Empirical Studies in Financial Accounting

Abstract Abstract

The speed of leverage adjustment is a central issue in capital structure research, yet the role of economic freedom in explaining this speed has received limited attention in the domestic literature. This study examines the effects of economic freedom and its components on firms’ leverage adjustment speed using data from 127 firms (2,813 firm-year observations) listed on the Tehran Stock Exchange during 2002–2024. The System Generalized Method of Moments (System GMM) is employed, controlling for year and industry effects. The results show that economic freedom significantly increases leverage adjustment speed. Except for government size, all components - including legal system and property rights, sound money, international trade freedom, and credit, labor, and business regulation - have positive and significant effects. Robustness tests confirm these findings. Overall, greater economic freedom facilitates adjustment toward target leverage by reducing institutional frictions and adjustment costs, supporting trade-off theory.

Keywords: Economic Freedom, Fraser Index, Heritage Index, Leverage Adjustment Speed, Trade-off Theory.

1. Introduction

The speed of leverage adjustment is a central concept in the capital structure literature. According to the dynamic trade-off theory, firms seek to maintain an optimal leverage ratio that balances the benefits and costs of debt financing. However, adjustment costs prevent firms from instantaneously reaching their target leverage, resulting in a gradual adjustment process. The speed at which firms move toward their target leverage reflects the efficiency of this process. In recent years, researchers have increasingly emphasized the role of institutional environments in shaping corporate financial decisions. Economic freedom, as a broad measure of institutional quality, reflects the extent to which economic activities are supported by secure property rights, sound monetary policies, open markets, and efficient regulations. Despite its potential importance, limited evidence exists on how economic freedom affects leverage adjustment, particularly in emerging economies. Therefore, this study investigates the impact of economic freedom and its components on the speed of leverage adjustment among firms listed on the Tehran Stock Exchange.

2. Literature Review

The dynamic trade-off theory suggests that firms continuously adjust their capital structures toward target leverage levels. Factors that reduce adjustment costs are expected to increase adjustment speed. Economic freedom can influence this process by improving legal protections, reducing regulatory barriers, enhancing monetary stability, and facilitating access to financial resources. Prior studies have highlighted the importance of institutional conditions in corporate financing decisions. Research by Ameer (2013), Fan et al. (2012), and Aflatooni et al. (2022) suggests that institutional quality and economic environments significantly affect firms’ financing behavior. However, evidence regarding the specific role of economic freedom in leverage adjustment remains limited. Accordingly, this study examines the overall effect of economic freedom and the effects of its five components: government size, legal system and property rights, access to sound money, freedom to trade internationally, and regulation of credit, labor, and business. Based on the theoretical arguments and prior evidence, the following hypotheses are developed:

H1: Economic freedom positively affects the speed of leverage adjustment.

H2: Government size has a significant effect on the speed of leverage adjustment.

H3: Improvements in the legal system and property rights increase the speed of leverage adjustment.

H4: Greater access to sound money increases the speed of leverage adjustment.

H5: Greater freedom to trade internationally increases the speed of leverage adjustment.

H6: Better regulation of credit, labor, and business increases the speed of leverage adjustment.

3. Methodology

The study uses a sample of 127 firms listed on the Tehran Stock Exchange during 2002-2024, resulting in 2,813 firm-year observations. Firm-level data were obtained from financial statements and the Rahavard Novin database, while economic freedom data were collected from the Fraser Institute. The speed of leverage adjustment was estimated using a dynamic partial adjustment model. To address endogeneity concerns associated with dynamic panel models, the System Generalized Method of Moments (System GMM) estimator was employed. Year and industry effects were controlled for in all estimations. Book leverage was used as the primary measure of leverage. The models also included several control variables, including industry leverage, firm size, growth opportunities, profitability, asset tangibility, free cash flow, and capital expenditures. Robustness analyses were conducted using market leverage and the Heritage Foundation’s Economic Freedom Index.

