statistical significance or the magnitude of the coefficients. I find that the managers’
decisions incorporating the level of EPS have a persistent effect on firms’ leverage, and the EPS effects are separate from various effects documented in prior literature.
5. Economic Mechanisms through Which EPS Effect on Capital Structure
Thus far, this study has shown the important effect of EPS level on firms’ capital structures. I now conduct additional analyses to enrich my findings. I begin with a brief discussion of the potential mechanisms behind the estimated effect of EPS on capital structures, which I use to guide my subsequent empirical analysis.
5.1. Potential mechanisms of the negative effect of EPS on capital structures
Jensen and Meckling (1976) and Smith and Watts (1982) suggest that managers' equity incentives − arising from stock-based compensation and stock ownership − better align the interests between managers and shareholders.9 These equity incentives, however, motivate these managers to increase the value of the shares because managers with high equity incentives are more likely to sell shares in the future. Given that the capital market uses current earnings to predict future earnings when pricing firm equity, these managers are expected to manage earnings to keep the short-term stock price high (Stein 1989).
Indeed, Cheng and Warfield (2005) find evidence supporting the positive effect of equity incentives on earnings management. They define CEO equity incentives as the various stocks and options owned by the CEOs as a percent of total shares outstanding, and find that CEO equity incentives increase the likelihood of earnings management. Other studies also show the relationship between earnings management
9 Lambert and Larcker (1987), Morck, Shleifer, and Vishny (1988), Hanlon, Rajgopal, and Shevlin (2003), among others examine the association of managerial ownership and stock-based compensation with future firm performance and find evidence consistent with the incentive-alignment effect of these equity incentive elements.
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and stock compensation through stock options (Baker et al., 2003; Bartov and Mohanram, 2004; Kwon and Yin, 2006). Because the negative relationship between EPS and capital structures is the result of EPS management via actions that have the opposite effect of equity offerings, such as share repurchases, and given prior studies’
findings that equity incentives induce managers to engage more in earnings management, I expect equity incentives to strengthen the negative impact of EPS on debt ratios. That is, the effect of EPS on capital structures is more pronounced when the CEO’s potential total compensation is more closely tied to the value of stock and option holdings.
Stein (1989) also suggested that earnings management can be a function of governance. Stein develops a model of inefficient managerial behavior and suggests that managers engage in costly behaviors to improve short-term accounting earnings to thereby induce the market to predict higher future earnings. Furthermore, the weight the manager places on short-term accounting earnings increases when the threat of a takeover (which threat leads to better external corporate governance) becomes stronger. In sum, corporate governance mechanisms can improve managerial performance, but may also encourage managers to manipulate current financial statement earnings.
A limited empirical literature has tested theories related to the Stein (1989) hypothesis that corporate governance increases focus on short-run accounting earnings. Actually, the limited number of papers discussing the influence of corporate governance on earnings management contradicts Stein's hypothesis.10 Leuz, Nanda, and Wysocki (2003) examine systematic differences in earnings management across 31 countries and find that strong corporate governance, marked by shareholder rights, limits managers’
acquisition of private control benefits, and thus reduces the incentives for managers to engage
10 We focus on the literature employing shareholder right as an indicator of corporate governance.
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factors associated with firms that use share repurchases to manage EPS and find that strong corporate governance discourages repurchase-based earnings management.A recent paper by Ohrn (2014), however, finds that earnings management behavior is concentrated among firms with strong corporate governance, which is consistent with the hypothesis of Stein (1989). Ohrn indicates that one of the reasons why empirical analyses have failed to confirm Stein’s hypothesis is that the levels of corporate governance and earnings management behavior are potentially determined simultaneously and he thus relies on a corporate tax policy, “bonus depreciation”, to address the issue.11 Ohrn finds that the investment behavior of strongly governed firms is less responsive to bonus depreciation, which is interpreted as evidence that corporate governance mechanisms encourage managers to focus on current financial statement earnings at the expense of long-run profits. Given the ambiguous findings on the influence of corporate governance on earnings management in previous literature, how corporate governance impacts the relationship between EPS and capital structures is therefore an empirical issue.
5.2. Empirical results
To shed light on the potential mechanisms behind the negative influence of EPS on leverage, I examine the heterogeneity in the coefficient on EPS, β, from equation (1). Specifically, I rank three groups of firms based on relevant variables and focus on samples within the lower and upper thirds of each relevant variables’ distribution.
