Earnings management prior to capital investment in Finnish SMEs

The aim of this study is to investigate whether the financing structure chosen for a capital investment, i.e. investment leverage ratio, is already reflected in the financial statement preceding the year of the investment. Earnings management related to capital investment financing is a narrow body of literature. To the knowledge of the author, there are no previous studies employing investment financing structure as a determinant of accounting choices. The test sample comprised 1159 firm years from Finnish SMEs with investments into property plant and equipment belonging to the larger half of all investments. The main analysis tested by means of OLS, whether the earnings management choices of investors deviated significantly from that of their annual industry average. As a robustness check, the analysis was repeated with two alternative approaches. The results from all the three models are substantially uniform, however only the main analysis indicated statistically significant negative relation between investment leverage ratio and earnings management of the previous fiscal year. This result is opposite to previous literature. The main contribution of this study is that it comments the previous findings from a new institutional context, which is arguably the main cause of opposite results. All in all, in the context of capital investments, Finnish SMEs appear to prefer building a reputation of credible reporting, and follow pecking order theory in their financing choices.