4. Results

The findings indicate that firms gradually adjust their leverage toward target levels, supporting the dynamic trade-off theory. The results also show that economic freedom positively affects leverage adjustment speed, suggesting that firms operating in more economically free environments move more rapidly toward their target leverage. The analysis of individual components reveals that legal system and property rights, access to sound money, freedom to trade internationally, and regulation of credit, labor, and business all enhance adjustment speed, whereas government size has no significant effect. Robustness tests further confirm these findings. Similar results are obtained when market leverage and the Heritage Economic Freedom Index are used, indicating that the conclusions are robust to alternative measures of leverage and economic freedom.

5. Discussion

The findings support the view that institutional quality plays an important role in corporate financing decisions. From the perspective of the dynamic trade-off theory, economic freedom reduces institutional frictions and adjustment costs, enabling firms to move more efficiently toward their target capital structures. Economic freedom contributes to this process through stronger property rights, more effective legal systems, greater monetary stability, improved market access, and more efficient regulatory frameworks. These conditions facilitate financing activities and reduce the costs associated with capital structure adjustments. The results are consistent with prior studies emphasizing the role of institutional environments in corporate financial behavior, including Ameer (2013), Fan et al. (2012), and Aflatooni et al. (2022). The insignificant effect of government size suggests that the quality of institutions and market efficiency are more important than the scale of government involvement in explaining leverage adjustment dynamics.

6. Conclusion

This study examined the relationship between economic freedom and the speed of adjustment in an emerging market setting. The results indicate that economic freedom enhances firms’ ability to move toward target leverage. Among its components, legal system and property rights, sound money, freedom to trade internationally, and regulatory quality positively affect adjustment speed, whereas government size does not. The findings highlight the importance of institutional reforms aimed at strengthening property rights, promoting monetary stability, and reducing regulatory barriers. Such reforms can improve financing efficiency and facilitate capital structure adjustments. Future research may investigate the effects of economic shocks, such as the COVID-19 pandemic and economic sanctions, on leverage adjustment, as well as the roles of corporate governance, financial constraints, and economic uncertainty in shaping capital structure dynamics.

Abstract Recent research has increasingly focused on earnings management through the classification shifting of income statement items. However, domestic studies have only minimally addressed this topic. While international research has extensively examined the impact of the COVID-19 pandemic on earnings management, there is a notable lack of empirical evidence concerning Iranian firms. This study investigates the presence of earnings management through classification shifting in Iranian firms, comparing the phenomenon during the COVID-19 outbreak with other periods. The analysis utilizes data from 137 firms listed on the Tehran Stock Exchange, covering 2012 to 2023, resulting in 1,644 observations. The models are estimated using the generalized least squares (GLS) approach, controlling for year and industry effects. The findings confirm the existence of earnings management through classification shifting among Iranian firms. Moreover, the results indicate that this practice intensified during the COVID-19 pandemic compared to other years. Robustness tests, which employed different time frames for the pandemic and decile-ranked values for research variables, corroborate the study's main findings.
 

Introduction

Research on earnings management surged following Enron's collapse in 2003, focusing on accrual-based earnings management, real earnings management, and classification shifting. Managers use accruals, manipulate business activities, and reclassify income statement items to influence reported earnings. Most studies have concentrated on accrual-based and real earnings management, with limited attention given to classification shifting.
The COVID-19 pandemic profoundly impacted earnings management by increasing financial distress and firms’ reliance on external resources, thereby motivating firms to present more favorable financial images. While evidence from developed countries highlights the pandemic's impact on earnings management, research on Iranian firms remains scarce.
This study aims to fill this gap by examining classification shifting among Iranian firms and assessing the influence of COVID-19. It contributes to the earnings management literature by providing empirical evidence of classification shifting in the Iranian context. Furthermore, it enhances the existing literature on the impact of macroeconomic events and crises by demonstrating the intensifying effect of COVID-19 on classification shifting. In light of the above, the objective of this research is to examine the impact of COVID-19 on earnings management through the classification shifting of income statement items.

