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Real earnings management and loan contract terms

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journal contribution
posted on 25.03.2019, 13:57 authored by Kostas Pappas, Eamonn Walsh, Alice Liang Xu
We examine the design of loan contract terms in the presence of borrower pre-issuance real earnings management (REM). Unlike other measures of earnings quality, REM is particularly difficult for outsiders to detect. However, lenders possess some private information which may allow them to correctly identify REM. Our empirical findings show that greater REM is associated with higher interest spreads, shorter maturities, a higher likelihood of imposing collateral requirements, and more intensive financial covenants, suggesting that lenders are likely to detect and penalise the borrower firm’s REM activities. These findings are robust to a series of sensitivity tests. In an additional test, we examine the impact of REM on bond terms and document that greater REM is related to higher bond yield spreads and more intensive covenants, but does not affect the maturity term or the collateral requirement. The findings in this paper can alert firms about the increase in borrowing costs when they use REM to boost current-period earnings.

History

School

  • Business and Economics

Department

  • Business

Published in

The British Accounting Review

Volume

51

Issue

4

Pages

373-401

Citation

PAPPAS, K., WALSH, E. and XU, A.L., 2019. Real earnings management and loan contract terms. The British Accounting Review, 51(4), pp. 373-401.

Publisher

Elsevier

Version

AM (Accepted Manuscript)

Rights holder

© Elsevier

Publisher statement

This paper was accepted for publication in the journal The British Accounting Review and the definitive published version is available at https://doi.org/10.1016/j.bar.2019.03.002

Acceptance date

13/03/2019

Publication date

2019-03-21

ISSN

0890-8389

Language

en