Abstract:
Purpose
Earning management is practice of manipulation of earnings to create a positive
business outlook with the ultimate goal ofminimizing financial costs. This study examines the
relationship between earning management and cost of capital while controlling for ROA, BtM
and firm size, to analyze whethersuch practices accomplish the initial expectations oflowered
cost of capital.
Methodology & Design
The paper targets the cement sector of Pakistan Stock Exchange. The data constitutes
a cross section ofseven random firms ofthe sector from a total ofseventeen. The hypothesis
ofthe study has been tested through statistical model of PEGLS auto regressive model with
REM. For robustness check, another variable of DtE (financial risk measure) was added into
the model as control variable.
Findings
The results show that discretionary accruals have a strong negative relationship with
cost of capital (p = 0.0052) which goes on to become strongly positive (p = 0.0013) in three
years’ time. The two respective iterations showed overall model significance of0.003896 and
0.052 which indicates that the control variables effectively controlled results while DA
produced negative relationship with cost of capital, however, the control became weaker while
producing positive relationship after three years due to importance oflagged effects. But the
relationship between cost of capital and DA remained significant and became positive.
Limitations
The limitations ofthis study include possible ineffectiveness ofproxy selection for risk
free rate as Pakistan is a developing economy and time constraint.
Recommendations
Managers should rethink their myopic behaviors related to reducing costs. Investors
should understand the impact oftheir behaviors on firms and capital market. Lastly, researchers
are recommended to use alternative proxies and perform research in different settings to
understand the dynamics ofnature ofstudied variables.
