How do firms respond to governmental environmental pressure? Evidence from real earnings management

Purpose The purpose of this study is to investigate the impact of firm environmental protection expenditures on real earnings management (REM) behavior. Design/methodology/approach This study covers the financial years 2011–2020 for Chinese A-share listed companies. This study uses a propensity score matching sample and estimates the ordinary least squares regression model to test this relationship. Findings This study identifies a positive relationship between environmental protection expenditures and REM. Furthermore, firm financial constraints and ownership concentration can either positively or negatively influence this relationship. Mechanism tests suggest that operating cost burdens and CEO compensation incentives play a mediating role. Research limitations/implications This study highlights the importance of developing environmental policies that encourage firms to invest in sustainability while ensuring transparency in their financial reporting. The authors also suggest that policymakers develop regulatory mechanisms that lessen firms’ reliance on earnings management. Originality/value This study significantly contributes to the existing literature by incorporating the cost-burden effect and agency theory to clarify how investments in environmental protection can lead to increased earnings management.