How does local debt expansion affect earnings management? Evidence from China

ABSTRACT

This paper explores the impacts of local government debts (LGD) on earnings management strategy and moderation effects of internal control. Using a purpose-build database incorporating Chinese LGD and listed firms, we find that firms engage in income-increasing earnings management in response to local debt expansion. The results remain stable to endogeneity tests and various robustness checks. Furthermore, the impacts of LGD are markedly pronounced in non-SOEs, firms audited by Big 4 auditors, young and declining firms, and firms located in less-marketized regions. Moreover, this study reveals that internal control exerts moderation effects on the relation between LGD and earnings management.

KEYWORDS:

• Local government debts
• Earnings management
• Financial constraints
• Internal control

JEL CLASSIFICATION:

• G30
• G34
• H74

Highlights

• We examine the impacts of LGD on firms’ earnings management strategy.

• Listed firms engage in income-increasing earnings management in response to LGD, and the tightened financial constraints is the underlying mechanism.

• The impacts of LGD are markedly pronounced in non-SOEs, firms audited by Big 4, young and declining firms, and firms located in less-marketized regions.

• Internal control exerts moderating effects on the relation between LGD and earnings management.

CRediT authorship contribution statement

Cong Yu: Funding acquisition, Methodology, Data curation, Formal analysis, Writing – original draft, Writing – review & editing, Supervision.

Linke Hou: Formal analysis, Investigation, Writing – review & editing.

Ran Wang: Software, Visualization.

Haiyue Liu: Project administration, Software, Writing – review & editing, Supervision.

Feiyue Li: Methodology, Writing – review & editing.

Disclosure statement

No potential conflict of interest was reported by the author(s).

Supplementary material

Supplemental data for this article can be accessed online at https://doi.org/10.1080/13504851.2024.2355301.

Notes

¹ Robustness tests and heterogeneity analysis are shown in Appendix B and Appendix C in the online supplementary material, respectively.

² The more detailed conclusion, including policy implications and limitations, is shown in Appendix E in the online supplementary material.

Additional information

Funding

This work was supported by the Social Science Planning Fund Program of Shandong, China under Grant [numbers: 23DJJJ20]; and the Natural Science Foundation of Shandong, China under Grant [numbers: ZR202211210244].