11 While bonus depreciation effectively increases the economic value of investment projects, it leaves the accounting earnings associated with any potential project unchanged. For managers that seek to maximize the economic value of the firm, bonus depreciation provides strong incentive for increased investment. In contrast, for managers that seek to maximize only accounting earnings, then bonus depreciation has no effect on their investment behavior. Therefore, the absence of response (or under-response) to the policy is evidence of earnings management. Ohrn’s (2014) research design avoids the simultaneity complications under the plausible assumption that corporate governance decisions are not made based on an investment response to the tax policy.
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In table 9, I examine whether equity incentives strengthen the negative impact of EPS on leverage. The sample here includes all firm-years with data on CEOs' stock-based compensation and ownership available from the Standard & Poor's ExecuComp database for the period from 1992 to 2012, aligning with the start year of the database.13 Following Berger, Ofek, and Yermack (1997) and Cheng and Warfield (2005), I use the share ownership (SHR_OWN), the unexercised options ownership (OPT_OWN), the unexercised exercisable options ownership (OPT_EXER_OWN), and the estimated value of in-the-money unexercised unvested options (OPT_ITM_V) by the CEO of a firm as the level of equity incentives. I run regressions on the low and high thirds of the distribution of these variables, respectively.
[Table 9 to be inserted here]
The results in table 9 show that all the coefficients on EPS are negative, but only those estimated based on subsamples in firms with high equity incentives are significantly different from zero (with one exception for the subsample divided by OPT_ITM_V. In addition, the coefficients on EPS based on the high equity incentives subsamples are many times in magnitude as compared to the low equity incentives subsamples, and the t-test for the difference in the coefficients on EPS based on high and low thirds subsamples respectively is negative and significant at the 0.01 level.
Overall, I find that the equity incentives strengthen the negative influence of EPS on
12 In this subsection, we show the results of using the changes in book leverage as dependent variable and basic EPS (EPSPX) as independent variables. We also examine the robustness of my results to changes in the measure of leverage and EPS, such as market leverage and diluted EPS (EPSFX) respectively.
13 We have checked the significantly negative effect of EPS on leverage, which is consistent with the results shown in Table 2, during the period from 1992 to 2012.
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the annual changes in debt ratios, which is consistent with the findings in prior literature that when managers’ compensation links more to stock price, they are intent on managing EPS through means that reduce outstanding shares which in turn affect capital structures.
In table 10, I examine the effect of EPS on annual changes in leverage across firms with different levels of corporate governance. I use the G-index and E-index as proxies for corporate governance, and the G-index and E-index are contained in the RiskMetrics Governance Legacy Database. In particular, Gompers, Ishii, and Metrick (2003) construct the G-index in a straightforward manner: for every firm, a point is added for every antitakeover provision that restricts shareholder rights. The score of the G-index is positively related to managerial power and inversely related to both the strength of shareholder rights and corporate governance; that is, an increase (decrease) in the G-index indicates a decrease (increase) in the strength of corporate governance.
I also use the E-index of Bebchuk, Cohen, and Ferrell (2009) to measure the strength of corporate governance, which consists of 6 of the 24 provisions used in the G-index of Gompers et al. (2003). Similar to the G-index, a high (low) E-index indicates weak (strong) shareholder rights, implying weak corporate governance in the firm. I begin the sample period from 1996 to 2009, as I require available data from RiskMetrics.14
[Table 10 to be inserted here]
Table 10 shows the regression results of equation (1) based on the bottom and top third subsamples of the G-index and E-index. I find that coefficients on EPS are both significantly negative for the estimation based on the subsamples of low and high strength of corporate governance, measured either by the G-index or E-index. A slight difference between the estimated results in these two subgroups is indicated by the
14 We have checked the significantly negative effect of EPS on leverage, which is consistent with the results shown in Table 2, during the period from 1996 to 2009.
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t-test of the difference in the magnitude of the coefficients on EPS for low and high G-index (E-index) subsamples: the coefficient on EPS based on the subsample in firms with high G-index (E-index) is significantly larger than that based on the subsample in firms with low G-index (E-index). The results provide weak evidence that EPS have more significant resulting effects on capital structures in firms with higher strength of corporate governance (lower G-Index or E-index), which to some extent supports the Stein (1989) hypothesis and Ohrn’s (2014) findings that corporate governance mechanisms encourage managers to focus on current financial statement earnings.
Overall, the results reinforce my argument that EPS influences leverage primarily through the actions that managers take to influence EPS. Thus the level of equity incentives reinforce the impact of EPS on capital structures because managers with high equity incentives are more likely to sell shares in the future and this motivates these managers to engage in EPS management to increase the value of the shares to be sold (Cheng and Warfield, 2005). The impact of corporate governance on the relationship between EPS and leverage is unclear; I find only limited evidence in support of the hypothesis that corporate governance mechanisms encourage managers to focus on current financial statement earnings.