjusted leverage proxy rank in the sample. Total
assets, Total sales and Deal value are in million USD. Return on equity is net income divided by book value of total
stockholders equity. Debt to equity ratio is total liabilities divided by book value of total stockholders equity.
Industry-adj leverage is debt to equity ratio of acquirer divided by industry-average debt to equity of universe firms in
the year of deal announcement.
Panel A: Descriptive statistics of all acquirers by payment method
Total
Non-cash acquirers
Cash acquirers
(N = 661)
(N=417)
(N=244)
Mean Median STD
Mean Median STD
Mean Median STD
Total assets
9014.4 1269.3 27574.5 7333.9
834.7 30261.1 11891.2 2427.3 21998.9
Total sales
5806.2
856.2 12946.1 4053.2
491.0 11269.9 8799.7 2008.2 14949.2
Deal value
1543.1
227.0 5661.9 2042.4
259.7 7007.3
689.7
189.9 1359.9
Return on equity
-0.0504 0.0449 0.7564 -0.1159 0.0268 0.9432 0.0608 0.0687 0.1255
Debt to equity ratio
0.4390 0.4241 0.2612 0.4387 0.3972 0.2955 0.4395 0.4550 0.1900
Industry-adj leverage
0.2922 0.1886 0.2824 0.2900 0.1790 0.2873 0.2960 0.2135 0.2744
Panel B: Descriptive statistics of non-cash acquirers by leverage level
Total
Low Leverage
High Leverage
(N=417)
(N=209)
(N=208)
Mean Median STD
Mean Median STD
Mean Median STD
Total assets
7333.9
834.7 30261.1 2700.4
370.9 6981.8 12453.9 1592.4 42984.1
Total sales
4053.2
491.0 11269.9 1799.3
203.5 4920.4 6538.7
929.9 15213.3
Deal value
2042.4
259.7 7007.3 1284.0
162.3 4849.6 2816.1
460.9 8785.4
Return on equity
-0.1159 0.0268 0.9432 -0.1971 0.0116 1.2779 -0.0271 0.0318 0.2559
Debt to equity ratio
0.4387 0.3972 0.2955 0.3218 0.2724 0.2064 0.5673 0.5361 0.3252
Industry-adj leverage
0.2900 0.1790 0.2873 0.0848 0.0770 0.0496 0.5157 0.4336 0.2709

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Table 4- Abnormal Accruals of the Total Sample by Method of Payment

The following table presents mean and median abnormal accruals percentages for acquirers over three quarters
preceding the deals announcement date. Abnormal accruals are calculated using industry-performance-matched
abnormal accruals models. The table demonstrates the results of t-test and Wilcoxon-Z test in parentheses. The tests
were applied for mean and median values, respectively. The results are shown for the overall sample of acquirers and
for each sub-sample by the method of payment. The symbols (*), (**) and (***) denote confidence interval of 10, 5
and 1 percent, respectively, in two-tailed test.

Abnormal Accruals
Quarter t-1
Quarter t-2
Quarter t-3
Cumulative

Total
(N = 661)
Mean
Median
(t-value) (Wilcoxon-Z)
0.3224
0.0578
(1.53)
(0.967)
0.3952**
0.0526*
(1.96)
(1.767)
0.1772
0.0563
(0.76)
(0.781)
0.8589**
0.1133*
(2.20)
(1.91)

Non-cash acquirers
(N=417)
Mean
Median
(t-value) (Wilcoxon-Z)
0.3941
0.0578
(1.36)
(1.306)
0.5246*
0.0525**
(1.82)
(2.146)
0.3101
0.0563
(0.91)
(1.106)
1.1378**
0.1132
(2.07)
(0.405)

Cash acquirers
(N=244)
Mean
Median
(t-value) (Wilcoxon-Z)
0.0479
0.0469
(0.14)
(-0.232)
0.0849
-0.054
(0.31)
(-0.110)
0.1118
-0.017
(0.37)
(-0.241)
0.2796
-0.717
(0.53)
(-0.758)

