Short-term debt maturity, monitoring and accruals-based earnings management
Introduction
Prior research on debt and earnings management generally assumes a detrimental effect for debt (see for example, Klein, 2002, Gupta et al., 2008). The underlying theme is to what extent debt causes insiders to manipulate accruals when the firm’s creditworthiness is in doubt. Examples include the use of accruals to avoid breaching covenants in debt contracts (DeFond and Jiambalvo, 1994) and to avoid lender enforcement (Gupta et al., 2008). We term these explanations financial distress theory. However, theory also suggests that debt may have a beneficial effect for financial reporting quality. Myers (1977), for example, suggests that debt’s beneficial effects are strongest when debt maturity is short, because the firm is required to approach lenders more often to obtain new loans, which disciplines insiders. Myer’s (1977) contention suggests that short-term debt may have a beneficial effect for earnings management, at least when creditworthiness of the firm is not in doubt. This is particularly relevant in practice, when reported earnings are generally regarded as one important factor in debt holders’ evaluation of the firm’s credit risk. For example, Treacy and Carey (1998) from The Federal Reserve Board report findings from interviewing individuals in large US banks that credit risk raters appraise the quality of financial reporting as well as the quality of management such as competency and integrity. The Comptroller’s Handbook of 2001 on Rating Credit Risk also expresses similar concerns on the borrower’s financial condition as well as the quality of management. As a result, more frequent appraisals in light of shorter term maturities are likely to serve also as a monitoring device that is likely to have a positive effect on the quality of financial reporting. In this paper, we examine whether accruals-based earnings management is lower in high creditworthy firms with more short-term debt.
Our study is motivated primarily by two factors. First, the empirical evidence on the relation between debt and earnings management is mixed; some studies find a positive relation, others find no relation and others, a negative relation. For example, Becker et al. (1998) find a negative relation between a leverage dummy variable and unsigned discretionary accruals which they attribute to financially distressed firms using income-decreasing accruals prior to contract renegotiation. Negative relations between leverage and unsigned discretionary accruals are also reported in Wang (2006) and Frankel et al. (2002), although these papers do not offer a reason. A recent study reporting a positive relation between unsigned discretionary accruals and debt is Klein (2002). Our survey (appendicized) of 43 papers published in 2006–2008 in eight finance and accounting journals, reveals that 18 papers explain accruals based earnings management using ordinary least squares regression. Of these 18 papers, 11 include a debt control variable and five give a directional prediction for its coefficient, all of which are positive.1 Results show that five of the debt variable coefficients are positive, two are negative and four are insignificant (see Table A1).2 Only two of these studies consider that debt can have benefits for financial reporting quality. The arguments for a monitoring role of lenders over management seem to have been ignored by most studies. Recently, finance studies have examined the beneficial effects of short-term debt. Datta et al. (2005), for example, argue that monitoring by lenders of short-term debt for firms with low liquidity risk can reduce agency costs, implying higher accounting quality.3 We posit that the failure to distinguish and model debt maturity structure arising for firms with high and low creditworthiness could contribute to the inconsistent empirical results documented in prior studies.
Second, there continues to be concern about the rampant earnings management in US companies (Levitt, 2007), despite the then chairman of the SEC, Arthur Levitt, proclaiming earnings management as a problem in 1998 (Loomis, 1999, p. 76). Earnings management is potentially detrimental to investors since it could adversely affect their resource allocation and management decisions (Bergstresser and Philippon, 2006). Prior studies that find evidence linking agency costs with variables such as director ownership and earnings management have called for more research on other agency cost variables that could affect earnings management (e.g. Warfield et al., 1995), but the pool of studies is still quite small and as such conclusions from these studies are at best tentative. Some studies examine internal governance mechanisms (Klein, 2002, Cornett et al., 2009), but despite the extensive prior research on the role of debt monitoring, there is no research of which we are aware that has examined the link between the agency-cost-reducing-role of short-term debt and earnings management.4 Evidence that can shed some light on the benefits of short-term debt in terms of earnings management is thus likely to be of interest to a wide range of market participants.
