Local government debt and earnings management: evidence from China

Purpose This study examines the effect of local government debt (LGD) on corporate earnings management using 25,624 firm-year observations from 2007 to 2019. Design/methodology/approach Pooled ordinary least squares (OLS) regression is used to examine the impact of LGD on earnings management. A difference-in-differences (DID) method is also used to alleviate potential endogeneity. Findings Results show that LGD motivates firms to increase earnings management, especially income-decreasing earnings management. Findings are robust to DID method and robustness tests. Heterogeneity analyses show that the positive effect of LGD on earnings management is pronounced in firms with political dependence and moderated by external governance mechanisms. Further discussions indicate that tax enforcement is an underlying channel for LGD to affect earnings management. Firms engage in downward real earnings management by increasing their abnormal discretionary expenditures and higher LGD leads to a greater book-tax difference in those firms that manipulate income-decreasing earnings management. Originality/value This study contributes towards examining the political costs hypothesis, the microeconomic effects of LGD and the determinants of earnings management.