The Effects of Discretionary Accruals by Non－listed Firms on the Association between Earnings and Cost of Debt
Asian Tax Journal Vol. 12 No. 3 (2011), pp. 429-458
Abstract
This paper investigates the effect of discretionary accruals on the association between earnings and cost of debt in non-listed firms. Private Korean companies rely heavily on bank financing. The majority of short-and long-term debt and interest expenses reported in a private Korean company's financial statements represents the amount of borrowings from commercial banks and other private lenders and associated interest expenses, respectively. Thus, managers have incentives to manipulate earnings in order to reduce their firm's cost of debt. Previous research documents that the information risk of creditors is higher for poorer accounting quality on the firms (Francis et al. 2005 ; Bharath et al. 2008). Opportunistic earnings management makes a firm's financial reports to be of low quality as they impair current earnings' ability to reflect the true underly firm performance. Therefore, we test whether the negative association between earnings and cost of debt is attenuated in a firm with higher levels of discretionary accruals. Especially, our test focus on private firms than on public firms because the cost of debt plays an more important role in their capital structure than the cost of equity. We use two proxies for a firm's cost of debt : borrowing's interest rate and yield spread. As in other studies, we use an discretionary accruals as our proxy for the outcome of opportunistic earnings management is measured using performance-adjusted discretionary accruals in Kothari et al. (2005). The Sample used in the study are 35,579 firm-years observations not listed on the Korean Securities Exchange during the 2005-2009 period. The results of this study are summarized as follows. We find that there is a negative relation between earnings and cost of debt, and a positive relation between discretionary accruals and cost of debt. We also provide evidence that the intersection term of earnings and discretionary accruals is positively related to cost of debt, which means that the negative association between earnings and cost of debt is attenuated in a firm with higher levels of discretionary accruals. These empirical results suggest that the aggressive earnings management in private firms makes creditors to bear higher information risk and leads to the increased cost of debt. This is, the results of this paper suggest that the relationship between earnings and cost of debt varies depending on earnings quality. These results are still hold even after applying a fractional ranks variable rather than a continuous variable as a dependent variable. And also t-statistics from Newey and West (1987) and Clustering test are significant, suggesting that our results are robust. Therefore, we conclude the aggressive earnings management by discretionary accruals lowers the quality of reported earnings and then the reliability of accrual accounting information is reduced. Thus, these findings are very useful and provide a lot of important implications to regulators, investors and creditors that are interested in cost of debt.
Keywords
- Non－listed firms
- Discretionary accruals
- Accounting earnings
- Cost of debt
- Borrowing’interest rate
- Yield spread
- Debt market’s assessment
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