To examine how the firm’s creditworthiness affects the relation between short-term debt and earnings management, we identify a group of investment grade firms (firms rated by S&P as BBB- or above) as firms that are likely to have higher creditworthiness and investigate the difference in the association between short-term debt and accruals-based earnings management, which is measured as Kothari et al.’s (2005) performance-adjusted discretionary accruals. Drawing data for US firms from COMPUSTAT annual data files from 2003 to 2006 with debt at year end, we find a positive relation between short-term debt and the absolute value of discretionary accruals, consistent with financial distress theory for lower creditworthy firms.5 We also find that this relation is significantly weaker for high creditworthy (investment grade) firms, consistent with the monitoring theory. A beneficial effect of short-term debt on accruals-based earnings management can be explained by more monitoring from lenders (Myers, 1977, Rajan and Winton, 1995), by weaker financial-distress-related incentives to manage earnings in higher creditworthy firms and by stronger governance mechanisms in high creditworthy firms (Ashbaugh-Skaife et al., 2006). We therefore include a battery of controls for firm risk and governance mechanisms and we deal with possible endogeneity by using the method of instrumental variables and two-stage least squares. We acknowledge the alternative explanation that the weaker association between debt and earnings management for firms with higher credit ratings could be due to the lower incentive to manage earnings instead of stronger monitoring by creditors. We conduct additional tests that suggest that our results may not be purely driven by the different incentives of earnings management for firms with different level of creditworthiness. In particular, we use equity-based compensation as a measure of earnings management incentives and find that the effects of debt on earnings management are indeed more negative for investment-grade firms with more equity-based compensation. This result is more in line with our debt monitoring argument than the alternative argument of lower earnings management incentives for investment-grade firms. However, we acknowledge that this test only identifies a setting with low incentives but not directly measures high monitoring, and as such our results should not be interpreted as conclusive evidence to completely rule out this alternative explanation. We leave this for future research.
Our evidence contributes to the finance and accounting literature by showing that there could be benefits for accounting quality from lenders’ monitoring. Researchers have consistently documented the benefits from monitoring by internal governance structures. The literature is less developed on the benefits of debt monitoring to users of financial reporting. The literature generally assumes that debt is positively related to accruals-based earnings management. By showing that debt maturity structure also matters for earnings management, our paper highlights a possible cause for the inconsistency in results documented by prior studies. The second contribution is that this paper complements Gul and Goodwin (2010) who show that more short-term debt is associated with lower audit fees, and that this relation is weaker for firms with higher quality credit ratings. Our results suggest that the reason for the higher audit fees for firms with less short-term-debt structures could be the more accruals-based earnings management or the potential for it. Finally, this paper contributes to the finance literature by providing evidence consistent with the monitoring role of short-term debt (Datta et al., 2005). While these prior studies suggest that short-term debt structures are likely to provide monitoring benefits, there is little or no empirical evidence on the consequences of these claimed benefits especially for short-term debt structures. This paper provides evidence of the monitoring benefits of short-term debt in terms of constraining accruals-based earnings management behavior.
The next section presents the theoretical background and hypotheses, and this is followed in Section 3 by a discussion of the research design. Section 4 presents and discusses the results and Section 5 concludes.
Section snippets
Earnings management
A large body of evidence shows that managers manipulate earnings for a variety of reasons (see, for example, Healy and Wahlen, 1999, Park and Shin, 2004, Chou et al., 2006). Both practitioners and policy makers are concerned about earnings management because of the attendant problem of information asymmetry and the potential that shareholders’ wealth can be reduced (Teoh et al., 1998a, Teoh et al., 1998b, Levitt, 2007).
Managers have two main ways to managing earnings. They can either engage in
Methodology
To measure earnings management one needs to capture managers’ flexibility in adjusting the reported earnings. One convenient way that is available to managers in adjusting earnings is to manipulate accruals (for example, Warfield et al., 1995, Becker et al., 1998, Bartov et al., 2000). In particular, current accruals are considered easier to manipulate and are more correlated with firms’ operations and profitability (Bradshaw et al., 2001, Ashbaugh et al., 2003), and since current accruals may
Main findings
In this section we report results for testing hypotheses 1 and 2. Since short-term debt increases liquidity risk and consequently the incentive to manage earnings, we expect the coefficient for DEBT3 to be positive. Recall that our dummy variable is zero for non-investment grade firms so the coefficient for DEBT3 represents the effect of short-term debt on REDCA for non-investment grade firms. In addition, our expectation is that monitoring benefits are relatively stronger vis-à-vis financial
Conclusion and limitations
Due to financial distress reasons, prior literature on the relation between accrual-based earnings management and debt generally assumes only a detrimental effect for debt. Lenders and others perform a monitoring role over borrowers and this monitoring reduces agency costs. Theory and empirical evidence from the finance literature suggests that short-term debt is more likely to inhibit opportunistic behavior by insiders than is long-term debt. We examine the extent of opportunistic behavior by
Acknowledgments
We thank the editor (Bin Srinidhi), an anonymous reviewer, Andy Chui, Ferdinand Gul, Li Jiang, Justin Law, Chung-ki Min, Anthony Ng, Nancy Su, Steven Wei, Cheong H. Yi, Kevin Zhu, participants at the 2010 European Accounting Conference (Istanbul), and workshop participants at the Hong Kong Polytechnic University, Macquarie University and the National University of Malaysia for their helpful comments. Errors are ours.
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