Literature Review

According to McVay (2006) and Saghafi and Jamalianpour (2018), managers can unexpectedly increase operating income by reclassifying operating expenses as non-operating expenses and non-operating income as operating income, thereby reporting lower non-operating income. In fact, a positive relationship between the size of the reduction in non-operating income and the increase in unexpected operating income can indicate the existence of classification shifting aimed at earnings management. On the other hand, since the phenomenon of earnings management has intensified during the COVID-19 pandemic (Deloitte, 2020; Chen et al., 2023), it is predicted that the COVID-19 outbreak will strengthen the positive relationship between the size of the reduction in non-operating income and the increase in unexpected operating income. To examine this issue, the first hypothesis of the research is formulated as follows:
Hypothesis I: With the outbreak of COVID-19, the positive relationship between the size of the reduction in non-operating income and unexpected operating income for the current year is strengthened.
There might be ambiguity regarding whether the positive relationship between reduced non-operating income and unexpected operating income is due to actual economic changes or opportunistic managerial behavior (McVay, 2006). McVay (2006) clarifies that if opportunistic classification shifting increases operating income in one year, it will not do so the following year if not repeated, leading to lower unexpected operating income. Conversely, if the change is due to real economic factors, the increase will persist. A negative relationship is expected between reduced non-operating income and changes in unexpected operating income the following year, an effect that may be intensified by COVID-19 (Taylor et al., 2023). The second research hypothesis is formulated to examine this:
Hypothesis II: With the outbreak of COVID-19, the negative relationship between the size of the reduction in non-operating income for the current year and changes in unexpected operating income for the following year is strengthened.

Methodology

In this study, data were collected from the Rahavard Novin database and Codal website and analyzed using Stata software. The generalized least squares (GLS) approach was used to estimate the models while controlling for the fixed effects of years and industries. Clustering correction at the firm level was applied to control for heteroscedasticity and autocorrelation of errors. Rank-decile values of variables were used in robustness tests to control for outliers and non-linear relationships. The statistical population included all firms listed on the Tehran Stock Exchange from 2012 to 2023, excluding those in insurance, banking, financial investment, holding, and leasing industries. Firms with fiscal years ending in March and no changes during the study period were selected, resulting in 137 firms (1,644 firm-years) across 13 industries. Data from three prior periods (2009-2011) were also used, with variables winsorized at the 1st and 99th percentiles.

Results

The results indicate that, with the outbreak of COVID-19, both the positive relationship between the size of the reduction in non-operating income and unexpected operating income, and the negative relationship between the size of the reduction in non-operating income and changes in unexpected operating income, have been strengthened. These results are consistent with the first and second hypotheses of the research, respectively.

Discussion

While academic literature often focuses on earnings management through discretionary accruals and real business activities, it has largely overlooked classification shifting. Domestic research in this area is also scarce. The first part of this study indicates that classification shifting is common among Iranian firms. Although studies in developed countries show COVID-19's impact on accrual-based and real earnings management, there is limited empirical evidence from Iran. The second part of the study reveals that classification shifting intensified during the COVID-19 pandemic, consistent with findings from Hsu and Yang (2022), Yan et al. (2022), Aljughaiman et al. (2023), and Taylor et al. (2023).

Conclusion

Given the research findings indicating the prevalence of earnings management through classification shifting and the increasing effect of COVID-19, shareholders and investors should, especially during crises, avoid behavioral consistency and anchoring on net and operating income figures. They should carefully examine classification shifts in financial statements and use more comprehensive analyses that include non-operating items to obtain a more accurate picture of financial performance during crises. Auditors should design specific tests to identify earnings management through classification shifting and enhance review quality during crises. External regulatory bodies should not reduce supervision but instead implement stricter regulations to oversee financial report quality and disclosure, ensuring firms provide greater transparency. Less supervision and less transparent reporting can exacerbate economic fluctuations during crises. These measures can help maintain and increase transparency and trust in financial markets and ensure optimal use of resources.
 