Table 5- Abnormal Accruals of the Total Sample by Leverage Level

The following table presents mean and median abnormal accruals percent for acquirers over three quarters preceding
the deals announcement date. Abnormal accruals are calculated using industry-performance-matched abnormal
accruals model. The overall sample is subdivided in this table into low and high leverage based on the acquirers
rank in the sample with respect to the industry-adjusted leverage ratio. The table demonstrates the results of t-test
and Wilcoxon-Z test in parentheses. The tests were applied for mean and median values, respectively. The symbols
(*), (**) and (***) denote confidence interval of 10, 5 and 1 percent, respectively, in two-tailed test.

Abnormal Accruals
Quarter t-1
Quarter t-2
Quarter t-3
Cumulative

Low leverage
(N=331)
Mean
Median
(t-value)
(Wilcoxon-Z)
0.667*
-0.0662
(1.88)
(0.956)
0.9128***
0.1486*
(3.13)
(1.669)
0.4936*
0.0074
(1.66)
(0.361)
1.9848***
0.426**
(3.41)
(2.522)

Journal of Financial and Economic Practice

High leverage
(N=330)
Mean
Median
(t-value)
(Wilcoxon-Z)
-0.088
0.0735
(-0.3)
(-0.055)
-0.281
0.053
(-0.91)
(-0.548)
0.0604
0.0585
(0.15)
(-0.871)
-0.433
0.0620
(-0.759)
(-0.280)

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Table 6- Abnormal Accruals by Leverage level vs. Method of Payment

The following table presents mean and median abnormal accruals percent for acquirers over three quarters preceding
the deals announcement date. Abnormal accruals are calculated using industry-performance-matched abnormal
accruals model. The table reports results per payment method sub-samples after subdividing the overall sample into
low and high leverage based on the acquirers rank in the sample with respect to the industry-adjusted leverage ratio.
The table demonstrates the results of t-test and Wilcoxon-Z test in parentheses. The tests were applied for mean and
median values, respectively. The symbols (*), (**) and (***) denote confidence interval of 10, 5 and 1 percent,
respectively, in two-tailed test.
Low leverage
High leverage
Non-cash acquirers
Cash acquirers
Non-cash acquirers
Cash acquirers
(N=232)
(N=99)
(N=185)
(N=145)
Mean
Median
Mean
Median
Mean
Median
Mean
Median
(Wilcoxon(Wilcoxon(Wilcoxon(Wilcoxon(t-value)
(t-value)
(t-value)
(t-value)
Abnormal Accruals
Z)
Z)
Z)
Z)
0.973** 0.090
0.0241
-0.499
-0.214
-0.0246
0.1603
0.2580
Quarter t-1
(2.09)
(1.526)
(0.05)
(0.667)
(-0.6)
(0.141)
(0.31)
(0.074)
1.2537*** 0.5514** 0.2351
-0.3475
-0.461
-0.1242
0.0503
0.4362
Quarter t-2
(3.15)
(2.55)
(0.66)
(0.995)
(-1.12)
(0.199)
(0.11)
(1.218)
0.9903** 0.1012
-0.513
-0.0765
-0.357
0.0687
0.7693
0.0220
Quarter t-3
(2.59)
(0.874)
(-1.16)
(0.701)
(-0.63)
(0.612)
(0.79)
(0.621)
3.0281*** 0.9903*** -0.339
-0.7654
-1.317*
-0.1550
1.137
0.5752
Cumulative
(4.02)
(3.605)
(-0.43)
(1.277)
(-1.67)
(0.191)
(1.53)
(0.798)

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Table 7- Regression Analysis of Acquirers Premerger Three-Quarter-Cumulative

