The Effects of Earnings Quality and Leverage Deficit on Financing Policy

Abstract

The paper examines the relationship between earnings quality and leverage deficit, as well as the impact of earnings quality on equity financing choice for under- and over-leveraged firms. Considering external financing and its components, equity and debt, and both accrual-based and real earnings management, we further examine the effect of earnings quality and leverage deficit on financing choice and activities.

The results show that the firm with leverage deficits has a higher earnings quality. The under-leveraged firm with worse earnings quality and the over-leveraged firm with better earnings quality tend to choose equity financing. Moreover, the firm prefers to engage in real earnings management before external financing or debt financing, but the firm tends to conduct accrual-based earnings management before choosing equity financing. Compared with the under-leveraged firm, the over-leveraged firm has more difficulty engaging in real earnings management before debt financing choice and activities; however, the over-leveraged firm has more difficulty engaging in accrual-based earnings management before choosing equity financing.