 
 
 

Abstract The accounting information quality and its relationship with financing decision-making is one of the important issues that attract interest from researchers. However, the way accounting information quality affects financing costs during the COVID-19 pandemic is a topic that has not been explored in domestic research. The purpose of this research is to investigate the effect of the accounting information quality on the cost of debt and to explore how this effect mainfested during the pandemic of COVID-19. In this regard, the data from 137 firms listed on Tehran Stock Exchange for 2012-2022 (1057 firm-years) have been analyzed. The generalized least squares (GLS) approach was employed to fit the models and fixed effects for years and industries were also controlled. The research results for the entire period demonstrate that an increase in accruals quality (as a proxy for accounting information quality) leads to the cost of financing through debts and this decrease is more pronounced for innate accruals quality than for discretionary accruals quality. Furthermore, the findings suggest that during the period of the COVID-19 pandemic, the impact of accruals quality and its innate and discretionary components on the cost of debt diminished. The results of the robustness tests using decile-ranked values of accruals quality support the main findings.

Introduction

The global pandemic of COVID-19 and the economic recession related to it brought many challenges to companies in most countries (Barai & Dhar, 2021). Due to the widespread effects of this disease and the various and costly measures taken by countries to control this pandemic, during the outbreak of COVID-19, the economic activities of companies faced a serious challenge (Aljughaiman et al., 2023). COVID-19 had a significant negative impact on the employment level of the workforce, reduced economic activity, and created high levels of uncertainty in many financial markets (Zhang et al., 2020). These conditions have most likely hurt the accounting information quality (Pham et al., 2023; Chen et al., 2023) and due to the inverse relationship between the accounting information quality and the cost of debt, it has led to an increase in the cost of debt. However, most of the empirical evidence in this regard is related to developed countries such as the United States, the United Kingdom, and Australia, and the evidence on emerging markets (such as the Iranian capital market) is limited in this regard. Therefore, this study aims to investigate the relationship between the accruals quality and the cost of debt and to compare the extent of this relationship during the COVID-19 pandemic and other years.

Literature Review

In accounting, accruals refer to a part of earnings that does not carry cash flow and is a product of the accrual accounting system. Therefore, accruals represent the difference between earnings and cash flows (Nallareddy et al., 2020). Since accruals are affected by managerial discretion, the accruals quality can be used to evaluate the accounting information quality and predict future cash flows (Le et al., 2021). The COVID-19 pandemic has significantly affected the global economy (Zhu & Song, 2021), involved many businesses in financial difficulties (Albitar et al., 2020) and intensified their dependence on resources provided by creditors and investors (Shen et al., 2020). Most likely, these conditions have affected the accounting information quality (Pham et al., 2023). During the COVID-19 pandemic, most companies have had enough motivation for earnings management (Lassoued & Khanchel, 2021). However, earnings management causes the financial information reported by companies to be inconsistent with their actual situation, and this means reducing the accounting information quality (Tariverdi et al., 2012). According to these materials, the research hypotheses are presented as follows:
H1: An increase in the quality of accruals causes a decrease in the cost of debt.
H2: In the period of the COVID-19 pandemic, the intensity of the effect of accruals quality on the cost of debt has decreased.

Methodology

This research is practical, analytical, quasi-experimental, correlational in terms of research purpose, and retrospective and post-event in terms of the time dimension of the data. To collect financial and accounting data, Rahvard Novin database and reports published on Codal website were used, and Stata software was used to analyze the data. To fit the models, the generalized least squares approach was used.

Results

The results show that compared to other years, during the COVID-19 pandemic, the accruals quality (the cost of debt) has decreased (increased) by 27% (35%). Also, the results indicate that an increase in accruals quality decreases the cost of debt. Furthermore, our results show that compared to other years, during the COVID-19 pandemic, the intensity of the effect of the accruals quality on the cost of debt has decreased.

Discussion

The research findings show that an increase in accruals quality significantly decreases the cost of financing. So, in order to reduce financing costs from debts, managers are advised to be diligent in improving the companies' accounting information quality. Finally, our results show that the cost of debt has increased during the COVID-19 pandemic, due to the decline in accruals quality and its components.

