Title

The effect of large leverage increases on opportunistic behavior and earnings management

Date of Completion

January 2005

Keywords

Business Administration, Accounting

Degree

Ph.D.

Abstract

This dissertation examines the effects of large leverage increases on opportunistic behavior and potentially associated earnings management. Jensen's (1986) control hypothesis predicts that high levels of free cash flow will increase the likelihood that managers will engage in opportunistic behavior, especially at low-growth firms. I test two hypotheses: (1) increased leverage reduces opportunistic behavior as proxied by three measures of agency costs, and (2) increased leverage reduces earnings management using three accrual-based measures of managerial discretion. I find that for low-growth, high free cash flow firms, increased leverage reduces one measure of opportunistic behavior. For low-growth, high free cash flow firms, increased leverage reduces earnings management for two accrual-based measures. These results contribute to the literature that examines the effect of opportunistic behavior on earnings management. In subsequent analysis, I examine cross-sectional differences in accrual measures and find that firms that undergo large leverage increases have significantly lower ending accrual levels than firms that remain consistently highly levered. This effect holds for firms with initially high levels of free cash flow. This analysis contributes to the literature that examines the leverage/earnings management relation. ^