ATJ Asian Tax Journal

Asian Tax Journal

Print ISSN 1738-3323 Online ISSN 2733-9270

The Effect of the Debt Dependance on the Association between Earnings and Cost of Debt in Private Firms

  • Park, Jong-Il Chungbuk National University College of Business Administration

Asian Tax Journal Vol. 14 No. 2 (2013), pp. 47-80

Abstract

The objective of this study is to investigate whether the negative relation between earnings level and cost of debt decreases with the level of leverage using a sample of private firms. We expect that the managers of high－leveraged firms would like to have a more opportunistic incentives to manage earnings. In addition, we expect that if creditors recognize the managers’ incentive, the relation between earnings and cost of debt will be affected by the level of leverage. Therefore, this study focuses on private firms because they heavily rely on debt markets to raise capital. We investigate whether the level of leverage affects the relation between earnings and cost of debt by focusing on the debt market’s responses to earnings management. To do this, we use two proxies for cost of debt, interest rates of debt and spread. The sample period covers from 2004 to 2009 and the sample consist of 40,362 firm－year data from private firms. The empirical test results are as follows. First, we find significantly positive relation between leverage and cost of debt after controlling the factors which are expected to affect cost of debt. We also find significant negative relation between earnings and cost of debt. Second, we find that the interaction terms on earnings and leverage are significant and positive even after controlling several factors which are expected to affect the level of cost of debt. The result shows that the negative relation between earnings and cost of debt decreases with the level of leverage. These findings indicate that debt investors consider both the level of earnings and leverage and evaluate the quality of earnings based on those factors. Therefore, the empirical results mean that debt investors regard the higher leverage as the higher possibilities of manager’s opportunistic earnings manipulation, that is, lower quality of earnings. We find consistent empirical results regardless of proxies of cost of debt(interest rates of debt or spread), the ways to measure dependent variables (practitional rank variable or continuous variable). In addition, these results do not change in additional test where using OLS regression, the method suggested to control the possibility of clustering attributes of data, and Newey and West(1987) method to alleviate the problem of cross－sectional and/or time－series dependence of data. The contributions of this study as follows. First, we focus on private firms in which cost of debt has more important implication because they do not have access to the stock market. Second, it shows that the relation between earnings quality and leverage can be differently evaluated by credit investor according to the level of leverage. In sum, while most of prior studies focus on listed firms in investigating management’s earnings manipulation based on debt covenant hypothesis, this study shows how the debt market actually evaluates the quality of earnings using the level of debt－ratio by focusing on private firms. We believe it is more appropriate for testing debt covenant hypothesis to focus on the private firms because they heavily relies on creditors rather than shareholders.

Keywords

  • Unlisted Company
  • Cost of Debt
  • Accounting Earnings
  • Debt/Equity ratio
  • Earnings Management
  • The Evaluation in Debt Market

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