Conclusion

Our results show that with the increase in the quality of accruals, the cost of financing through debts has a significant decrease, and this decrease is more for the innate components of accruals quality than for its discretionary part. In addition, the findings indicate that during the COVID-19 pandemic, the intensity of the effect of the accruals quality and its innate and discretionary components on the cost of debt has decreased. The results of supplementary tests confirm the research main findings.

Abstract The existence of firms' excess cash causes resources to stagnate and, cash deficit causes loss of investment opportunities. Therefore, firms generally try to maintain an optimal level of cash holdings. In addition, firms attempt to quickly correct any deviations from the optimal level of cash holdings. The level of cash holdings and the speed of correcting the gap between the actual and the optimal level of cash holdings depend on several factors. The purpose of this study is to investigate the effect of the firm's business strategies (defenders and prospectors) on the level of cash holding and its speed of adjustment. In this regard, the data of 120 firms listed on the Tehran Stock Exchange (TSE) during 2013-2020 (960 firm-years) have been used. The static models are estimated using ordinary least squares (OLS) estimator and, the system generalized method of moments estimator (GMM) is used to estimate dynamic models. The results show that the prospectors have a smaller cash holdings ratio than defenders, and also, the prospectors have lower cash holdings speed of adjustment than defenders. The results of supplementary tests that confirm the research's main findings are consistent with the predictions made in trade-off theory.

Abstract One of the firms’ tools to provide a low-risk image is adopting a persistent dividend policy. However, it should be noted that due to financial constraints, many firms are unable to implement this policy in the long run. This research investigates the role of earnings quality in adopting a persistent dividend policy in 148 firms listed in Tehran Stock Exchange (TSE) (includes 1628 observations) during 2007-2017. To measure earnings quality, I use five proxies and to investigate their role in adopting a persistent dividend policy, I employ partial adjustment model and dividends adjustment speed concept. To estimate the models, I apply the Generalized Method of Moments (GMM) with system estimator. The research results show that compared with other firms, firms with lower total accruals, lower discretionary accruals, higher accruals quality, smoother earnings and higher overall earnings quality, are more able to conduct a persistent dividends policy. The research results using differenced-GMM estimator confirm the research primary results. These findings are consistent with the predictions of the signaling theory

Abstract
Some valuation models use the accounting earnings and others use the cash flows as inputs to
measure the intrinsic value of stocks. The empirical evidences show that the performance of
earnings-based models is generally higher than that of non-earnings-based models. In addition,
based on empirical evidences, earnings management that is done using accruals and real activities
manipulation; shift the earnings quality, and using the managed earnings in earnings-based
valuation models lead to incorrect results. The first stage of this research that is done on 116
firms listed in Tehran Stock Exchange from 2003 to the end of 2013 compares the performance of
Residual Income Model (RIM) and discounted cash flow model (DCF). The second stage compares the
performance of mentioned models in suspected and non- suspected firms to earnings management and to
control the effects of some variables on results, the regression analyses is applied. The research
results show that, although in total sample the performance of RIM is higher than that of
discounted DCF, the performance of RIM is significantly lower than that of DCF in suspected firms.

Abstract Some valuation models use the accounting earnings and others use the cash flows as inputs to measure the intrinsic value of stocks. The empirical evidences show that the performance of earnings-based models is generally higher than that of non-earnings-based models. In addition, based on empirical evidences, earnings management that is done using accruals and real activities manipulation; shift the earnings quality, and using the managed earnings in earnings-based valuation models lead to incorrect results.
The first stage of this research that is done on 116 firms listed in Tehran Stock Exchange from 2003 to the end of 2013 compares the performance of Residual Income Model (RIM) and discounted cash flow model (DCF). The second stage compares the performance of mentioned models in suspected and non-suspected firms to earnings management and to control the effects of some variables on results, the regression analyses is applied. The research results show that, although in total sample the performance of RIM is higher than that of discounted DCF, the performance of RIM is significantly lower than that of DCF in suspected firms.