Abnormal Accruals
The following table presents the results of ordinary least squares regressions of acquirers premerger cumulative
abnormal accruals, which are calculated using industry-performance-matched abnormal accruals model. The table
reports results per payment method sub-samples. DLEVi is a dummy variable that takes 1 if the acquirer has industryadjusted leverage ratio above sample median and 0 otherwise, CASHi is a dummy variable that takes 1 if the acquirer
offered cash to finance the deal and 0 if stocks were included in the offer, CASH
i* DLEV
i is a binary interaction term
that takes 1 the acquirer was non-cash and ranked as low-leveraged in the sample and 0 otherwise, LEVi is the
acquirers industry-adjusted leverage ratio, RSIZEi is the relative size of the deal measured by relating the book value of
total assets of the target to the book value of total assets of the acquirer and SOXi is a dummy variable that takes 1 if the
deal was announced in the post Sarbanes-Oxley era and 0 otherwise. Numbers in parentheses represent p-values in twotailed tests. The symbols (*), (**) and (***) denote confidence interval of 10, 5 and 1 percent respectively.

Panel A: Regression results of the total sample

(1)
1.514**
(2.62)

Constant

(2)
0.821
(-1.12)

(3)
0.141
(0.17)

-0.1447
(-0.16)

-0.287
(-0.31)

-2.555*
(-1.85)
1.9529**
(-2.41)

-2.554*
(-1.86)
1.857**
(2.30)
1.430*
(1.71)
661
3.05**
0.0172
0.0206

DLEVi
CASHi
CASH
i*DLEV
i
-2.238
(-1.63)

LEVi
RSIZEi
SOXi

661
2.66
0.1034
0.0042

N
F-statistic
P-value
Adj R2

661
3.08**
0.0276
0.0158

Total sample
(4)
(5)
2.462*** 1.606**
(3.62)
(2.06)
-3.055*** -3.276***
(-3.01)
(-3.22)
-2.217*
-1.959
(-1.8)
(-1.55)
3.362*
3.743**
(1.92)
(2.12)

1.853**
(2.33)

661
3.24**
0.022
0.0166

661
4.09***
0.0029
0.0309

(6)
0.400
(0.47)
-1.977**
(-2.37)
-0.263
(-0.28)

(7)
0.849
(0.99)
-3.428***
(-3.37)
-2.470*
(-1.92)
4.423**
(2.47)

1.739**
(2.17)
1.346*
(1.63)
661
3.60***
0.0068
0.0261

1.738**
(2.19)
1.733**
(2.05)
661
4.14***
0.0011
0.0389

Panel B: Regression results after segregating the sample based on payment method
Non-cash acquirers
Constant

(1)
(2)
2.291*** 1.399*
(3.02)
(-1.72)

DLEVi
LEVi

-4.265**
(-2.33)

RSIZEi
SOXi
N
F-statistic
P-value
Adj R2

417
5.44**
0.0205
0.0165

(3)
0.4115
(0.42)

(4)
(1)
0.606
-0.260
(0.61)
(-0.33)
-3.474***
(-3.09)
-4.775*** -5.158***
2.120
(-2.62)
(-2.79)
(1.16)
2.05**
1.956** 1.764*
(-2.24)
(2.14)
(1.95)
2.244** 2.222**
(1.99)
(1.98)
417
417
417
244
5.22*** 4.84*** 5.43*** 1.35
0.006
0.0027
0.0012
0.2473
0.0314
0.0425
0.0486
0.0027

Journal of Financial and Economic Practice

Cash acquirers
(2)
-0.645
(-0.8)

(3)
-1.173
(-1.09)

2.319
(-1.28)
0.644
(-0.25)

2.673
(1.42)
0.242
(0.09)
0.825
(0.74)
244
0.86
0.4647
-0.0034

244
1.02
0.364
0.0003

(4)
-0.739
(-0.64)
0.674
(0.60)

1.272
(0.51)
0.639
(0.56)
244
0.3
0.8233
-0.0167

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