This study examines the role of earnings management in the relationship between firm performance and capital structure, dividing earnings management into discretionary and nondiscretionary accruals to test established theories on the capital structure. Using data on 802 companies in the member countries of the Asia-Pacific Trade Agreement (APTA), our findings reveal that, in the absence of earnings management, the relationship between the capital structure and firm performance follows the trade-off theory or the pecking-order theory. Our results are consistent with agency theory only through managers’ intervention via earnings management. In India, substantial opportunistic behavior in discretionary accruals is observed, and management seems to focus on manipulating capital structure performance in opportunistic ways. Furthermore, discretionary earnings are focused more on hiding asset inefficiency that arises from forced increases in firm size, reducing earnings risk. These practices reduce the impact of the capital structure on firm performance. This study has vital implications for debt managers and performance analysts in APTA member countries. Rather than testing the applicability in a traditional way, this study recommends dividing earnings management into discretionary and nondiscretionary accruals to test capital structure theories. Because nondiscretionary accruals play a dominant role in earnings management, firm behavior is consistent with trade-off or pecking-order theory, as seen in patterns in the relationship between the capital structure and firm performance, whereas agency theory holds only after external intervention by managers in terms of earnings management.
Earnings management has been one of the most crucial and specialized areas of research in finance for many years. The concept of earnings management1 and its measurement have been extensively studied. Studies have identified accruals as the most suitable measure of earnings management (DeAngelo, 1986, pp. 400–420; Dechow, Sloan, & Sweeney, 1995, pp. 193–225; Healy, 1985; Healy & Wahlen, 1999; Jones, 1991). Scholars understand that earnings management practices are used to fabricate firm performance, which might misguide owners or investors (Balsam, Bartov, & Marquardt, 2002; Burgstahler & Dichev, 1997a, 1997b; Chung, Firth, & Kim, 2005; Schipper, 1989; Scott, 2000; Siregar & Utama, 2008).
With the development of earnings management concepts, numerous studies have been conducted to explain its relationship with other aspects of business (Balsam et al., 2002; Chaney & Lewis, 1995; Dechow et al., 1995, pp. 193–225). However, the literature is scarce concerning the manipulation of capital structure efficiency through earnings management. The variation in the impact of the capital structure on firm performance between managed performance and unmanaged performance is still unaddressed.