2.1 Earnings Management
One of the first definitions of EM was given by Schipper (1989), who mentioned EM is a deliberate attempt to influence the external financial reporting process with the goal of gaining a personal advantage. Healy and Wahlen (1999) mentioned that EM occurs when managers use discretion in financial reporting and transaction structuring to change financial reports to deceive some stakeholders about their firm’s true economic performance or influence the results of the contracts based on reported accounting numbers (Höglund, 2012).
EM can be both opportunistic and beneficial (Jiraporn et al., 2008). However, when managers of a firm utilize EM opportunistically for their self-interest rather than the benefit of stockholders, the result is detrimental to the firm. Meanwhile, when managers exercise discretion over earnings within GAAP to protect shareholders’ interests, it is regarded as ethical and advantageous. Additionally, EM is morally right and helpful in informing the public and stockholders about private information (Nia et al., 2015). EM can be defined as a manipulation of earnings using the discretion granted by corporate laws and accounting standards and/or restructuring activities, which predict that firm value is not negatively impacted. Generally, the previous definition split EM into two types. First is “Paper EM”, which depends on manipulating earnings using discretion granted by corporate laws and accounting standards that rely on accounting estimates, policies and accruals. According to Commerford et al. (2016), it can also be known as “accounting EM”. Accounting EM helps in comprehending accounting accruals and their impact on a firm’s performance measurement (Schipper, 1989). The second type of EM is “Real EM”, which refers to the manipulation of earnings by employing restructuring activities to positively impact a firm, such as by expanding product lines, or show a neutral impact on expected firm value, such as by accelerating the time of sales. Real EM considers the management of earnings through strategic timing of operating, financing and investing decisions. In other words, a powerful instrument for real EM practice is the timing of revenue-generating activities and reporting ( Nour, et al., 2022).
Many reasons encourage firms to engage in EM. They allegedly use it to smooth earnings, restrain debt covenants, increase share prices, boost management wealth, bargain with labor unions, execute management buyouts and implement bonus plans. Moreover, compensation plans and the value of executives’ stock and stock options are the main incentives that EM provides (Burilovich & Kattelus, 1997; Oberholzer-Gee & Wulf, 2012).
2.2 Capital Structure
Capital structure can be defined as the source of financing employed by a firm to finance its assets, growth opportunities and daily operations (Martin & Baker, 2011). There are many measures for capital structure which represented by “leverage”. Leverage is measured using four distinct methods by (Rajan & Zingales, 1995).The ratio of total debt to total assets is the original and most general definition of leverage. Second, the ratio of short/long term debt to total assets. Third, total debt to net assets. Finally, total debt to capital, where capital represents total debt in addition to equity. This ratio focuses on “capital employed”, therefore it most accurately depicts the impact of prior financial choices. Additionally, it most immediately links to the agency issues with debt.
Corporate finance still lacks a unified capital structure theory, even 50 years after Modigliani and Miller (1958). Although the present theories are useful as analytical tools for analyzing the empirical results, none of them is able to fully account for the decision to choose a capital structure. Each theory can explain certain stylized facts but not others. According to the literatures, the most reliable indicators for describing corporate leverage are the following: profitability, size of firm, tangibility, median industry leverage, expected inflation rate, and market-to-book ratio. These are the "core leverage factors" that determine capital structure decisions, according to ( Frank & Goyal, 2009)
To clarify, according to the capital structure theory, the value of a firm increases if the capital structure includes a high amount of debt due to the tax benefits afforded by the debt (Modigliani & Miller, 1958, 1963). The authors believe that if the neutrality theory is contested, two competing theories must be considered while choosing external financing: the pecking order theory and the trade-off theory. The first theory implies that due to information asymmetry, firms are required to finance in a hierarchical order. Myers and Majluf (1984) clarified the theory by the existence of leadership behavior. A decreasing financial hierarchy is used when managers consider the investors’ interests, which begins with using retained earnings, debt and new equity issuance, respectively. On the other hand, when managers act in their own interest, the hierarchy is altered; hence, it will first address retained earnings, followed by the issue of new equity and finally using debt to avoid its disciplinary role.
2.3 Corporate Governance
CG was first proposed by the Cadbury committee. The committee believed CG to be a system for directing, controlling and managing firms by determining the role of the board of directors and shareholders. The board of directors oversees the management of their firms, whereas the shareholders’ responsibility in governance is to select the directors and auditors and ensure that an effective governance framework is in place (Cadbury Report, 1992).
