Equity-Hungry Firms Inflate, Debt-Laden Firms Restrain Reveals IIM-I Study

Indore (Madhya Pradesh): A study by Indian Institute of Management Indore has revealed that financial constraints affect earnings management in opposite ways depending on whether firms rely on equity or debt.

Equity-constrained firms, typically younger and R&D-driven, face higher information gaps with investors and are more likely to inflate earnings to secure funding.

In contrast, debt-constrained firms, which are larger and more leveraged, avoid manipulation to prevent covenant breaches and higher borrowing costs.

The research also found that investment opportunities amplify these tendencies, highlighting that financing choices directly shape reporting behaviour.

The study, conducted by Prof Pradip Banerjee of IIM Indore, has shed fresh light on how different types of financial market pressures shape corporate reporting behaviour. Published in the Australian Journal of Management, the research highlighted that constraints in equity markets and debt markets push firms in fundamentally different directions when it comes to managing earnings.

Analyzing 46,149 firm-year observations across 7,096 US-listed companies between 1997 and 2015, the study found that equity-constrained firms are more likely to manipulate earnings, while debt-constrained firms tend to adopt more conservative reporting practices.

To arrive at these insights, Banerjee applied a novel Financial Statement Divergence (FSD) score, based on Benford’s Law, which provides a more reliable way of detecting financial statement manipulation than earlier residual-based models.

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The research underscores that financing choices—whether through equity or debt—directly influence managerial incentives. Equity-constrained firms, often younger and more R&D-intensive, face greater informational gaps with investors. To sustain access to external funding, managers in such firms are more prone to inflate earnings, signaling financial strength even under resource strain. “For equity-constrained firms, the temptation to present stronger numbers is significant, but the long-term credibility of reporting is at stake,” Banerjee said.

Debt-constrained firms, by contrast, face close monitoring from creditors and are bound by stringent contractual obligations. The study revealed that these firms generally avoid aggressive earnings management, fearing covenant violations and higher borrowing costs. Such firms, typically larger and more leveraged, adopt conservative accounting practices to maintain creditor trust and financial stability.

Importantly, the study highlighted the moderating role of growth opportunities. Firms with strong investment prospects but limited equity financing are especially prone to earnings manipulation, while those with similar prospects but high debt exposure lean toward caution. This finding suggests that investment strategy and financing structure must be viewed together, rather than in isolation.

The study also offers governance insights. Boards of equity-constrained firms are advised to enhance audit oversight and disclosure transparency, while managers of debt-constrained firms should prioritize compliance and clear communication with creditors. Prof. Banerjee emphasises that “one-size-fits-all” governance mechanisms are ineffective, given the different pressures exerted by equity and debt markets.

For policymakers, the research provides a more nuanced framework to understand corporate reporting behaviors. By distinguishing between equity and debt constraints, regulators can design oversight measures that address market-specific risks.