A Cross-Country Study on the Relationship between Financial Development and Earnings Management

This paper investigates if the level of financial development influences accrual-based and real earnings management in an international setting. It is likely that financial development heightens the monitoring and scrutiny of accounting figures, because of strengthened laws and regulations for investor protection and by the extension, sophisticated market participants. Therefore, we first hypothesize that both accrual-based and real earnings management decrease with greater financial development. However, managers tend to apply real earnings management, instead of accrual-based earnings management, under strict accounting standards, regulations, and close scrutiny by auditors. Thus, we explore the alternative hypothesis that financial development decreases accrual-based earnings management but increases real earnings management. We examine the relationship between financial development and both types of earnings management by using 54,178 observations in 37 countries from 2009 to 2012. The results show that managers are restrained with regards to both types of earnings management under higher levels of financial development. We interpret these results as showing that (1) higher quality accounting information is needed in countries with more developed financial systems, (2) financial development disciplines managers and mitigates their incentives to manage earnings, and (3) a link between financial development and accounting institutions in each country.