A governance system can also be defined in a broader sense as a set of complex constraints that determine granted profit by the firm in the course of relationships with stakeholders and shape the ex-post bargaining over them (Zingales, 1998). This definition encompasses rules for both determination of value addition by firms and their distribution among the stakeholders (Claessens & Yurtoglu, 2013). According to the Organization of Economic Cooperation (OECD; 2012), CG can be defined as a group of relationships between a firm’s managers, board of directors, stakeholders and shareholders. CG also encompasses the mechanism that determines a firm’s goals and provides methods for meeting those goals.
2.4 Earnings Management and Capital Structure
Many intensive managers must engage in EM due to the cost of capital. (Nikoomaram et al. 2016) and (An et al. 2016) exposed a positive significant relationship between debt ratio and discretionary accruals (EM). This result is consistent with the disciplining role of debt to minimize the agency cost of FCF when combined with the assumption that a firm’s EM reflects the agency conflicts of information asymmetry between managers and investors.
On the other hand, (Jelinek 2007) revealed a negative association between leverage and opportunistic behavior, implying that an increase in leverage leads to a decrease in managers’ opportunistic behavior and EM. Additionally, (Tahir et al.2011) examined various factors related to EM impacting the capital structure of Pakistani non-financial firms for a period of five years. The results revealed that EM represented by return on assets (ROA) had a negative impact on the gearing ratio. Hence, based on the aforementioned argument, the researchers assumes the following:
H1: A positive significant association exists between EM and DCAPS of the firm.
2.5 The Size of the Board of Directors
The responsibility of managing a firm’s activity and making strategic decisions regarding the financial mix is dependent on the firm’s board of directors. The impact of the size of the board of directors on the capital structure of a firm has been well examined in prior studies (Abobakr & Elgiziry, 2015; Alabdullah et al., 2018; Feng et al., 2020; Grabinska et al., 2021; Sheikh & Wang, 2012; Wen et al., 2002; Yusuf & Sulung, 2019). However, the empirical results for this relationship are mixed.
Wen et al. (2002); (Feng et al. 2020) proved a positive relationship between the size of the board of directors and capital structure. The authors suggested that a greater size of the board will follow a higher level of gearing policy. The authors also mentioned that when the number of directors increases, the limitation to arriving at a clear decision also increases, which is reflected in the efficiency of CG mechanisms, causing higher levels of financial leverage. Furthermore, (Sheikh and Wang, 2012) revealed a significant positive relationship between the size of the board and the debt ratio. This result was supported by the theory of resource dependency, implying that when the size of the board is greater, the ability of the board to raise funds and improve the firm’s value also rises.
On the other hand, the result of (Abobakr and Elgiziry, 2015) demonstrated a negative relationship between the size of the board and capital structure, suggesting that a large number of directors can pressurize the managers to have a low level of gearing policy and improve their firm’s performance. Moreover, (Alabdullah et al.2018) investigated the impact of two key measurements of board features on the growth and capital structure of emerging market Jordanian non-financial firms. The results showed a negative relationship between the size of the board and the debt ratio. Hence, based on the previous argument, the researchers assume the following hypothesis:
H2a: size of the board of directors has a significantly positive role in moderating the relationship between EM and DCAPS of the firm.
2.6 Board independence
Non-executive directors are an essential component of modern CG. A few studies have examined the relationship between the presence of non-executive directors and capital structure, although the pieces of evidence vary. (Wen et al. 2002) proved that the existence of non-executive directors depicted a significant negative relationship with gearing levels. A probable explanation of this finding may be that non-executive directors supervise managers more effectively, forcing managers to seek lower gearing levels to achieve superior results. Moreover, (Uwuigbe 2014) revealed a negative and significant relationship between board independence and debt-to-equity ratio.
On the other hand, (Alves et al.2015) mentioned that the higher the proportion of independent directors, the higher the reliance on external financing sources (debt) rather than internal sources (retained earnings). Moreover, Tarus and Ayabei, 2016); Ehikioya et al. (2021) found that board independence positively related to leverage. This can be supported by the agency theory, which asserts the ability of outside directors to exert pressure on and influence managers to increase debt financing to increase the firm value. Following the viewpoint of the agency theory, the researcher proposes the second hypothesis, as follows:
H2b: non-executive directors have a significantly positive role in moderating the relationship between EM and DCAPS of the firm.
