Compound Financial Instruments and Earnings Management: A Pecking Order Theory Perspective

Abstract

Compound financial instruments that possess both debt and equity characteristics grant an option for investors to convert the debt instrument into equity, which can ultimately impact the issuing firm’s capital structure and the wealth of existing shareholders. Consequently, firms may be incentivized to engage in earnings management even after issuing the instrument to influence outside investors’ decisions. This study investigates whether firms engage in earnings management when issuing compound financial instruments and whether this behavior aligns with their financing preferences. Using a sample of 3,567 firm-years from the Korean securities market between 2012 and 2019, our results provide empirical evidence that firms with a high preference for equity engage in positive earnings management to encourage investors to exercise their call options. Conversely, firms that prefer debt to equity engage in negative earnings management to decrease the likelihood of investors exercising their call options. These findings suggest that firms are incentivized to strategically manage earnings after the issuance of compound financial instruments in line with their financing preferences, shedding light on the relationship between earnings management and issuing compound financial instruments.