Empirical Evidence on the Relation between Real Earnings Management and the Cost of Debt
Asian Tax Journal Vol. 16 No. 5 (2015), pp. 243-283
Abstract
The purpose of this paper is to test the impact of real earnings management on the realized cost of debt financing. Prior literature documents that raising capital provides incentives for real earnings management (hereafter REM) because managers tend to inflate earnings to reduce the risk premium (Graham et al. 2005). On the other hand, debt investors tend to focus on a firm’s ability to generate future cash flows to ensure the payment of periodic interest and the principal. REM activities distorts the quality of reported earnings, which can impact debt investors’ estimates of future cash flows. Because REM can have direct negative consequences on the level of future net cash flows, debt investors are likely to be concerned about and respond to REM activities. While accrual-based earnings management (AEM) only affects accrual numbers, REM boosts short-term earnings at the expense of distorting real operations (Roychowdhury 2006), it causes real operations to deviate from their optimal levels, with the primary objective of misleading stakeholders on underlying economic performance. Prior studies argue that REM is opaque to outside stakeholders and difficult to detect (Graham et al. 2005; Cohen et al. 2008; Zang 2012). Because they are not subject to external monitoring and scrutiny by auditors and regulators. In addition, REM could have negative consequences at the level of future cash flows (Leggett et al. 2009; Kim et al. 2009 etc). Given the negative effect of REM on the level of future cash flows, REM can affect debt value negatively. Since this paper focus on the impact of REM on the interest cost of borrowing, there is little evidence on how creditors in the debt market perceive REM. We study investigates whether debt investors require higher or lower risk premiums in response to REM. If debt investors perceive REM as opportunistic behavior, we predict a positive association between REM and cost of debt (managerial opportunism hypothesis). Similarly, if debt investors mistake REM earnings management for operational efficiency, we predict a negative association between REM and cost of debt (operational efficiency hypothesis). It is an open question whether potential debt investors perceive REM as an opportunistic behavior or an operational efficiency. Following recent REM studies (e.g., Roychowdhury, 2006; Cohen et al. 2008; Ge and Kim 2014 etc), we consider three types of REM are considered: sales manipulation, overproduction and abnormal reduction of discretionary expenditures. The test variables are four REM proxies (Ab_CFO, Ab_PROD, Ab_DISE, and comprehensive measure of REM is sum of Ab_CFO, Ab_PROD, and Ab_DISE). To capture the effect of REM via all three strategies or various combinations of the three strategies on the realized cost of debt financing, we develop a single, comprehensive measure of REM. And our proxy for AEM is the abnormal accruals from the performance-adjusted, as described by Kothari et al. (2005). We measure realized cost of debt as borrowing yield spread (YS), and use fractional ranks variable of YS. This paper define the realized cost of debt as the reported interest expense in a given year divided by the average of the interest bearing debt for that year and the preceding, and borrowing yield spread represents the difference between the interest rate on the firm’s debt and the average annual prime rate. To do this, this paper examines a relationship between REM and cost of debt using a sample of 10,479 firm-year in listed companies from 2001 to 2011. We examine all listed firms in the Korean stock market, tests are performed using a full sample of KOSPI and KOSDAQ listed firms. Findings of this paper are following. First, we find that cost of debt is negatively related to the proxies for abnormal overproduction, abnormal reduction of discretionary expenses and a comprehensive measure of REM. Overall, our results show that debt investors require a lower risk premium for firms engaging in REM. These findings suggest that accounting information plays an important role in the capital allocation process. In other words, the results suggest that debt investors fail to properly incorporate earnings management activities through REM for listed firms. Especially, this study reports the evidence that debt investors do not properly incorporate the information of REM. In that regard, our results also suggest that REM can be benefits to firms and thus for corporate managers to use REM and bring economic incentives. These results suggest that debt investors perceive real earnings management as evidence of operational efficiency and thus offer favorable pricing terms to firms with real earnings management. Overall, these results imply that, in the debt market, investors do not see through real earnings management. Similarly, with respect to the control variables, we find that the proxy for AEM is significantly negative associated with YS. This paper contributes to the understanding of how debt investors consider and reflect earnings quality into a firm’s borrowing interesting rates by investigating the effects of REM on borrowing yield spread. Because debt investors are known as experts in evaluating firm’s overall creditworthiness and its capacity to satisfy its financial obligations, a firm’s borrowing interesting rates determined by REM can have an important effect on the efficient resource allocation. Therefore, understanding the debt markets consequences of REM is important and interesting in its own merit. So, we expect the findings in the paper to have useful implications for scholars, practitioners, accounting standard setters, and regulators. Our study contributes to the REM literature. Also, academics can also apply the discussion in this paper for related researches.
Keywords
- Realized cost of debt
- Borrowing yield spread
- Real earnings management
- Accrual-based earnings management
- Managerial opportunism hypothesis
- Operational efficiency hypothesis
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