2.7 Gender Diversity
Women on boards of directors tend to be more independent as they operate independently of the network. According to OECD (2012), a greater representation of female directors may introduce heterogeneity in values, beliefs and attitudes, broadening the range of perspectives in the process of decision-making. (Carter et al., 2003) Women on boards devote more time to observe the executive directors as they are more committed to attending board meetings and keeping better records than male directors (Adams & Ferreira, 2009). Many researchers have explored the impact of gender diversity on firm performance (Brahma et al., 2021; Marinova et al., 2016). Other researchers have investigated the effect of women’s presence on the value of a firm, including Isidro and Sobral (2015), who discussed whether a firm experiences economic benefits from having more women on its board of directors following the introduction of legally binding quotas for women on corporate boards in European firms by the European Commission. The results revealed that more female representation on corporate boards of major European firms indirectly increased firm value. A portion of the indirect effect is due to greater adherence to ethical standards, which accounting-based financial performance does not consider.
Additionally, previous studies have argued that moderating risky firm decisions is related to the existence of women on a firm’s board of directors because they tend to strengthen the monitoring function by considering risk averseness, which leads to decreased reliance on debt in the firm’s capital structure (Adams & Ferreira, 2009). However,( Abobakr and Elgiziry, 2015), along with Heng Teh and Azrbaijani (2012), proved that female existence on the board of directors showed an insignificant impact on CAPS. As a result, the researchers developed the following hypothesis:
H2c: female board members have a significantly positive role in moderating the relationship between EM and DCAPS of the firm.
2.8 CEO Duality
The impact of a CEO’s dual roles on a firm’s capital structure is a topic of ongoing discussion. (Zaid et al. (2019) stated that the CEO and chairman combination increases the risk of authority abuse, thereby leading to distorted managerial decisions. Thus, giving the same person both tasks might weaken the control process and pose a negative effect on a firm’s performance, which can impact its reputation of the “ability of debt-paying” in the eyes of creditors and lending institutions. In other words, due to the high perception of the risks associated with CEO duality, professional lenders will not invest in such firms. On the other hand, given that CEOs are highly skilled and knowledgeable individuals, CEO duality may increase the firm’s value. Keeping this in mind, the researcher can contend that when a firm faces a CEO duality situation, it is more likely to use an ideal level of debt in its capital structure (Mande et al., 2012). Thus, while duality is probably beneficial for some firms, separation will be advantageous for others.
However, (Agyei and Owusu ,2014); (Kyereboah and Biekpe 2006); (Tarus and Ayabei, 2016) showed that CEO duality has negative effect on financing decisions, mentioning that when a CEO also serves chairman duties, it increases the agency cost and negatively impacts the willingness of creditors to lend to these firms. On the other hand, (Dimitropoulos 2014) and (Sewpersadh 2020) proved a positive correlation between CEO duality and leverage. Based on the previous argument, the researchers assume the following hypothesis:
H2d: CEO duality situation have a significantly positive role in moderating the relationship between EM and DCAPS of the firm.
2.9 Institutional Ownership
The active monitoring hypothesis states that the presence of institutional investors can reduce the managerial moral hazard issue in a firm by closely controlling and monitoring the performance of the firm (Jensen, 1986). The presence of institutional shareholding in a firm allows it to raise long-term financing at a lower cost. First, these institutional investors serve as a source of long-term debt. Second, they act as an effective control mechanism for the firm’s strategic decisions by reducing managerial opportunism and agency costs, which leads to an increase in the confidence of investors and lenders. In other words, high institutional ownership guarantees that managers will implement corporate strategies in the best interests of the shareholders (Barclay & (Warner, 1993). Moreover, institutional investors are perceived to be more at risk than small shareholders as they hold larger ownership stakes, which also encourages them to keep a close eye on the managers.
(Kumar 2015) revealed that firms with a higher proportion of foreign ownership or a smaller proportion of institutional ownership have lower debt levels. Additionally,. (Tayachi et al. 2021) mentioned that financing choices and dividend policy for sample firms are positively impacted by institutional ownership, causing investors to decide to invest more in institutional ownership that lowers the agency cost rather than in firms with a higher percentage of managerial ownership. However, (Liao et al. 2015) proved that the adjustments of the capital structure toward a target of shareholders are encouraged by institutional ownership rather than the desired level of managers.
On the contrary, (Puspita and Suherman 2018) illustrated that institutional ownership has a significantly negative impact on the debt-to-equity ratio, as well as a negative but insignificant impact on the debt-to-assets ratio. Based on the previous argument, the researchers assume the following hypothesis:
H2e: institutional ownership has a significantly positive role in moderating the relationship between EM and DCAPS of the firm.